Timing Is of the Essence

Checking the calendar may be key in uncovering a fraud. When 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. …