Efficient Tests of Balances Series--No. 36: Revenue Misrepresentations in Financial Statements

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Common Financial Statement Misrepresentations

Citizen Works, a nonprofit corporation founded by Ralph Nader, produced “The Corporate Scandal Sheet” which presented 41 major scandals involving corporations and large accounting firms that occurred in the five years or so up to and including 2002.  These findings remain the cause of misrepresentations in today's financial statements. The causes of the scandals can be summarized in four main categories:

   Causes of Scandals                                                                Number of Cases

Off-balance sheet loans or accounting activity.                                      4

Various violations of laws.                                                                    8

Accounting errors overstating net income.                                             10

Improper revenue recognition.                                                               19

Reading further documentation of these scandals will reveal that many of improper activities involve simple manipulations of income.  WorldCom, for example, simply capitalized certain operating expenses and arbitrarily reduced its allowance for uncollectible accounts.  Enron and others created vehicles and contracts in order to record immediate revenues and, at the same time, ignored potential losses inherent in the agreements.  At least four of the energy companies increased revenues using artificial “round trip” energy trades to inflate income.  At least two telecommunications companies used network capacity swaps with other similar companies to inflate revenues.

For decades, most auditors of large corporations performed limited tests of internal controls and analytical procedures to verify financial statement assertions for revenues.  This list of scandals gives us understanding about why current accounting and auditing standards revisions focus on revenue recognition.

Improper Revenue Recognition in Smaller Entities

Many CPA firms have experienced revenue recognition problems with smaller clients.  Here are a few examples:

  • A nightclub that continually reports a very low gross margin from beer and liquor sales (Skimming).
  • An operator of nursing homes includes numerous relatives on multiple payrolls (Inflating Medicaid reimbursements).
  • A construction contractor that purchases all materials for certain contracts to increase actual costs before its year end (Dumping materials at sites to inflate the percentage of completion).
  • A trailer leasing company that bills customers for extra, unused trailers each month (Fraud).
  • Products shipped subject to customer approval are recorded before receiving such approval (Improper cutoff).
  • Billing customers for products shipped on consignment, or before products are shipped and recording revenue prematurely (Inflating revenues).
  • Recording multi-year contracts, or revenues benefiting future periods, at the date of the contract or customer order (Improper matching of costs and revenues).
  • Recording grant revenues when received rather than as expended (Improper matching costs and revenues).
  • An entity that won’t provide inventory quantities and pricing information until the CPA informs management of the taxable income before the inventory adjustment (Fraud).  Ouch!  This one could be personal!

We can see from the discussion above that opportunities for misrepresentations of revenue recognition are many and varied.  Some may be inadvertent and some may be intentional.  In the materials that follow, we’ll discuss approaches to enable auditors to effectively verify financial statement assertions and respond to risks of material misstatements due to error or fraud.

This subject and others are included in my live and on-demand webcasts which can be accessed by clicking the applicable link on the left side of my home page at www.cpafirmsupport.com.


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