Revenue recognition entails a level of difficulty because they vary by industry. Revenue recognition is the largest single source of public company financial statements’ restatements. The SAS 99 requires special consideration of fraud risk and it can occur in any industry. Some of the improper recognition practices are misclassification of unusual, extraordinary, and nonrecurring gains as income from continuous operation or over-accrual of rebates receivables due from vendors, recording fictitious transactions, and recognizing revenue from installment sales prior to the appropriate period.
The AICPA, American Institute of Certified Public Accountants describes the following fraud schemes with respect to revenue recognition:
· Recognizing revenue prematurely. Revenue generally should be recognized when title and risk of ownership have passed. Common fraud techniques include certain "channel stuffing" (for example, shipping inventory in excess of orders, or providing special incentives to customers to purchase more inventory than is now needed, in exchange for future discounts and other benefits), reporting revenue after goods are ordered but before they are shipped, improper year-end cutoff procedures, reporting revenue when significant services are still to be performed or goods delivered, and improper use of the percentage-of-completion method.
· Recognizing revenue that may not be earned. Common fraud techniques include reporting sales for bill and hold transactions, consignment sales and sales subject to other contingencies, sales with guarantees against losses and right of return, sales coupled with future purchase discounts or credits, and other side agreements that affect the substance of the transaction.
· Reporting sales to fictitious or nonexistent customers. This may include falsified shipping and inventory records.
. Sales to related parties in excess of market value.
. In exchanges of non-monetary assets, reporting revenue in connection with exchanges of certain similar non-monetary assets, such as indefeasible right to use (IRU) capacity swaps consisting of exchanges of leases, with no business purpose, and reporting exchanges of non-monetary assets at inflated fair values.
· Reporting peripheral or incidental transactions, such as certain nonrecurring gains, as sales revenue.
Revenue recognition principle provides that revenue is recognized:
•when it is earned AND
•when it is realized or realizable
•Earnedwhen earnings process is substantially complete
•Realized when goods & services exchanged for cash or claims to cash
•Realizable when assets received are convertible into a known amount of cash
For example, for long-term contracts such as construction-type contracts two different methods of accounting are recognized:
· Percentage-of-Completion Method
· Completed-contract Method.
Revenues and gross profits are recognized each period based upon the progress of the construction. Construction costs plus gross profit earned to date are accumulated in an inventory account called Construction in Process, and progress billings are accumulated in a contra inventory account, Billing in Construction in Process.
Long-term construction contracts require dependable estimates of extent of progress and cost to complete. A reasonable assurance of collectibility of the contract price is also required. The absences of inherent hazards that make the estimates doubtful are part of the criteria. One of the most popular input measures used to determine the progress toward completion is the cost-to-cost basis. Under this approach, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract.
The completed-contract method states that revenue and gross profits are recognized only when the contract is completed. Construction costs are accumulated in the inventory account called Construction in Process, and progress billings are accumulated in a contra inventory account called Billings on Construction in Process.
Accountants are under pressure to prevent or detect fraud, whether following SAS 99 and the Sarbanes-Oxley Act or meeting a company’s internal fraud prevention expectations. Recent headlines are highlighting the urgent need for well-trained fraud and forensic accountants.