Fraud Prevention in Revenue Recognition

As the economy continues to face headwinds, corporations face pressure to meet investor and lender expectations for financial performance. The need to show that targets are being met raises the risk of accounting fraud. One key risk area is revenue recognition: US firms are being closely monitored by the SEC, and UK companies must be ever more alert since the introduction of the failure to prevent fraud offence.

The risk of room for interpretation

Accounting standards provide wide room for interpretation when it comes to how companies recognise the timing and value of their revenue. This is because the relevant facts can be vastly different across industries. For example, a retail business sells products every minute compared to a construction firm that builds one skyscraper over three years. These implicit differences leave room for bad actors to manipulate estimates or judgements to misrepresent revenue figures and potentially commit accounting fraud.

Examples of creative mis-accounting

High profile examples of improper revenue recognition are common in both the UK and US, e.g. Revolution Beauty and Under Armour. In the course of FRA’s work, we have seen firsthand a wide range of schemes used to artificially improve revenue recognition, which can increase the companies’ sales figures and their balance sheet assets. and their balance sheet assets.

• “Pull Forward Revenue”: Long term contracts which span multiple accounting periods can be manipulated to book revenue earlier than appropriate and improve current year results.
• “Channel Stuffing”: Inappropriate close relationships with distributors can be abused to  oversell products close to a year end and artificially increase sales.
• “Round Tripping”: Collusion with customers to create transactions with no commercial basis which increase revenue figures of both parties by creating sales to each other.
• “Bill and hold”: Transactions where customers are invoiced before the goods are delivered and therefore revenue may be recognised early.
• Undeclared side agreements: Such arrangements allow sales personnel to avoid scrutiny and book revenue inappropriately, for example making sales to customers close to period end with an undeclared side arrangement to allow for return of goods.

Regulatory authorities are live to this risk and ready to levy substantial penalties in serious matters.  This is apparent with the £129m fine paid by Tesco under the terms of a Deferred Prosecution Agreement with the Serious Fraud Office, and the over $12.5m paid by Synchronoss Technologies and several of its executives to settle separate corporate and individual SEC charges.

Clarifying the role of the auditors

A common misconception is that revenue recognition is not an issue experienced by entities subject to an annual external audit. Whilst it is true that an auditor should ordinarily presume that there are risks of fraud in revenue recognition and tailor their testing of the company’s books and records accordingly, past cases show us that not all issues can be uncovered through the annual audit. Companies need to be alert to this risk.

Scrutiny for their past failures also has auditors taking on more responsibility in identifying red flags and concerns for further investigation outside of the external audit process. We are seeing more instances of auditors detecting red flags through their standard procedures and requiring independent investigation before they are comfortable to proceed with their audit and sign off the accounts, even if this results in reporting deadlines being missed.  

Identify the facts defensibly

In our experience, best practice when faced with red flags or allegations of inappropriate revenue recognition is to engage independent lawyers and forensic accountants to carry out a privileged investigation. A full investigation should interrogate financial records, review email and mobile data, and interview the relevant company personnel. All of this can only be achieved with a close partnership between the legal team and the forensic accountants.

Quickly engaging expert assistance is crucial when a complex revenue recognition investigation is required. Beyond conducting the investigation, advisors can help resolve matters such as the remediation of compliance and internal control gaps. They should also have experience presenting the results of forensic procedures to auditors, regulators or investigating authorities. Maintaining trust that a thorough and transparent investigation has been carried out will be imperative in allowing all parties to resolve any issues and minimise further disruption to the company.

What do lawyers need to know about accounting judgments?

Revenue recognition is one risk area where judgment-based accounting can lead to legal and reputational consequences for companies. For an overview of what lawyers need to know about accounting judgments, watch our 45-minute webinar here.