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.