Fishing in Revenue Streams

Revenue accounts are fraudsters' favorite targets in financial statement frauds because they often contain the largest numbers and high volumes of transactions within general ledgers. As CFEs, we need to understand the underlying causes and motivations for overstating revenues. But don't bury yourself in the ledgers; investigatory interviews and other analyses are imperative.

One of your longtime clients operates a growing local bicycle shop. For the past several years, the bank has allowed the shop to borrow money to purchase inventory just before spring. However, the bank is concerned about the poor national economy and the possibility of weak sales at the bike shop. The business' bank has extended a $100,000 line of credit, so it wants audited financial statements within 120 days of year end.

Levi, the bike shop owner, says he has to bring in the newest models by spring. "There's lots of competition these days and I'm asking my manager to really step up his efforts this year," he says.

Historically, the best sales months are in the spring and summer months. Levi tells you that he's contributed additional capital, in small installments, to the shop during the year. He says that over time, he's contributed $30,000 when the shop needed some extra cash.

Your staff conducts several interviews while planning the audit. The bike shop's bookkeeper says that Levi and the store's manager, Tom, are under a lot of pressure. Even though business has been good, both have spent a lot of time worrying about sales. Since late summer, the bookkeeper says, Tom has been interested in tracking the sales and receivables in the shop's accounting system. She says Tom has been so concerned that sometimes he's working after hours to "stay on top of things."

Most people have bought bikes with cash and credit cards, and the bike shop only recently started to offer financing to buyers. Historically, she says, receivables had been low; last year they were just more than $2,000. However, the bookkeeper says receivables this year were more than $16,000.

During the audit, your staff auditor prepares a reconciliation of revenues to cash receipts, and she was unable to reconcile revenues to receipts within an immaterial difference. The unreconciled difference indicates possible fraud: overstated revenues.

MOST COMMON FRAUD TECHNIQUE

In May 2010, the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, issued a report on "Fraudulent Financial Reporting 1998 – 2007" from a comprehensive analysis of 347 fraudulent financial reporting cases investigated by the U.S. Securities and Exchange Commission. COSO reported that one of the most critical findings related to revenues. The report indicated, "The most common fraud technique involved improper revenue recognition, followed by the overstatement of existing assets or capitalization of expenses. Revenue frauds accounted for 60 percent of the cases, versus 50 percent in [the prior COSO report covering] 1987 – 1997."

Asset/revenue overstatements are a sub-group of financial fraudulent statements in the ACFE Occupational Fraud and Abuse Classification System (the Fraud Tree).

WHY REVENUES MATTER

Revenues are an important measurement of growth and performance in almost all entities. Internal and external sources monitor revenues as a key indicator of financial health.

Given this information, it's easy to see that revenue accounts deserve special attention. U.S. auditing standards assume there's a risk of improper revenue recognition in all financial statement audits. As a result, you need to understand the underlying causes and motivations for overstating revenues and employ specific tools and techniques to detect fraud in revenue streams during their investigations.

WHAT MOTIVATES SOMEONE TO OVERSTATE REVENUES?

Lenders, analysts and investors with high expectations for growth and profitability can exert significant pressures on businesses. If companies don't meet these expectations, their ability to attract new investors and borrow money could be impaired. Also, lenders that see stagnant or declining revenues might force companies to renegotiate existing lines of credit with less favorable terms or rates. If the revenues are poor, bankers might deny needed new credit.

Other pressures come from internal sources. When compensation is tied to sales growth or other specific results, CFEs need to carefully review those results to determine if anyone has manipulated the numbers to trigger bigger paydays.

Key employees may circumvent weak internal controls if they're able to adjust sales figures. They can quickly record fraudulent entries if no one regularly reviews details of sales accounts or month-end adjustments.

Other fraudsters might consider overstatements as quick, one-time fixes for earnings shortfalls. If they can accelerate sales into the current period, they may rationalize that they're merely borrowing from next month's sales to provide for the current period needs. "Sales won't be overstated," they may say. "We are simply adjusting the timing."

METHODS TO OVERSTATING REVENUE

Overstatement schemes can be diverse and complex. We'll consider three possibilities.

First, companies can overstate revenues by simply falsifying individual sales on selected invoices. A second method is posting manual adjusting entries into the general ledger to increase revenues at the end of the month, quarter or year. A third method involves accelerating legitimate sales into an earlier period or by "holding the period open" until the desired results are achieved. This means real sales will be recorded in the wrong, earlier period.

