Early revenue recognition has long accounted for a substantial portion of financial statement fraud. By recording revenue early, a dishonest business seller or an employee under pressure to meet financial benchmarks can significantly distort profits. Fortunately, fraud experts have tools for catching revenue recognition fraud.

Multiple methods

Early revenue recognition can be accomplished in several ways. A dishonest owner or employee might:

• Keep the books open past the end of a period to record more sales,
• Deliver product early,
• Record revenue before full performance of a contract,
• Backdate agreements,
• Ship merchandise to undisclosed warehouses and record the shipments as sales, and
• Engage in bill-and-hold arrangements.

In this last scenario, a customer agrees to buy merchandise but the company holds the goods until shipment is requested. It and any of these schemes might be carried out by one employee or several in collusion.

Catching revenue recognition fraud: expert strategies

Probably the most obvious marker for early revenue recognition is when a company records a large percentage of its revenue at the end of a given financial period. Significant transactions with unusual payment terms can also be a danger sign. When these or other red flags are unfurled, it’s time to investigate.

Fraud experts might compare revenue reported by month and by product line or business segment during the current period with that of earlier, comparable periods. They typically employ software designed to identify unusual or unexpected revenue relationships or transactions.

Reading the signs

If, for example, an expert suspects merchandise is billed before shipment, he or she will look for discrepancies between the quantity of goods shipped and quantity of goods billed. The expert will also examine sales orders, shipping documents and sales invoices; compare prices on invoices with published prices; and note any extensions on sales invoices.

What if the expert suspects merchandise was shipped prematurely? He or she compares the period’s shipping costs with those in earlier periods. Significantly higher costs could indicate an early revenue recognition scheme.

The expert also may sample sales invoices for the end of the period and the beginning of the next period to confirm the associated revenues are recorded in the proper period. If phantom sales are suspected, reversed sales in subsequent periods and increased costs for off-site storage may provide evidence of fraud.

Exposure can be fatal

If improper revenue recognition is exposed to the public, the resulting scandal can destroy a company. Contact me immediately if you suspect it or other forms of financial statement fraud.

(This is Blog Post #622)