Efficient Tests of Balances Series--No. 34: Improper Revenue Recognition
In January, 1999, the AICPA published Audit Issues in Revenue Recognition which identified circumstances and transactions that may signal improper revenue recognition. As subsequent publicized misrepresentations in financial statements have demonstrated, there is nothing new under the sun, at least for improper revenue recognition! Some of the examples mentioned in the AICPA report include the following:
- Letters of intent are used in lieu of signed contracts.
- Products are shipped before the scheduled shipment date without the customer’s approval.
- Products can be returned without obligation after a free “tryout” period.
- Customers can unilaterally cancel a sale.
- Obligations to pay for products are contingent on a customer’s resale to a third party or on financing from a third party.
- Sales are billed for products being held by the seller before delivery.
- Products are shipped after the end of the period.
- Products are shipped to a warehouse (or other intermediate location) without the customer’s approval.
- Sales are invoiced before products are shipped.
- Part of a product is shipped and the part not shipped is a critical component of the product.
- Sales are recorded based on purchase orders.
- Obligations to pay for the product depend on the seller fulfilling material unsatisfied conditions.
- Products still to be assembled are invoiced.
- Products are sent to and held by freight companies pending return to the seller for required customer modifications.
- Products require significant continuing vendor involvement (such as installation or debugging) after delivery.
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).
Efficient substantive procedures auditing revenues and other account classifications resulting from cost-beneficial audit strategies are discussed in my live and on-demand webcasts which can be accessed by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com