Falsifying Individual Sales

From fraudsters' points of view, overstating individual invoices and managing false billing schemes are time-consuming and detailed processes. They have to continuously manufacture numerous documents and post monthly entries. And they will likely work with, through or around several accounting employees for extended time periods. Because the falsified invoices are buried in authentic-looking details, it can be difficult for the CFE to separate true invoices from false ones.

You might catch this type of fraud via tips and in-depth interviews. A non-fraud accounting department employee might notice senior management's unusual activity or involvement. For example, during an interview, an employee tells you, "She [the CFO] set up that client and has always handled that one herself because there were lots of credit memos and adjustments on that account." You should carefully consider why the CFO would be involved in this detail, which accounting clerks normally would perform.

You might identify suspicious transactions by testing for items posted at unusual times, such as weekends, holidays or before or after regular working hours.

Finally, fraudsters might falsify addresses on individual sales accounts. Culprits might use their home addresses to intercept auditor confirmations or other correspondence. So consider matching customer addresses to employee addresses.

Falsifying Sales by Journal Entries

Fraudsters know that they can simply overstate revenues by posting bogus adjusting journal entries because all they need is access to the general ledger. These sales adjustments would typically circumvent the normal sales, accounts receivables and cash receipts cycles. The frauds might be difficult to detect if the processes are complex or if the fraudsters post the adjustments among other entries in accounts with high volumes of transactions.

Review significant manually posted adjustments, and be particularly skeptical of entries posted at or near the end of a year. If the adjustments have large, round or even numbers, the amounts may be fabrications or estimates. Request and examine supporting detail for all large and unusual transactions at year end.

Finally, it's particularly important to account for the numeric sequence and completeness of adjusting entries at year end. If a controller falsifies sales by a manual entry, he or she is likely to exclude that adjustment when providing you with the listing of other adjustments posted at year end.

Recording Sales in the Wrong Period

A popular method of overstating revenues involves recording legitimate revenues in the wrong period.

Suppose, for example, ABC Company hopes to finish the year with $1 million in sales. If, in late December, the total sales are only $900,000, ABC has to book an additional $100,000 to achieve its goal. ABC's controller might be encouraged to hold the books open and record some of the first sales in January as December sales until the goal is achieved. The sales are legitimate sales; they're simply recorded in the wrong period. From the fraudster's view, this may be the best option. If he is caught, he can claim that the sales are real; he just made an error in timing.

Another reason for this method's popularity is that it's difficult to detect. Unless the CFE has collected other, specific cut-off information and tests for the improper postings with that specific information, this fraud probably won't be detected.

Again, tips and in-depth interviews might help catch this type of fraud. A non-fraud participant in the accounting department might notice unusual activity or senior management, such as a controller or CFO, involved in an area typically managed by an accounting clerk.

Additionally, you would want to analyze the sales cut off at the end of the year. This typically involves selecting several of the last items recorded as sales for the year and examining supporting documentation to determine if the sales are recorded in the correct period. This also works on the expense side. For example, if the company wants to inflate earnings, it might delay recording purchases and expenses. You would detect this by analyzing the purchase cut off just after year end. Select the first few purchases recorded in the new year and examine supporting documentation to determine if the purchases are recorded in the correct period.

DETECTING OVERSTATEMENTS

Don't rely on any single approach to detect fraud. Each engagement is going to be different. Use a variety of tools and detection techniques. We'll concentrate on three detection techniques: tips, a reconciliation of general ledger revenues to cash receipts and a revenue cut-off test.

The ACFE's "2010 Report to the Nations" identified tips as the leading fraud detection technique. Tips can come from internal or external hotlines and effective interviews. Employees are the first and best sources of information. As a first step in detecting overstatement schemes, interview sales and accounting personnel to better understand the flow of information, the processes and the controls.

Interview individuals at various levels — beginning at the lower echelons or staff members not considered suspects. Collect information about possible opportunities to misstate revenues, as well as the possible rationalizations and motivations of key players. Carefully document evidence of any significant weaknesses in internal controls or suspected fraud, errors or irregularities.

