Auditor Skepticism and Revenue Transactions
By Jimmy W. Martin
When Skepticism Is Healthy—Even Necessary
The accounting profession has long devoted considerable effort to defining the requisites for revenue recognition. FASB, the SEC, and the AICPA have covered the subject in various pronouncements, and studies from Treadway to Jenkins have cited the need for additional attention. Nonetheless, embarrassing cases such as Lucent, Microstrategy, Sunbeam, and Xerox haunt the profession.
This article analyzes the recent problems to determine what can be learned from them. The author studied SEC Accounting and Auditing Enforcement Releases (AAER) issued over the past decade, focusing on those related to revenue recognition. From this study of the AAERs, he identifies and discusses problem areas that contribute to the numerous accounting failures, and points out issues auditors should consider when gathering evidence to support their opinion on financial statements.
No area has perplexed auditors more in recent years than revenue transactions. Prominent cases in the late 1990s, including Cendant and America Online, and more recently Lucent, Microstrategy, Sunbeam, and Xerox, illustrate the problems of recording revenue. Various studies, from the Treadway Commission in 1987 to the Jenkins Committee in 1994, have cited the need to focus on revenue recognition problems. In 1999, the AICPA issued the white paper Audit Issues in Revenue Recognition, which attempted to address the issues. SEC Staff Accounting Bulletin (SAB) 101, issued in late 1999, raised several revenue recognition questions and provided some much-needed guidance. In 2000, the SEC staff issued Revenue Recognition in Financial Statements: Frequently Asked Questions and Answers to further clarify staff views on revenue recognition. That same year, the Public Oversight Board (POB) Panel on Audit Effectiveness issued its Report and Recommendations, a portion of which addressed the revenue area. Finally, in 2001 the AICPA published an audit guide on revenue recognition.
The author reviewed revenue-related Accounting and Auditing Enforcement Releases (AAER) issued by the SEC during the 1990s to determine where accounting failures occurred and what lessons can be learned from those mistakes. Many of these releases relate to companies in high-growth areas such as technology, and the research identifies several high-risk areas that auditors should view with increased skepticism.
When companies recognize revenue, they assert that a transaction actually occurred, and was recorded on a timely basis at the proper amount. A revenue transaction occurs when a company transfers goods or services to a customer, the earnings process has been substantially completed, and the likelihood of collection is reasonably assured. While revenue is generally recognized when service is rendered or merchandise is shipped, various problems may cast doubt on the economic substance of the transaction.
Occasionally, a company may record sales revenue for goods that will be shipped later. The auditor must examine this arrangement— a “bill-and-hold” or “ship-in-place” transaction—closely. Such transactions may merit revenue recognition, but the risk is high. The SEC, in AAER 108, stated several criteria a company must consider before recording a bill-and-hold transaction as revenue (see Exhibit 1). For example, if the customer has a legitimate reason for requesting delayed shipment, such as a temporary lack of storage space, revenue recognition may be proper.
Auditors must be unusually skeptical before accepting such revenue as legitimate. Assuming that bill-and-hold goods are material, the description and quantity of goods should be confirmed directly with the customer. In addition, the auditor should ask the customer to explain the business purpose behind the delayed shipment.
An egregious example of the customer not having a substantial business purpose is found in AAER 1393: Sunbeam Corporation induced its customers into accelerating purchases by offering discounts for buying seasonal merchandise months before they normally would. Sunbeam offered to store the off-season merchandise until the customer needed it. The SEC concluded that the buyer did not have “a substantial business purpose for ordering on a bill-and-hold basis when its only motive is to obtain the various inducements offered by the seller.”
Although some companies may provide letters signed by the customer that request a delayed shipment, such a letter does not by itself provide adequate evidence that a revenue transaction has occurred, because the company may have persuaded the customer to write it. Some kind of direct customer contact is necessary in order to obtain critical information about the transaction. Exhibit 1, which is partly based on AAER 108, contains several key questions that auditors should consider before accepting that revenue on bill-and-hold transactions is properly recorded. The SEC does not claim these questions are all-inclusive; in fact, AAER 108 and SAB 101 state that it is possible for a transaction to meet all of these criteria and still fail to meet the revenue criteria. Auditors must always consider the economic substance of the transaction before attesting to the client’s revenue presentation.
