PICPA - Improper Revenue Recognition: A Problem for the Profession

Improper Revenue Recognition: A Problem for the Profession

Winter 2000

Rose Marie L. Bukics, CPA, and John M. Fleming, CPA


During the past several years, numerous incidents of improper revenue recognition have occurred in companies large and small. Recently, the Committee on Sponsoring Organizations of the Treadway Commission issued its landmark 11-year study of fraudulent financial reporting indicating that improper revenue recognition is a significant problem in business today.

Meanwhile, Arthur Levitt, Chairman of the SEC, has declared war on what he classifies as deliberate attempts to manage earnings. In a recent speech entitled "The Numbers Game," Levitt outlined five areas of accounting that he classified as "hocus pocus." Improper revenue recognition was among the five items cited.

The fraudulent financial reporting study and the content of the Levitt speech indicate that internal and external CPAs are not always alert to the possibility of intentional misstatement of revenue by clients or management. Therefore, opportunities to prevent or detect improper revenue recognition are often missed.

This article is designed to identify improper revenue recognition techniques and recommend prevention and detection actions that internal and external CPAs can take to minimize the possibility of improper revenue recognition occurring.

Revenue Recognition Requirements
While revenue recognition should seem straightforward, recent reports of various techniques used to manipulate the recording and reporting of revenue might suggest the need for a closer examination of the topic. What lessons can be learned from the recent problems uncovered through investigations by various authorities? The primary lesson is that CPAs need to exercise additional care when assessing whether the existence or timing of revenue recognition is appropriate for the circumstances that underlie each transaction.

Revenue or gain is recognized when the value of an asset is enhanced as a result of an exchange transaction. Alternatively, revenue or gain can result from a transaction that causes a liability to decrease. It is important to note that the definition of revenue comes implicitly from the definition of assets and liabilities (of course, not all asset increases or liability decreases are caused by revenue transactions). Thus, when determining whether revenue has been recognized in a particular transaction, the basic question to be answered is whether or not an asset has increased in value, or a liability has decreased in value (or a combination of both) due to a product or service transaction. If the answer to the question is yes, then revenue should be recognized.

Two practical requirements exist for revenue recognition. The first is that revenue must be earned; the second is that the amount must be realized or realizable. Earned is usually understood to mean, "when the sales process is complete," i.e., the transfer of legal title to goods, which is generally evidenced by delivery of a product, or the completion of services rendered. However, situations in which revenue is recognized prior to or after delivery of the product or service are also acceptable in certain cases. These situations can often require closer examination to determine whether the revenue recognition is proper. Examples of recognizing revenue before or after delivery include contract accounting, bill and hold transactions, installment sales and sales of multiple element software.

While the delivery of goods or providing of services is often the event of substance for the recognition of revenue, other issues can cloud the determination of when to properly record revenue. For example, revenue recognition before or after the delivery of goods or services, the different types of goods or services provided and the wide range of industry revenue recognition alternatives, can introduce complexities into what may have appeared to be a straightforward transaction.

In addition to timing considerations, one must also consider the pressures exerted to make sales quotas, earnings estimates or other forecasts that are considered key to a company's performance. Such external pressures may dictate that CPAs need to be increasingly aware of some of the improper techniques used to manage the reporting of revenues.

Consider some of the more common improper revenue recognition techniques, most of which have been publicized recently:

* Shipping consigned inventory to resellers and recognizing revenue upon shipment.

* Recording product shipments to company-owned facilities as sales.

* Recognizing revenues when products sold have a right-of-return provision.

* Recognizing revenue before software development commitments were fully performed.

* Reinvoicing past due receivables to improve the age of receivables.

* Pre-billing future expected sales.

* Overstating percent complete when using contract accounting.

* Leaving the books open at the end of the reporting period.

* Performing duplicate billings.

* Creating fictitious customers and fictitious revenue transactions.

