hen companies get desperate to show earnings or reduce losses, sometimes they resort to fraudulent timing differences to show phony profits. By recognizing these often simple schemes CPAs can usually detect material financial statement frauds early, before they become catastrophic.
There are five basic methods companies use to create bogus profits (See “The Fraud Beat,” JofA , Oct.00, page 93; and Mar.01, page 91 ). One of them is fraud in timing differences, also called cut-off fraud. It normally involves one of two basic techniques: recording revenues early and/or recording expenses and liabilities late. The schemes for late recording of liabilities mirror those of early revenue recognition, so we will cover only the latter topic.
REVENUE RECOGNITION VS. FRAUD
According to GAAP, revenue is recognized when the earnings process is complete and the rights of ownership have passed from seller to buyer. Examples of rights of ownership include: possession of an unrestricted right to use the property, title, assumption of liabilities, transferability of ownership, insurance coverage and risk of loss. How revenue is actually defined is a highly complex issue, but fraud is not so complicated. It involves purposeful attempts to deceive, not good-faith disagreements on accounting treatments. The auditor will normally find that revenue recognition frauds can be subdivided into three categories: holding the books open past the end of the accounting period, recording revenue when services are still due and shipping merchandise before the sale is final.
Playing with time. Probably the most common method to illegally recognize revenue early is to hold the books open past the end of the accounting period to accumulate more sales. Proper accounting cut-off tests prevent most of these problems, but not all. A Boca Raton, Florida, company programmed its time clocks to stop at exactly 11:45 am on the last day of each quarter. Shipments time-stamped with that date would continue until quarterly sales targets were met. Then the clocks would begin ticking again. That technique, though, was a bit too obvious. Alert auditors uncovered the scheme when they noticed a batch of time cards all stamped with the same date and time.
Recording revenue when services are still due. Unless services have been rendered completely, GAAP prohibits booking the entire revenue amount. But it is all too common for companies to (1) ignore percentage-of-completion contracts by taking the cash payments into income, (2) fail to record offsetting accruals for services paid for in advance, and (3) record refundable deposits as income.
Shipping merchandise before the sale is final. Frequently, consignment merchandise is counted as being sold. In more than a few cases, companies—around the time of an audit—have shipped merchandise to private warehouses for storage and counted those shipments as sales.
DETECTING PREMATURE REVENUE RECOGNITION
Most of the techniques that CPAs can use to detect premature revenue recognition are textbook audit procedures. The trick is to apply the proper degree of professional skepticism in interpreting the results. A lack of diligence in employing reasonable and necessary techniques like the ones described below can easily lead to an audit failure.
If one employee processes the same transaction from beginning to end, premature revenue recognition is easier to accomplish. Adequate internal control involves the following segregation of duties: order entry, shipping, billing, accounts receivable detail and general ledger. Even adequate internal controls can be overridden by management, so be alert to indicators that controls are not being followed. If sales or shipping invoices are out of numerical sequence, check to see if the documentation has been hidden.
In early premature revenue recognition schemes, goods are often billed before they are shipped, so quantities of goods shipped will not reconcile to goods billed. Test the reconciliations for accuracy. Select a sample of sales transactions from the sales journal, obtain the supporting documents and
Inspect the sales order for approved credit terms.
Compare the details among sales orders, shipping documents and sales invoices for inconsistencies.
Compare the prices on sales invoices against published prices.
Recompute the extensions on sales invoices.
When merchandise is shipped early, the shipping costs near the end of the accounting period could be higher. Compare shipping costs to previous periods for reasonableness. Moreover, conduct a standard cut-off test by selecting invoices from the end of the previous period and those from the beginning of the next period. Examine the invoices to make sure they are recorded in the proper period. When in doubt, verify major sales through confirmations or by telephone. Look for discrepancies in sales records.
By recording expenses late, a company can fraudulently boost its net income. (A variation of this technique is failing to record returns and allowances in the proper period.) Most frequently, accounts payable personnel are told to hold all unpaid bills until the beginning of the next accounting period. Often, the unpaid invoices are simply secreted in a desk or filing cabinet, out of sight of the auditors. Ask those responsible for recording liabilities whether they have been instructed to hide unpaid bills. Document the inquiry in your workpapers.
REMEMBER THE MOTIVE
To determine how much pressure is on management to show earnings, find out whether the company is attempting to raise additional funds through stock issues or borrowings. If these risk factors or others are present, recognize this reality: Companies can and do significantly influence income, expense and profits by massaging the cut-off time. As an auditor, considering this fact as part of the risk equation will help keep you from being fooled by fake cut-offs.
