Revenue Inflation and Deflation: Detecting Fictitious Revenues in Financial Statements

Long before WorldCom and Enron, managers were inflating and deflating the numbers to increase stock prices, earn fat bonuses, comply with loan covenants, cover up asset misappropriations, and fund personal expenses, among other motives. 

"Bud," the controller of a large company, "Bacme Inc.," knew the financial picture looked dismal.1 But rather than admitting business was declining, he decided to "pretty up" the income statement. Prior to the auditors' arrival he inflated accounts receivable and revenue. The ruse worked so well, he tried it again the next year, and the year after.

Intentional misstatement of revenues became the fashionable fraud in 2002. But the crime existed long before WorldCom and Enron. In 1999 alone, more than half of the Security and Exchange Commission's (SEC) fraud cases involved falsifying revenue.

As stocks fizzle, Wall Street presses firms to keep earnings and share prices high. Also, stock options and bonus packages are pegged to company performance. After the SEC issued its Staff Accounting Bulletin No. 101 of Dec. 3, 1999, on revenue recognition, 32 companies changed accounting policies or restated revenue.

Auditors and fraud examiners need to know the revenue inflation (and deflation) red flags and learn the lessons from the well-known and obscure cases.

Let's revisit Bud and his efforts to pump up the numbers. In the early audits, he could easily conceal his misdeeds. Bacme's audit firm usually sent in junior auditors to confirm and audit accounts receivable.

Bud would make excuses for not confirming certain balances: a customer was located out of the country and it would take too long for a response, or the company's accounting department was a mess and it would not be able to provide an accurate response. Bud would then convince the auditor to review invoices and shipping documents that he had fabricated. He would also encourage the auditors to call customers on the phone in lieu of sending written confirmations of sales. He would dial the number of an alleged vendor and hand the phone to the auditor. The auditor would document whom he talked to and the response. The auditor would not realize that Bud was actually talking to an accomplice either down the hall or across the street at a pay phone. When the auditors did send sales confirmation forms to vendors they would unwittingly mail them to post office boxes set up by Bud the controller. He would collect the confirmations, forge signatures, and return them with the "no exception" box checked (which indicates that the respondent agreed with the information).

After several years of fooling the auditors, the fraud had grown to extremely large numbers. One year, Bud found a unique but desperate way to conceal the fraud. When the auditor was ready to deliver the confirmation forms, he accompanied Bud to the post office and watched him hand the stamped envelopes to the postal workers. However, Bud later rushed back to the post office and explained in a feigned panic that he had made a tragic error: Company A's statement had been placed in Company B's envelope, and so on. Acting like a man on the verge of a nervous breakdown, he explained that if the confidential information were mailed to the wrong address his company's reputation would be destroyed. He convinced the postmaster to retrieve the confirmations and so he was able to divert suspicion one more time. After Bud was finally caught he said if he could not have retrieved the confirmations he had enough dynamite to blow up the post office and that he was desperate enough to do it.

So why did Bud misstate the financial statements, lie to the auditors, and consider blowing up a post office? To protect his ego - he did not want to tell upper management and owners that his financial guidance had failed.

Here are some lessons auditors and fraud examiners can learn from this case:

• Know your clients and the industry in which they operate. Look beyond the financial statements to understand what unique risks exist.
• All members of the audit team must be professional skeptics.
• Do not be predictable. Bud said he knew the auditor's scope and sampling methodology therefore he could hide many fraudulent transactions.
• Make sure clients don't fabricate documents with desktop publishing software, scanners, color printers, and the Internet. Bud said he could fabricate any document if he had enough time. Smart fraud examiners will pull their own original documents as they need them. Sometimes we expose ourselves to additional risk by politely adjusting to our clients' work schedules.
• Do not allow fees to dictate staffing resources and the extent of work performed. Sometimes it is better to withdraw from the engagement than take on the additional risk.

Motives and Techniques 

Bud the controller may have misstated revenue because he had a big ego, but others do it to avoid reporting a pre-tax loss, earn bonus awards or stock options, bolster financial results to meet analysts' expectations, or fulfill corporate earning targets.

Others may be motivated to increase the stock price, comply with loan covenants, cover up asset misappropriation, obtain national stock exchange listing status or avoid de-listing status, or fund personal expenses.

Fraudsters may overstate by recognizing revenue on consignment sales in which merchandise is owned by someone else but the company receives part of the profit once it is sold to a third-party company. A fraudster may recognize 100 percent of the revenue at the time of the sale when the company is only entitled to a portion. The fraud examiner should ask the company about the existence of consignment inventory.