Improper Revenue Recognition Risk Factors
While many different techniques can be used to enhance the recognition of revenue, the existence of the following identifiable risk factors should alert CPAs to the problems these techniques produce.

* Incentive Compensation Plans—The existence of incentive compensation plans linked to revenue or income targets increases the risk that management may take actions to inflate revenue to achieve these targets.

* Close to Violating Bank Debt Covenants—When it appears an entity may violate its debt covenants, the management of the entity may take actions to improve the performance criteria that make up the debt covenants.

* Significant Loan Guarantees by Owners or Members of Management—When significant personal loan guarantees exist for company debt and a company is having performance problems, owners or management may take steps to prevent the loan guarantees from being called.

* Planning an Initial Public Stock Offering—Ownership or management may attempt to improve reported performance in order to increase the potential price of shares offered in an IPO.

* Industry is Highly Vulnerable to Changing Technology or Product Obsolescence—Some companies are at increased risk due to the nature their products or the development of competitors' products. To continue showing high growth or increasing profits, managements of these companies may resort to fraudulent tactics to appear to be performing in a more positive light.

* Loss of Major Customer(s)—Loss of major customers puts increasing pressure on management to demonstrate that the loss is not significant and performance is not greatly affected. Management may take fraudulent actions to hide the negative impact of these conditions.

* Increase in Related Party Transactions—When a company is having financial or reporting problems, it may resort to using its related parties to fraudulently create transactions which improve the reported performance of the entity.

* Unusual Sales Volume at Year-end—This activity may indicate that management has overstated revenue at year-end to improve reported performance.

Although the risk factors discussed above may exist in a company, using any of the improper revenue recognition techniques identified earlier can occur only if the operating environment is conducive to such techniques.

To prevent such a situation, effective deterrents to improper revenue recognition can be operational in the workplace.

Deterrents to Improper Revenue Recognition
Establishing and Maintaining an Effective Control Environment
One of the first deterrents to improper revenue recognition is for management to recognize and actively embrace its responsibility for an effective control environment. Designing an effective internal control environment is essential in preventing or detecting improper revenue recognition activities. Creating such an environment requires a three-step process: setting the tone at the top, linking employees' goals and objectives to company goals and objectives, and ensuring that the internal control system is properly implemented and monitored.

The tone at the top is the first consideration when evaluating an operating environment. Management must establish a corporate culture that creates an operating environment that constantly communicates what is and is not acceptable behavior for management and employees and provides incentives and disincentives to support this behavior. Management must lead and empower employees to work toward common goals and recognize that if improper business or accounting activities take place, these activities are identified and corrected.

A lack of commitment by those responsible for the system may indicate an operating environment that is vulnerable to improper revenue recognition methods. Such problems can flourish when there is limited oversight and commitment by management or the board of directors. Further concern should arise in an operating environment that permits management to override controls designed specifically to prevent or detect errors or fraud.

The second step in designing an effective internal control environment is linking management and employee goals and objectives to company goals and objectives. Successful and ethical organizations are able to motivate employees to work toward organizational goals and objectives if the organization can demonstrate that by achieving the organization's goals the employees also achieve their individual goals and objectives. For example, management staff 's need for performance rewards can be achieved through the earning of stock options. Staff needs for recognition can be achieved by reward and publicity activities. In addition, employees' need for flexible work arrangements can be provided based on certain performance criteria. Their need for career development can be met by a tuition reimbursement program, also based on certain performance criteria.

Linking of employee or management goals to organizational goals reduces the potential motivation by management and employees alike to participate in improper revenue recognition activities.

The third step is to ensure that an internal control system is properly implemented and that the control environment is actively monitored by independent internal control processes. This requires that a company have an evaluative mechanism within the system to determine whether the control procedures are being used and to determine whether they are effective.

This may lead to a periodic redesign of the system if necessary. Of course, the lack of an effective internal control environment and the use of ineffective internal control policies and procedures create an operating environment that can be easily manipulated. Internal controls serve as the first line of defense in deterring improper revenue recognition activities.