Side Letter Agreements
During the 1990s, an increasing number of sales transactions were accompanied by side letter agreements (SLA). An SLA is a document, usually written by the sales officer or the customer, that conveys special rights to the customer, some of which may undermine the revenue aspects of the transaction. Some SLAs specify that the customer has to pay only if certain conditions are met. For example, an SLA might state that “no payment needs to be made until the goods are sold.” According to SAB 101, SLAs that make collection contingent on the ultimate resale to an end-customer constitute consignment transactions. Exhibit 2 provides examples of AAERs pertaining to SLAs and the contingencies they introduce.
Identifying the existence of SLAs can be difficult, especially when the company’s accounting personnel are unaware of them. Ultimately, the most effective safeguard is a reliable internal control system that prohibits side agreements and is aggressively monitored by top management and internal auditors. If such monitoring policies are absent, auditors should design procedures to search for SLAs. Experience shows that SLAs have often been used to enhance sales in the computer software and medical equipment industries.
When a risk assessment indicates the possibility of SLAs, the auditor should consider the following techniques:
Shipments to Controlled Destinations
Most companies know that their auditors expect to see shipping documents to support sales entries. In one scheme, however, goods are shipped and shipping documents generated while the merchandise is routed to a warehouse controlled by the seller. A variation of this scheme is to ship merchandise to a freight forwarder, thus giving the impression that goods have been shipped to a customer. A freight forwarder accepts merchandise from clients and stores the goods until sufficient quantities are accumulated for shipment at favorable bulk rates. Freight forwarders can reduce shipping costs and improve service; however, a sales transaction should not be recorded until the freight forwarder releases the merchandise to the carrier.
Shipments to controlled destinations may be difficult to detect. Auditors should examine shipping documents with skepticism and consider the following questions:
If the company uses freight forwarders, the auditor should exercise extreme caution about revenue transactions recorded near the client’s fiscal year-end. Auditors should determine whether such goods were picked up by a freight forwarder, then contact the freight forwarder and determine whether the goods were released to the carrier by the fiscal year-end, a necessary requirement for revenue recognition. Also, as noted in SAB 101, auditors must verify that title to the goods and risks of ownership have transferred to the customer.
While shipments to freight forwarders may increase the risk of cutoff problems, other factors may also increase the danger of improper cutoff. In some industries, most notably computer software, the company’s customers may delay ordering goods until the end of the quarter, when the buyer’s negotiating power may be enhanced if the supplier is under pressure to meet sales targets. This practice may result in a large percentage of purchase orders arriving on or near the last day of the quarter. Under these circumstances, a company may be tempted to record all of the orders as revenue in order to meet the period’s sales target, even if some of the merchandise is not shipped until the new quarter. The company may try to cover up the irregularity by backdating the shipping documents.
AAER 1350 illustrates the SEC’s insistence on obtaining a proper cutoff of revenue transactions. The SEC’s investigation of Microstrategy, Inc., revealed that on the night of September 30, 1999 (the end of the firm’s third quarter), Microstrategy was engaged in negotiations with NCR Corporation in an attempt to finalize a software sales transaction. Although the contract was not finalized and signed until the morning of October 1, Microstrategy recorded approximately $17 million as third-quarter revenue. Because Microstrategy missed the midnight cutoff by a few hours, the SEC rejected the firm’s premature attempt to recognize revenue.
The SEC is concerned that auditors may be performing inadequate cutoff tests, as expressed by then SEC Chief Accountant Lynn Turner, speaking on May 31, 2001, at the 20th Annual SEC and Financial Reporting Conference sponsored by the Leventhal School of Accounting, Marshall School of Business Administration, at the University of Southern California: “testing of a few transactions before and after year end may very well be insufficient to provide a reasonable basis for the auditor’s report.” Where risks of improper cutoff are high, auditors should be present at year-end to obtain sales cutoff information, then, later, trace the data into sales records to ascertain that shipments made near year-end are recorded in the proper period. Auditors should consider expanding their normal cutoff tests in the following situations:
When customers have the right to return goods, the amount of sales revenue is contingent on the quantity of goods that may by returned. In these circumstances, SFAS 48 states that revenue should not be recorded at the sale date unless the seller can make a reasonable estimate of returns. SFAS 48 also indicates factors that may impair a firm’s ability to estimate returns, namely: the length of the return period, a lack of historical experience (as with a new product), the susceptibility of the product to external factors such as obsolescence, and the absence of a large volume of relatively homogeneous transactions.