In a conditional sales situation, a customer will purchase a product only if certain conditions are met. A fraudster will wrongly recognize revenue on conditional sales that haven't been completed. Fraud examiners can discover this scheme by obtaining specific written representations from management about the existence of such arrangements, reviewing A/R agings, asking specific questions about past due balances, and confirming not just the dollar amount of the transaction but also the terms with the customer.

Fraudsters also may overstate by recognizing revenue:

• when ownership has not passed to the customer;
• on bill-and-hold transactions (companies will record sales revenue for goods that will be shipped later);
• on shipments not ordered by the customer or shipping defective product and not reflecting the return potential; or
• upfront on multi-year contracts.

Other techniques for overstating revenue include:

• backdating shipping documents;
• improperly using the percentage-of-completion method of accounting (GAAP allows a company to accrue revenue as work is being done but only if certain conditions are met);
• delaying recognition of returns;
• falsifying journal entries to record fictitious revenue; and
• falsifying sales with related parties.

Cases of Understated Revenue 

Revenues may also be understated to avoid taxes, reduce assets and income that could have an impact on divorce filings, or to conceal a theft. In two recent cases I have worked on, revenue was understated to conceal embezzlement.

The first involved a secretary at a church where there was little segregation of duties. The secretary would write and sign checks (although two signatures were required), receive and reconcile bank statements, post the general ledger, and prepare financial statements. On Sunday, two church members would collect the donations and take the receipts to the bank night depository for safekeeping but not deposit.

On Monday morning a church volunteer would pick up the collection money from the bank and take it to the church office. The volunteer and the secretary would count the money and prepare the deposit. The volunteer would enter the donor data into the computer system. At the end of each quarter, the secretary would send itemized contribution statements to donors.

Unfortunately, the computer system that would record the individual donations was not integrated to the general ledger. The church secretary would re-enter the collection amounts into the general ledger but usually for $1,000 to $5,000 less than the true amount deposited each Monday.

During the week following the deposit, she would write checks payable to cash for an amount equal to the reduction of the deposit recorded. The church used a manual check disbursement system. The secretary was good at convincing the secondary check signers to sign blank checks. No one questioned why the checks were written for cash. The local bank tellers cashed the checks with just her endorsement because they knew she worked for the church and was an authorized check signer. Because she would not enter the checks payable to the general ledger, she would not have to record the cash going out. Of course, the general ledger and cash would both balance.

The secretary eventually was caught by accident. A bank employee, who was also a member of the same church, was walking through the proof department and noticed a $2,000 church check payable to cash. He asked the church's finance director if this was a common transaction. The finance director reviewed the checkbook and noted that the stub in question was marked as void. On the back of the stub was the code NC2, which we suspected meant "no check for $2,000." He reviewed other checkbook pages and detected similar occurrences. That was the start of the fraud examination. In just 36 months the secretary had written checks to cash for more than $750,000. Had the investigation covered her 23 years as secretary at the same church the amount may have been in the millions; we found that she had written checks to cash for even amounts in the early years of her job.

After numerous congregational meetings, the church decided not to prosecute the secretary. She is working as a church secretary in another state.

The church now reconciles the donor statements to the general ledger. A person totally independent of the bookkeeper now receives, opens, and reconciles the bank statements. The church also segregated duties and prohibited authorized check signers from signing blank checks. A local CPA firm annually reviews the financial statements and controls.

We found another perpetrator at a towing company using a similar scheme. The bookkeeper would pull invoices out of the week's work and take a similar amount of money out of the safe before she or one of the owners deposited it. Since no one would account for the numeric sequence of invoices, the fraud was not detected. The owner only discovered the crime when he found a list of the monies that she stole. According to her list, the fraud covered an eight-month period for $25,000 but the owner's expert witness said she had stolen more than $250,000 since she was hired five years before. However, because of weak internal controls, employees' knowledge that the owners frequently took cash from the business, and several employees having access to the money in the safe, we couldn't validate the $250,000 figure.

Like a Fine Wine 

Businesses can understate or overstate revenue for eventual financial gain. Hundreds of firms do so every year without being caught. "Investors have lost tens of billions of their savings … as a result of financial fraud involving improper revenue recognition," said Lynn Turner, former chief accountant for the SEC.2 "It is time to make sure revenue, like a fine wine, is not booked before its time," he said.
As fraud examiners we need to recognize the red flags of revenue inflation and deflation long before they become mini-WorldComs or Enrons and the lawyers reveal the nasty details in bankruptcy court.

1 Names and details have been changed.
2 Speech given by Lynn Turner, then chief accountant of the Securities and Exchange Commission, May 31, 2001.

Donna Ingram, CFE, CPA, is a partner with May & Company in Vicksburg, Miss. She has served as president and treasurer of the Association's Central Mississippi Chapter.