Establishing and Maintaining an Effective Internal Audit Function
For those organizations large enough to maintain an internal audit function, an independent internal audit group can be very effective for preventing or detecting improper revenue recognition. Internal audit teams routinely perform operational and compliance reviews which, if done properly, would identify materially unusual or unexpected relationships and investigate their causes. Even smaller entities could benefit from applying internal audit procedures by periodically using their external audit firm, by applying industry benchmarks to performance, or by engaging a member of the organization's trade association to perform an operational review.

Effective Use of Analytical Procedures
Analytical procedures can be a powerful tool to identify unusual or unexpected trends or relationships within an organization. The effective use of analytical procedures requires that the CPA understand the organization's business and industry and the accounting principles being followed by the organization. In addition, the CPA must develop an understanding of the industry trends and relationships within the organization's specific industry. Once these understandings have been achieved, the CPA can develop expectations concerning trends and relationships and meaningfully compare those expectations to reported financial information.

For example, the following ratios would alert the CPA to unusual or unexpected revenue relationships within an organization.

* Accounts Receivable Turnover—Net Credit Sales / Average Accounts Receivable

* Days Sales Outstanding—360 Days / Accounts Receivable Turnover

* Quality of Earnings—Cash Flow from Operations / Net Income + Depreciation

* Gross Profit Margin—Gross Profit / Sales

* Profit Margin—Net Income / Sales

* Cash Flow Return—Cash Flow from Operations / Sales

In addition, certain nonfinancial ratios may prove very meaningful in identifying improper revenue recognition. For example:

* Predicting sales for a retailer by multiplying industry average sales per square foot to amount of retail space available for selling.

* Predicting sales by determining average sales by customer and multiplying average sales by the number of customers.

* Predicting tuition revenue in an academic environment by multiplying student tuition by the number of full-time equivalent students enrolled.

* Determine industry average sales per employee and multiply result by the number of employees within the organization.

* Determine industry average for average gross profit per employee and multiply result by the number of employees within the organization.

* Determine the number of meals served in a hospital to calculate number of patient days multiplied by average daily hospital charges to predict hospital revenue.

* Obtain cleaning staff's log of rooms cleaned to compute hotel occupancy multiplied by daily room rates to predict hotel revenue.

* Determine the number of napkins laundered to calculate number of meals served in a restaurant and multiply by average meal charge to predict restaurant revenue.

* Determine the number of cups used by a concessionaire to calculate the amount of beer or soda served multiplied by the beer or soda's selling price to predict concessionaire revenue.

* Obtain a doctor's appointment calendar to determine the number of appointments and multiply appointments by average patient charges to predict the doctor's revenue.

A final observation concerning the use of analytical procedures is appropriate. Disaggregated analytical procedures (by month, by product, by profit center, etc) are more powerful than period to period analytical procedures. Disaggregated analytical procedures permit the CPA to assess more closely unusual trends and relationships by focusing on the root causes of the trend or relationship, not simply the result of the unusual trend or relationship. For example, if an organization wrote off past due customer accounts receivable balances in one period, then rebilled the customers, the unusual increase in reported sales would be more apparent in a disaggregated analysis than in a period-to-period analysis.

Increased attention to the risk of improper revenue recognition will improve the chances of early detection or even preventing it in the first place. Ensuring an effective control environment, linking employee goals to organizational goals, implementing and monitoring internal controls and effectively using analytical procedures are significant and effective steps a CPA can take to minimize the possibility of improper revenue recognition going undetected.

Rose Marie L. Bukics, CPA, is a professor of economics and business at Lafayette College in Easton.

John M. Fleming, CPA, is the director of auditing and accounting at Loscalzo Associates, P.A. He is president of the PICPA Greater Philadelphia Chapter.

Copyright Pennsylvania Institute of Certified Public Accountants Winter 2000