CASE STUDY: VACUUMING UP FRAUD
Don Sheelan, CEO, looked satisfied. He didn’t yet know it, but he should have been mortified. Sheelan had just mortgaged all his personal assets to acquire the controlling interest in the 100-year-old Regina Vacuum Cleaner Co. Sheelan wouldn’t ordinarily have made such a bold move, but he’d already been successful, and he was looking for a new challenge. He also had a point to make to his sister, a very savvy investor in her own right. The two siblings had been intensely competitive since birth. Don must have relished the thought of saying, “Okay, Sis, try to top this.”
Unfortunately for Sheelan, things just didn’t turn out the way he’d planned. First, the debt he assumed to buy Regina stock meant big note payments for him personally. The only way to pay those notes was with revenue from Regina, so Sheelan and his team met quickly to discuss ways to improve the company’s bottom line. Sheelan knew that if the profits didn’t increase dramatically, he was going to have big trouble.
Regina, a public company, had a reputation for putting out products as tough as steel. Indeed, the company’s new management team, headed by Sheelan (who knew nothing of the industry), decided the old product line was “over-engineered” and that the company could greatly improve profitability by developing a whole new generation of vacuum cleaners. It seemed like the perfect solution.
But Sheelan had to get the money to build his new product line. Since he was financially tapped out, the funds would have to come from Regina’s profits. So Don Sheelan came up with a plan, carried out by his CFO, to artificially boost profits for a few quarters, which would then drive the stock price higher. The funds generated from this increase would be used to develop the new product line. The CFO’s motive in assisting in an illegal scheme to inflate profits was simple enough: He believed in Don Sheelan’s new product idea, and he thought any juggling of the books would only be temporary. Besides, he wanted to keep his job.
There were any number of ways to create fake income, but the CFO felt that monkeying with the cut-off dates for sales and expenses was the least risky. He instructed the sales manager to backdate sales invoices to the prior period. However, that meant the CFO also had to tell the warehouse to predate shipments. That worked once or twice, but it necessitated increasingly large amounts of illegal entries to avoid being discovered. Out of necessity, the CFO turned from cut-off fraud to another technique: shipping consignment merchandise and booking it as sales. Then he started holding unpaid bills in a filing cabinet, and failing to recognize them as liabilities.
IF YOU CAN’T STAND THE HEAT…
The schemes worked, giving Sheelan his much-needed cash infusion. And because Regina had never reversed any of the false sales—the key indicator of cut-off frauds—the schemes weren’t detected by the auditors. Quickly, the newest generation of vacuums was engineered and the factory’s assembly lines whirred into production. A multimillion dollar ad campaign introduced the new Regina vacuum to an eager public, which began snapping them up in record numbers. Initially, profits soared, helping bury the previous financial chicanery. Sheelan’s sister was impressed. But then problems with the new design started cropping up. First, a few customers returned the machines, claiming the internal gears had stripped. Then there were scattered reports that the vacuum’s innards were melting. Regina’s experts quickly pinpointed the problem: plastic. In his greed to increase profitability, Sheelan had the original vacuum’s sturdy metal parts replaced with plastic ones. The new vacuums, as Sheelan would quickly discover, simply couldn’t take the heat.
What started out as a trickle of returns turned into a raging torrent. Before long, the warehouse supervisor called with disturbing news: there was no more room to store the returned vacuums. Sheelan’s CFO then called to report more bad news: The auditors were coming. It didn’t take Sheelan long to identify the crisis. If the auditors saw the boxes stacked in the warehouse, they would surely figure out what was going on.
In desperation, the company rented off-site storage space to hide the worthless merchandise. One of Sheelan’s lieutenants made sure that all of the documentation reflecting the returns was removed—no bills of lading, no warehouse count sheets, no inventory return forms. The trick worked, temporarily.
Sheelan’s problems were only just beginning. Eventually, word got out to consumers that the new vacuums were bad. Regina’s reputation started suffering. Sales began to slow. Sheelan was now faced with two problems: huge returns and decreasing sales. Before long, there were more defective vacuum cleaners in the warehouses than there were newly manufactured ones in the Regina factory.
Sheelan’s efforts to creatively juggle the books undoubtedly created a great deal of stress. Besides, he and his CFO were constantly having to stall auditors who wanted additional information. When one tells many lies, it becomes very difficult to keep track of them. And even though Sheelan wasn’t an accountant, he finally realized what the numbers were doing: At the current rate of balance sheet and income statement manipulation, it would be only a matter of time before the fraud became too big to conceal.
