Checklist to Detect Premature or Fictitious RevenueFollowing on my previous post Premature or Fictitious Revenue Recognition [A Closer Look, this post provide a checklist of items to consider in detecting premature or fictitious revenue as a supplement. While the questions are simple, many requiring only a yes or no answer, they are designed to require thought, necessitating that the reader consider all aspects of the financial statements and footnotes so that the reader is more attuned to the implications of the answers provided for the possibility of premature or fictitious revenue. Enjoy!

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A. What is the company’s revenue recognition policy?

1. Before delivery or performance?

     a. Is it really earned?

2. At delivery or performance?

    a. Is there a right of return or price protection?
        (i). Has the company provided adequately for returns
             or price adjustments?

    b. Does the company offer side letters offering a right of
        return or price protection not contained in the actual
        sale contract?
        (i). Do side letters effectively negate the sale?

3. After delivery or performance and full customer acceptance?

 

B. Was there a change in the revenue recognition policy?

1. Did the change result in earlier revenue recognition?

 

C. Are there any unusual changes in revenue reported in recent quarters?

1. What is revenue for each of the last four to six quarters?

2. Does any one quarter show unusual activity not explained by seasonal factors?

3. How do quarterly changes in revenue compare with the industry or selected competitors?
     a. For companies with a strong seasonal effect,
         changes in quarterly revenue should be calculated
         using amounts taken from the same quarter of
         the previous year?
     b. If quarterly data are not available, or if quarterly data
         give misleading signals, annual data can be used.
         Three or more years of data should provide a sufficient
         number of data points to get a meaningful indicator of
         potential problems.

 

D. Review disclosures of related-party transactions.

1. Is there evidence of significant related-party revenue?
    a. Is this revenue sustainable?

 

E. Does the company have the physical capacity to generate the revenue reported?

1. What is revenue per appropriate measure of physical capacity for each of the last four to six quarters?

2. How do the measures compare with the industry or with selected competitors?
    a. Possible measures of revenue per physical capacity:
        (i). Revenue per employee
        (ii). Revenue per dollar of property, plant, and equipment
        (iii). Revenue per dollar of total assets
        (iv). Revenue per square foot of retail or rental space

 

F. Are there signs of overstated accounts receivable or other accounts that might be used to offset premature or fictitious revenue?

1. Compare the percentage rate of change in accounts receivable, property, plant, and equipment, and other assets with the percentage rate of change in revenue for each of the last four to six quarters.

    a. What are the implications of differences in the rates
        of change in these accounts and revenue?

2. Consider whether unexplained changes in other asset or liability accounts might be explained by premature or fictitious revenue.

3. Compute A/R days for each of the last four to six quarters.
     a. What are the implications of changes noted in
         A/R days over the last four to six quarters?

     b. How does the absolute level of A/R days and changes
         therein compare with the industry and selected competitors?

 

G. Does the company use the percentage-of-completion method for long-term contracts?

1. Is management experienced in applying the method?

2. Has the company reported losses in prior years from cost overruns?

3. Depending on data availability, compare the percentage rate of change in unbilled accounts receivable with the percentage rate of change in contract revenue for each of the last four to six quarters.

     a. If unbilled accounts receivable is increasing
         faster than contract revenue, it implies that amounts
         recognized as revenue are not being billed.
         (i). Is there a particular reason why amounts recognized
              as revenue are not being billed?
         (ii). Note that for some contractors, quarterly data may
             give misleading signals.

 

Certain key contract benchmarks may not have been met during the quarter, limiting amounts billed over that short of a time frame. In these cases, annual data should be used.