Efficient Tests of Balances Series--No. 40: Audit Evidence and Auditing Procedures for Revenues--Fraud Risk and Audit Planning
SAS No. 99, Consideration of Fraud in a Financial Statement Audit (Redrafted AU-C 240), requires an auditor to consider improper revenue recognition as a potential fraud risk on all audits. If improper revenue recognition is not identified as a fraud risk, the auditor is required to document the reasons why.
SAS No. 99 (AU-C 240) indicates that an audit should be planned and executed with appropriate professional skepticism. Practice Alert 98-3, Responding to the Risk of Improper Revenue Recognition, issued in November, 1998 and updated through April 15, 2004, identifies these conditions that may increase the risk of misstatement:
- A change in the company’s revenue recognition policy.
- New product or service introductions or new sales arrangements.
- Sales terms that do not comply with the company’s normal policies
- Existence of longer that expected payment terms or installment receivables.
- Significant sales or volume of sales that are recorded at or near the end of the reporting period.
- Individually significant sales.
- Unusual or complex revenue transactions.
- Unusual volume of sales to distributors/resellers.
- Sales billed to customers prior to the delivery of goods and held by the seller.
- The use of non-standard contracts or contract clauses.
- The use of letters of authorization in lieu of signed contracts or agreements.
- Transactions with related parties.
- Transactions involving barters, swaps, “round trip” or “back to back.”
- The existence of “side-agreements.”
- Multiple-element arrangements.
- Revenue recognition when right of return exists.
- Control environment considerations, such as:
- Aggressive accounting policies or practices.
- Pressure from senior management to increase revenues and earnings.
- Lack of involvement by the accounting/finance department in sales transactions or in the monitoring of arrangements with distributors.
As mentioned above, SAS No. 99 requires auditors to conduct a “brainstorming meeting” during engagement planning. Considering common revenue recognition frauds will make such meetings more effective. Practice Alert 98-3 mentions the following revenue recognition frauds:
- Sales in which evidence indicates the customer’s obligation to pay for the merchandise depends on:
- Receipt of financials from a third party.
- Resale to a third party.
- Fulfillment by the seller of material unsatisfied conditions.
- Sales of merchandise that are shipped in advance of the scheduled shipment date without evidence of the customer’s agreement or consent.
- Pre-invoicing of goods that are in the process of being assembled or invoicing prior to, or in the absence of, actual shipments.
- Shipments are made after the end of the period.
- Sales are not based on actual orders to buy.
- Shipments are made on cancelled or duplicate orders.
- Shipments are made to a warehouse or other intermediary location without the instruction of the customer.
- Shipments that are sent to and held by freight forwarders pending return to the company for required customer modifications.
- Altered dates on contracts or shipping documents.
Auditors’ responses to potential fraud risks can be numerous and varied. Practice Alert 98-3 lists these among others:
- Comparing revenue reported by month and by product line or business segment (disaggregated data) from the current period with the prior period.
- Confirming with customers certain relevant contract terms and the absence of side agreements.
- Inquiring about any sales near the end of the period and any related unusual terms or conditions.
- Performing appropriate sales cutoff procedures.
- Testing controls for electronic systems.
- Performing a detailed review and investigation of any client adjusting journal entries that appear unusual.
- Scanning (reading) the general ledger, accounts receivable sub-ledger and sales journal for unusual activity during the year and a period subsequent to the balance sheet date..
- Analyzing and reviewing deferred revenue accounts for propriety of deferral.
- Analyzing and reviewing credit memos and accounts receivable adjustments for a period subsequent to the balance sheet date.
- Reviewing significant year-end contracts and periods subsequent to the balance sheet date for related revisions, cancellations, returns, credits, etc.
- Confirming sales agreements and the absence of right of return and other terms that might affect the period of recognition.
Any improperly recorded revenues should be considered for an adjustment proposal, discussed with management and included in the communication to persons charged with governance.
For more information regarding auditing revenues and other financial statement classifications, live and on-demand webcasts, and self-study courses, are available by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com.