In addition to these criteria, SAB 101 lists other factors that may impair the ability to make a reliable estimate of returns. Companies in the computer software industry, which often market their product through distribution channels, merit special attention from auditors, especially with regard to the following circumstances:
Example. AAER 1133 illustrates what can go wrong when customers have a right to return merchandise: A software designer shipped software to distributors that, in turn, sold to end-customers. The designer sometimes granted very liberal return rights in order to establish relationships with distributors. The company, however, established an allowance for estimated future returns and exchanges (distributors were allowed to exchange out-of-date software for newer versions). Company policy was to include in the allowance any inventory in the hands of distributors that exceeded a 45-day supply, effectively reducing revenue for excess inventories that might not be sold due to the product’s rapid obsolescence.
To implement this policy, the firm’s sales manager monitored the amount of inventory in the hands of distributors, but the company’s vice president of sales directed the sales manager to understate the distributor’s inventory. This understatement created the appearance that a small allowance was needed to cover the distributor inventory, when the actual distributor-held inventory greatly exceeded a 45-day supply.
The software designer overstated net sales further when one of its distributors exercised its right to exchange older software for newer versions that had been released. The designer recorded the shipment of replacement software as a new sale instead of an exchange.
Finally, the designer shipped $750,000 of software to a new distributor under sales terms that allowed the distributor to return, at any time, any product purchased within the first 60 days of their relationship. The company recorded the shipment as revenue, although due to the liberal return rights it should have included the entire amount in the allowance account, thus negating any net revenue.
Additional evidence is required where controls are weak. For example, rather than relying on data generated by a weak control system, the auditor can confirm the quantity of inventory directly with the distributor. When sale policies allow the exchange of new product versions for older versions, the auditor should find examples of such exchanges and ascertain that the accounting is proper.
Where returns can be estimated, auditors must obtain evidence that an adequate allowance for sales returns is provided; moreover, if the SFAS 48 and SAB 101 risk factors prevent the company from making a reasonable estimate of returns, the auditor must confirm that related shipments are not recorded as sales until the right of return expires. The ability to make reasonable predictions of returns will vary, and a high degree of predictive power is not always needed. To determine the required degree of accuracy, auditors should study the sales contract. The more liberal the firm’s return policies, the greater the need for precision in estimating returns. SAS 57, Auditing Accounting Estimates, provides additional guidance in this area.
Percentage of Completion
Revenue recognition problems arise when a company’s services cover more than one accounting period, such as long-term construction projects and research and development contracts. Under certain conditions, GAAP permits a company to accrue revenue as the work is being done. AICPA Statement of Position 81-1 cites these necessary conditions:
The percentage of completion (POC) method can be used only if all of these conditions are met; otherwise, all of the revenue should be recognized in the period that the work is completed.
SAS 57 outlines several factors to consider when evaluating the reasonableness of accounting estimates. In addition, when studying the company’s internal control structure, the auditor should carefully examine the entire information system for contract administration. As discussed in SOP 81-1, good contract estimates depend upon all areas that participate in production, cost, and administrative control of contracts.
The auditor must also examine the contract to determine whether the objectives are clearly defined. If terms are missing or ill defined, the auditor may not be able to determine whether the objectives have been met.
Written contracts are especially important in ensuring that objectives are clearly defined. In AAER 132, a company contracted to develop a telephone information computer system. Because the contract did not define the software design specifications, the SEC concluded that the company could not reasonably estimate the cost of developing the system.
Finally, certain inherent hazards may destroy the reliability of revenue and cost estimates. SOP 81-1 defines inherent hazards as contract conditions or external factors that raise questions about the ability of either party to perform their obligations under the contract.
Assuming that the first two criteria are met, the auditor must still ascertain whether both parties to the contract can fulfill their responsibilities. In assessing collectability, a key determinant is the initial investment. If the initial investment is relatively small, the purchaser may decide to walk away from the contract. SFAS 66 presents guidelines for determining a reasonable minimum down payment for certain real estate transactions, but at present no guidance for other types of transactions exists.
