Fictitious Revenues & Red Flags Associated With Fictitious Revenues

Introduction:

Fictitious Revenues: Fictitious Revenues involve sale of goods or services that did not occur. Fictitious invoices can be fake, but can also involve legitimate customers. A fictitious invoice can be prepared for a legitimate customer even though goods are not delivered or services have not been rendered. At the end of accounting period sale will be reversed, which will help conceal the fraud. However artificially high revenues of the period might lead to revenue shortfall in the new period, creating need for fictitious sales. Another method is to use legitimate customers and artificially inflate or alter invoices.

In some cases companies go to great length to conceal fictitious sales. To record purported purchase of fixed assets, a fictional entry is made by debiting fixed assets and crediting cash for the amount of purchase. A fictitious sale entry is made for the same amount as false purchase, debiting accounts receivable and crediting sales account. The cash outflow that supposedly paid for the fixed assets is “returned” as payment on the receivable account, though in practice cash have never moved. The result of this fabrication is an increase in both fixed assets and revenue.

Red Flags: 

The cause of fraudulent transaction reporting is the combination of situational pressures on either the company or the manager and the opportunity to commit the fraud without the perception of being detected. These pressures are known as “red flags”.

Explanation:

What are the Red Flags associated with Fictitious Revenue?

The following red flags are associated with fictitious revenues:

• An unusual large amount of long overdue accounts receivable
• Outstanding accounts receivable from customers that are difficult or impossible to identify and correct.
• Significant volume of sales to entities whose substance and ownership is not known
• An unusual surge in sales by minority of units within the company.

Timing Differences:

Financial statement fraud may involve timing differences-that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired.

Premature Revenue Recognition:

Revenue should be recognized in the accounting records when a sale is complete-that is, when performance obligations are satisfied, revenue is recognized.  Revenue should not be recognized when for work that is to be performed in subsequent accounting periods, even though the work might be under contract.

Example is ABC, and Company sells products that require engineering and adapting work before they are acceptable to customers. However, the company records sales revenue before completing the engineering, testing, evaluation, and customer acceptance. In some cases, sales do not take place for weeks or months.

Long Term Contracts:

Revenue and expenditure are recorded as per percentage of completion method. The percentage of completion method recognizes revenue and expenses as measurable progress on project is made, but this may be vulnerable to manipulation. Managers can often easily manipulate percentage of completion and the estimated costs to complete a construction project to recognize revenue prematurely

Channel Stuffing:

Channel stuffing is the practice of sending more goods to distributors and customers than they actually need. A seller engages in this practice to artificially boosts its sales and profit levels. On the downside stealing from future period sales makes it harder to achieve sales growth in those future periods.  The pressure to meet sales goals can in turn lead to restatement.

Recording Expenses in Wrong period:

Timely recording of expenses is often compromised due to pressures to meet budget goals or due to lack of proper accounting controls. As the expensing of certain costs are pushed into periods other than ones in which they actually occur, they are not properly matched against the income. This might take the sales revenue from the transactions almost pure profit, inflating earnings.

What are the Red Flags associated with Timing Differences?

• Rapid growth of unusual profitability, especially compared to that of other companies in same industry.
• Recurring negative cash flows from operations or an inability to generate to positive cash flows from operations while reporting earnings and earnings growth.
• Significant, unusual, high complex transactions especially those close to period’s end.
• Unusual increase in gross margin or gross margin in excess of industry peers.
• Unusual growth in the day’s sales in receivables ratio (receivables/average daily sales)
• Orders might raise questions about the collectability of the accounts receivable.

Conclusion:

Based on the above certain points, Fraud examiners at the time of checking or scrutinizing may have a look on factors mentioned above and the red flags associated with the same. Fraud examiners must analyze the Red Flags, get into the root cause of the same and come out with the conclusion with the help of data analysis together with supporting documents. Fraud Examiners should document their conclusions, how they reached those conclusions, what evidence they based the conclusions on.