Here are some interviewing tips:

• For every word you speak in an interview, the interviewee should speak four.  
• Ask open-ended questions and offer the interviewee a confidential method for follow-up contact if desired.  
• Carefully ask about known or suspected errors, irregularities or frauds.  
• Ask if any staff compensation is based on the achievement of specific revenue results.  
• Ask if any staff members are experiencing financial difficulties or have any addiction issues.  
• Ask if any employees are "living large" or "living beyond their means." 
• Record all the answers and compare the responses to observations and the accounting data to see if the discussions agree with the data.   

A second step in detecting an overstatement scheme is to reconcile general ledger revenues to cash. Fraudsters can easily overstate revenues with a variety of methods, but it's more difficult to falsify cash in the bank. It's possible to isolate overstatements and cut-off errors and irregularities by reconciling revenues, per the general ledger, to cash receipts in the bank statements. However, the process isn't easy. In fact, most reconciliations require several hours of effort because of complex non-revenue cash receipts such as cash transfers, loan proceeds, interest income and changes in accounts receivable balances. But the reconciliation is worth the effort.

A third step in detecting an overstatement scheme involves running a cut-off test. This analysis requires you to:

• Extract transactions immediately preceding and immediately following the year-end date to determine if they're accurately reported in the correct period.  
• Analyze the supporting documentation.  
• Review the sales terms and sales agreements.  
• Consult the revenue recognition policies.   

Additionally, you need to determine when the risk of ownership passes. Generally, if the earning process is complete and the risk of ownership has passed, the revenue will be recognized. Conversely, if the seller has to provide additional services or retains ownership and possession of the property, the revenue is generally not recognized.

RECONCILING REVENUES TO CASH RECEIPTS

Let's take another look at the opening bike shop example. During the audit, your staff auditor prepares a reconciliation of revenues to cash receipts (See Figure 1 below.) and is unable to reconcile revenues to receipts within an immaterial difference. You decide to review the individual monthly sales and notice that sales peak in the spring and summer months and decline in the fall. (See Figure 2 below.)

[Figures 1 and 2 are no longer available. — Ed.]

February and December are notable exceptions. In February, the bank advanced $100,000 for the purchase of the new year's inventory. If you subtract $100,000 from the total cash deposits in February, the net cash receipts are $25,465.98. This approximates the February sales of $24,097.97. There appears to be no unexplained problems in February. However, December shows a more worrisome difference. According to Figure No. 2, sales for December exceed bank deposits by $26,870.53 ($70,396.49 less $43,525.96). You determine that you need to extend your testing of December sales figures.

At this point, you decide to instruct your staff auditor to capture certain cut-off information. The cut-off information shows the last five sales transactions for 2011 and the first five sales transactions for 2012. (See Figure 3 below.)

[Figure 3 is no longer available. — Ed.]

According to your cut-off testing work paper (Figure No. 3), the numeric sequence of sales invoices indicates no gaps. The sequence of invoice numbers looks okay; however, there's an issue with the dates. It appears that items one through five were delivered (or sold) in January but recorded in December. It now appears that Tom held the books open to record additional sales in 2011. At this point you would want to again extend your procedures to work backwards from invoice number 239501 (item No. 1 in Figure 3) to determine how many more invoices were improperly included in 2011 totals.

After you compile that list, you present your findings to Levi. When confronted, Tom acknowledges the improper recording of January sales into December totals.

ADDITIONAL TIPS

In addition to reconciling total sales to cash deposits and testing the cut-off, it's often worthwhile to review sales dates. It's not unusual for a bike shop to have weekend sales. However, it might be unusual for a bicycle manufacturer, for example, which probably only operates Monday through Friday, to have weekend sales. So always consider inquiring about reasons for journal entries posted on nights or weekends.

When sales were accelerated into December, you might also notice a lack of sales entries for the first few days in January. Looking at Figure No. 3, you can see there are no sales recorded between January 1 and January 6 because the shop accelerated those into December. If you detect gaps in sales dates or dates with no sales, this might indicate some of the January sales were pulled into the previous period.

TEST REVENUES AND INTERVIEW EMPLOYEES

Studies show that revenues are a favorite target in financial statement frauds. Tailor the tests for the revenue accounts to the particular circumstances of each case. Employ various tests on the detail of the sales transactions but always solicit tips and strive for open communication with the sales and accounting staff.

Ken Stalcup, CFE, CPA, is the litigation, valuation and forensics team manager of Somerset CPAs, P.C., in Indianapolis, Ind.

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