Fictitious revenue may be recorded in numerous ways. For example, a company might appear to have sold merchandise to a customer but also enter into another contract to purchase goods or services from the same customer. To make these schemes appear realistic, the company must receive cash payments from the purported customer and repay the customer later to cover the offsetting contract. The objective is to make the top-line revenue growth look better. AAER 930 provides a good example of offsetting contracts. An effective way to detect such a scheme is to compare a list of the company’s customers with a list of its vendors. If a company appears on both lists and the transaction amounts are similar, the auditor should investigate further.
Fictitious sales schemes are not always elaborate. Less complex methods include shipments of bogus products or defective products. In AAER 971, a company shipped goods to a customer and recorded revenue, even though the customer had agreed only to evaluate the product. In some extreme cases, goods were shipped and booked as revenue although the customers had not ordered the goods.
Auditors can learn from these phony transactions. They should be skeptical about large revenue transactions recorded near the fiscal year-end. Because the company may be trying to meet sales targets, supporting documentation should be examined with skepticism and due professional care. Purchase orders should be examined for conditional language that may indicate the sale is contingent on some future event. In AAER 903, certain purchase orders were actually titled “conditional purchase order.”
In reviewing purchase orders, auditors should look for cancellation clauses that could negate the sale. Auditors should read sales contracts and look for cancellation privileges and lapse dates. Revenue should not be recorded until the cancellation privilege lapses. The absence of a requested shipping date on a purchase order may indicate that the customer will notify the seller when shipment is to occur, which might mean that no exchange is presently being requested.
While a careful review of documentation may identify fictitious revenue, analytical procedures may provide circumstantial evidence that revenue has been overstated. For example, if a company is recording fictitious revenue, its days sales outstanding (DSO) may look unusual. A cunning company may try to hide this red flag by devising schemes to refresh receivable balances. Some companies camouflage the problem by holding the cash receipts journal open, thereby allowing more of the receivables to appear “paid off” at period-end. Auditors should increase cash receipts cutoff tests when this is suspected.
Another approach to lowering the DSO is to simply reclassify accounts receivable amounts to another account. In AAER 843, a company reduced its accounts receivable by crediting the asset account by $75,000 each month and by debiting an expense account. When asked about the monthly write-off, the company claimed that the customer was paying off its account by providing “services.”
Analyzing the trend of the following ratios can be a useful test of the reasonableness of revenue:
Auditors can also compare trends in cash flows from operations to trends in revenues. Finally, SAB 101 notes that shipments at the end of the accounting period that significantly reduce the backlog of customer orders may be an indicator of lower shipments and revenue in the next reporting period. This situation would require disclosure in the management’s discussion and analysis (MD&A) section of the annual report.
Exhibit 3 includes examples of fraud schemes and cites lessons to be learned from each scheme.
Staying One Step Ahead
According to the Committee of Sponsoring Organizations’ (COSO) 1999 report, approximately one-half of the AAERs issued between 1987 and 1997 were related to revenue misstatements. Moreover, the POB Panel on Audit Effectiveness studied AAERs issued between July 1, 1997, and December 31, 1999, and found that approximately 70% of the cases involved overstated revenues. The majority of these AAERs pertained to companies in the computer or technology industries, as well as manufacturing and financial services.
As business transactions become more complex, unscrupulous individuals will find new and innovative ways to distort revenue. Software companies increasingly engage in multiple-element transactions that may obscure the proper revenue recognition point. A critical question is whether the software element can be separated from the other services and thus allow the immediate recognition of the portion of the revenue that relates to the transfer of the software product.
In recent months, companies such as Global Crossing and Qwest have engaged in “round-tripping” transactions wherein the firms swap network capacity and record these transactions as revenue. The SEC is currently investigating the question of whether such swaps should be recognized as revenue. Regardless of the outcome, the profession should regard these cases as a serious reminder that they must remain vigilant and stay abreast of the changing business environment.
Finally, auditors should carefully study revenue-related AAERs to familiarize themselves with fraud schemes that are being used to create bogus revenue. Exhibit 4 lists selected AAERs related to each major problem area discussed in this article. By focusing on the different methods of revenue misstatement and how auditors can detect these discrepancies, the auditing profession may be better prepared to deal with revenue fraud in the future.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2002 CPA Journal. Legal Notices
Visit the new cpajournal.com.