The Fraudulent Illusion of Early Revenue Recognition

Improper revenue recognition has long accounted for a substantial portion of financial statement fraud. By simply recording revenue early, a dishonest business seller trying to inflate the sale price or an employee under pressure to meet financial benchmarks can create the illusion of greater-than-actual profits.

The reverse situation sometimes occurs, especially when companies face pending litigation. A dishonest controlling shareholder might delay revenue recognition or prematurely record expenses to lower business value in divorce or minority shareholder lawsuits. If you suspect an unscrupulous owner has been artificially lowering profits, look for the reverse signs of early revenue recognition.

There are numerous schemes where the timing of revenues and expenses are manipulated to increase or decrease earnings as desired. Schemes of this kind exploit ambiguities and complexities in accounting and financial reporting standards to deceive stakeholders and creditors.

How it happens

Early revenue recognition can be accomplished in multiple ways, including by:

• Keeping the books open past the end of the period to record more sales,
• Delivering product early,
• Recording revenue before the full performance of a contract,
• Backdating agreements,
• Shipping merchandise to undisclosed warehouses and recording the shipments as sales, and
• Engaging in bill-and-hold arrangements.

In this last scenario, a customer agrees to buy merchandise, but the company holds the goods until shipment is requested. It and any of these schemes might be carried out by one employee or several in collusion.

What to look for

Probably the most obvious marker for early revenue recognition is when a company records a large percentage of its revenue at the end of a given financial period. Significant transactions with unusual payment terms can also be a danger sign. When these or other red flags are unfurled, it’s time to investigate.

An expert might begin by comparing revenue reported by month and by product line or business segment during the current period with that of earlier, comparable periods. Experts can also employ software designed to identify unusual or unexpected revenue relationships or transactions.

More specifically, if an expert suspects merchandise is billed before shipment, he or she will look for discrepancies between the number of goods shipped and quantity of goods billed. The expert will also examine the details of sales orders, shipping documents, and sales invoices; compare prices on invoices with published prices, and note any extensions on sales invoices.

When an expert suspects merchandise was shipped prematurely, he or she will compare the period’s shipping costs with those in earlier periods. Significantly higher costs could indicate an early revenue recognition scheme.

The expert also may sample sales invoices for the end of the period and the beginning of the next period to confirm the associated revenues are recorded in the proper period. If phantom sales are suspected, experts look for reversed sales in subsequent periods and increased costs for off-site storage.

Whom to call

Early revenue recognition has been featured prominently in many financial scandals over the years. But watch out for the reverse side of the coin, too. Some unscrupulous owners have a financial incentive to make their companies look unprofitable. Regardless of whether profits are reported too early — or too late — early detection by a qualified financial expert can reduce the potential harm to your clients.

Contact your BMF Advisor to help identify potential discrepancies in your financial statements.