COPPING A PLEA
Facing that fact, Sheelan and his CFO had a heart-to-heart talk. The auditors would be coming again, they observed, just like every year. And this time, they were bound to find something. The CEO and CFO consulted with their respective ministers, then decided to retain an attorney. After hearing the whole story, the lawyer came to a logical conclusion: The Regina executives needed to admit guilt and throw themselves on the mercy of the court. The CFO avoided jail, but Sheelan was confined for a little over a year, living most of the time in a halfway house. Regina folded, and investors and creditors lost $40 million. Sheelan has millions in civil judgments that he will likely never be able to repay. And perhaps worst of all for Don Sheelan: He had to tell his sister.
Failures such as the one at Regina are expensive and embarrassing for the auditor. Could the scheme have been detected earlier? Perhaps. If the auditors had known about Don Sheelan’s financial predicament, they might have been more skeptical. That would have led them to spend more time looking at the major asset and income items, which could have—in turn—uncovered the cut-off fraud. In this and most cases of financial statement manipulation, the motives of the insiders are key. If it appears that one individual (or a small group) has everything riding on the company’s success, auditors should try to learn about their financial circumstances. For example, if the auditors had asked Sheelan to voluntarily submit his individual tax returns for review, they may have been able to spot that Sheelan was in hock up to his neck. That fact could have altered the entire scope of the audit.
The second lesson is one auditors hear often: Know the client’s business. Although Regina’s auditors had examined the company for years, a different company began to emerge when Sheelan took over. No longer did Regina manufacture its legendary metal vacuum, the entire income stream depended on new and untried products. In examining a company’s revenue component, it is always important for the auditor to factor in any changes in how that revenue is derived, not just how much there is.
ASK THE RIGHT QUESTIONS
A third lesson is specific to auditors of manufacturing, wholesale and retail firms—those with a loading dock. Every inventory item eventually finds its way to the loading dock, either coming or going. As a result, key shipping and receiving personnel know if financial shenanigans are occurring in inventory. At Regina, for example, early returns of the new vacuums came directly to the loading dock. The same employees saw the warehouse becoming too full of junked merchandise and knew that off-site storage had to be rented. The loading dock employees also knew shipping documents had been backdated and that consignment merchandise had been counted as sales.
In a thorough audit involving inventory, the CPA should ensure he or she spends enough time on the loading dock. In addition to the normal audit steps, the auditor should make diligent inquiries. Asking tough questions is not hard if you do it right. Here is an example: “Mr. Warehouseman, as you know, part of my job as an auditor is to detect fraud. As a result, I will need to ask you and other people I talk to some specific questions about fraud and abuse. Do you understand?”
When you have broken the ice, ask the following:
Has anyone in the company ever asked someone on the loading dock to misstate the amount of merchandise the company ships or receives?
Are you aware of anyone in the company asking someone on the loading dock to destroy, conceal, backdate or postdate documents?
Has anyone in the company asked you to do anything else you thought was illegal or unethical with respect to your job?
If you receive answers that make you pause, assess the risk of material financial statement fraud in light of other relevant information. Don’t be reluctant to ask penetrating (but non-accusatory) questions. You may be surprised at what people will tell you and the mere fact that employees understand that auditors are looking for fraud can be a significant deterrent.
THE ACID TEST
The final lesson to be learned from the Regina Vacuum case is: It’s all too easy to get lost in a fog of numbers. Indeed, many auditors have had sleep interrupted by financial data streaming through their subconscious. Nonetheless, before the auditor signs off on the engagement, he or she should use an acid test to evaluate the analytical review, reflecting on this question: If management was attempting to conceal a material financial statement fraud, where would it show up? By thinking of fraud as a “worst-case” scenario, you will find your focus quickly sharpen and the degree of your professional skepticism increase. Had the auditors in the Regina case used the same standard, perhaps they might have discovered the significant increase in the cost of off-site storage, which might have led them to suspect that bad merchandise was not being reflected as sales returns.
The auditor who uses these techniques will find they can pay big dividends. Any legitimate client will appreciate your anti-fraud efforts. After all, fraud costs money. And if a client resists or restricts your efforts to detect and deter fraud, that should raise a big red flag.
JOSEPH T. WELLS, CPA, CFE, is founder and chairman of the Association of Certified Fraud Examiners, Austin, Texas. He can be reached at firstname.lastname@example.org .