Following on my previous post (Evolving Problems In Revenue Recognition), the following controls can be used to spot transactional errors or attempts to alter the reported level of revenue for the standard revenue recognition systems:
Investigate all journal entries increasing the size of revenue. Any time a journal entry is used to increase a sales account, this should be a “red flag” indicating the potential presence of revenues that were not created through a normal sales journal transaction. These transactions can be legitimate cases of incremental revenue recognition associated with prepaid services, but can also be barter swap transactions or fake transactions whose sole purpose is to increase revenues. It is especially important to review all sales transactions where the offsetting debit to the sales credit is not accounts receivable or cash. This is a prime indicator of unusual transactions that may not really qualify as sales. For example, a gain on an asset sale or an extraordinary gain may be incorrectly credited to a sales account that would mislead the reader of a company’s financial statements that its operating revenues have increased.
Compare the shipping log and shipping documents to invoices issued at period-end. This control is designed to spot billings on transactions not completed until after the reporting period had closed. An invoice dated within a reporting period whose associated shipping documentation shows the transaction as having occurred later is clear evidence of improper revenue reporting. If invoices are based on services instead of goods provided, then invoices can be matched to service reports or timesheets instead.
Issue financial statements within one day of the period-end. By eliminating the gap between the end of the reporting period and the issuance of financial statements, it is impossible for anyone to create additional invoices for goods shipping subsequent to the period-end, thereby automatically eliminating any cutoff problems.
Compare customer-requested delivery dates to actual shipment dates. If customer order information is loaded into the accounting computer system, run a comparison of the dates on which customers have requested delivery to the dates on which orders were actually shipped. If there is an ongoing tendency to make shipments substantially early, there may be a problem with trying to create revenue by making early shipments. Of particular interest is when there is a surge of early shipments in months when revenues would otherwise have been low, indicating a clear intention to increase revenues by avoiding customer-mandated shipment dates. It may be possible to program the computer system to not allow the recording of deliveries if the entered delivery date is prior to the customer-requested delivery date, thereby effectively blocking early revenue recognition.
Compare invoice dates to the recurring revenue database. In cases where a company obtains a recurring revenue stream by billing customers periodically for maintenance or subscription services, there can be a temptation to create early billings in order to record revenue somewhat sooner. For example, a billing on a 12-month subscription could be issued after 11 months, thereby accelerating revenue recognition by one month. This issue can be spotted by comparing the total of recurring billings in a month to the total amount of recurring revenue for that period as compiled from the corporate database of customers with recurring revenue. Alternatively, one can compare the recurring billing dates for a small sample of customers to the dates on which invoices were actually issued.
Identify shipments of product samples in the shipping log. A product that is shipped with no intention of being billed is probably a product sample being sent to a prospective customer, marketing agency, and so on. These should be noted as product samples in the shipping log, and the internal audit staff should verify that each of them was properly authorized, preferably with a signed document.
Verify that a signed Acknowledgment of Bill-and-Hold Transaction has been received for every related transaction. If a company uses bill-and-hold transactions, then this control is absolutely mandatory. By ensuring that customers have agreed in advance to be
billed for items to be kept in the company’s warehouse, one can be assured of being in compliance with the strict GAAP rules applying to these transactions. Also, a continual verification of this paperwork (shown earlier in Exhibit 1-2) will keep managers from incorrectly inflating revenues by issuing false bill-and-hold transactions.
Confirm signed Acknowledgment of Bill-and-Hold Transactions with customers. If a company begins to match bill-and-hold acknowledgment letters to invoices issued to customers (see last control), the logical reaction of any person who wants to fraudulently continue issuing bill-and-hold invoices is to create dummy acknowledgments. Consequently, it is useful to contact the persons who legedly signed the acknowledgments to verify that they actually did so.
Do not accept any product returns without an authorization number. Customers will sometimes try to return products if there is no justification required, thereby clearing out their inventories at the expense of the company. This can be avoided by requiring a return authorization number, which must be provided by the company in advance and prominently noted on any returned goods. If the number is not shown, the receiving department is required to reject the shipment.
Compare related company addresses and names to customer list. By comparing the list of company subsidiaries to the customer list, one can determine if any inter-company sales have occurred and whether these transactions have all been appropriately backed out of the financial statements. Since employees at one subsidiary may conceal this relationship by using a false company name or address, one can verify the same information at all the other subsidiaries by matching subsidiary names and addresses to their supplier lists, since it is possible that the receiving companies are not trying to hide the inter-company sales information.
Require a written business case for all barter transactions. Require the creation of a business case detailing why a barter transaction is required and what type of accounting should be used for it. The case should be approved by a senior-level manager before any associated entry is made in the general ledger. The case should be attached to the associated journal entry and filed. This approach makes it less likely that sham barter swap transactions will be created.
Verify that cash-back payments to customers are charged to sales. Compare the customer list to the cash disbursements register to highlight all cash payments made to customers. Investigate each one and verify that the revenue account was debited in those instances where cash-back payments were made. This should not apply to the return of overpayments made by customers to the company.
Create a revenue accounting procedure to specify the treatment of gross or net transactions. When a company deals with both gross and net revenue transactions on a regular basis, there should be a procedure that clearly defines for the accounting staff the situations under which revenues shall be treated on a gross or net basis. This reduces the need for internal audit reviews (see next control) to detect revenue accounting problems after the fact.
Review the revenue accounting for potential pass-through transactions. In situations where there is either an extremely high cost of goods sold (indicating a possible pass-through transaction) or where there is no clear evidence of the company’s acting as principal, taking title to goods, or accepting risk of ownership, the internal audit staff should review the appropriateness of the transaction.
Trace commission payments back to underlying sale transactions. One can keep a list of all business partners who pay the company commissions, and run a periodic search on all payments made by them to the company. The internal audit staff can then trace these payments back to the underlying sales made by the company and verify that they were recorded at net, rather than at gross.
I realize the controls noted here are not comprehensive enough to cover revenue recognition of every kind of business operations; additional controls will be listed in subsequent entries I am going to post in the future that apply to more detailed revenue recognition scenarios.
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