The Fraud Audit: Responding to the Risk of Fraud in Core Business Systems

by Leonard W. Vona
Copyright 2011 John Wiley & Sons, Inc.

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APPENDIX

Fraud Audit Planning Program:

Revenue Recognition

FRAUD RISK STRUCTURE: REVENUE RECOGNITION

SAS 99 states that the auditor should ordinarily presume that there is a risk of
material statement due to fraud related to revenue recognition.
The search for revenue fraud should start with understanding how management has historically misstated revenue. Revenue fraud can be categorized into
four major groups, with each group having several general schemes and several
industry-specic fraud schemes.
I. Management records ctitious revenue through a false billing
scheme. Illusion is the key word in this fraud scheme. Management must
provide representations, supported by documentation, that a customer
exists, delivery has occurred, or that services have been rendered, and
that the revenue transaction has been realized. Documentation will be
obtained, created, or altered to support the false assertions. The overall

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audit approach should search for and critically examine each of the main
revenue assertions. The attributes of a false billing scheme are:
A. The revenue transaction is recorded through the billing system.
B. The revenue transaction is recorded through the use of ctitious
customers and the use of real customers.
C. Management obtains, creates, or alters documents to provide the
illusion that the customer ordered the product or services.
D. The delivery of the product is disguised in one of many methods.
E. The realization of the receivable is concealed.
II. Improper recognition of revenue either because it was recorded prematurely
or intentionally delayed to a later period. In this case, the problem relates to:
A. The revenue is not realized and is eventually returned. The audit
approach should focus on the realization assertion.
B. The revenue is eventually recognized. This fraud scheme is the most
difcult to detect because all the revenue assertions are achieved. The
audit should focus on the delivery point of the revenue transaction and
the documentation.
C. Improper recognition schemes occur as follows:
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Recognition of revenue on soft sales from customers that have
not agreed to purchase the item.
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Recognition of revenue on products that is incomplete or awed.
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Recognition of revenue on partial shipments.
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Recognition of revenue involving multiple deliverables that have
not all been satised
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Recognition of revenue in the improper period.
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A single revenue transaction.
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Misapplication through timing factors.
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Premature recognition.
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Delayed recognition.
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Disputed sales.
D. Related party transactions are frequently linked to sham transactions
and occur as follows:
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Sales activity between two parties, often related by law or industry,
where insufcient consideration is given for the sales transaction.
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Seller provides total nancing to transfer consideration.
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Below FMV transactions.
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Borrowing or lending on an interest-free basis or at a rate of interest
signicantly above or below market rates.

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Exchanging property for similar property in a non-monetary

transaction.
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Loans with no scheduled terms for when or how the funds will be
repaid.
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Loans with interest accruing differently from market rates.
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Loans to parties lacking the capacity to repay.
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Loans advanced for valid business purposes and later written off as
noncollectible.
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Nonrecourse loans to shareholders.
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Agreements requiring one party to pay the expenses on the others
behalf.
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Business arrangements where the entity pays or receives payments
of amounts at other than market values.
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Consulting arrangements with directors, ofcers, or other members
of management.
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Goods purchased or sent to another party at less than cost.
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Material receivables or payables from/to related parties such as
ofcers, directors, and other employees.
E. Consignment income. Transfer of product is based on a consignment contract.
F. Channel stufng. The practice of offering extremely favorable
terms to move a sales transaction into a current period. The
inducement is so favorable the customer purchases the product in
the current period instead of in a later period. Signs of the practice
are large discounts, pricing below FMV or cost, extended payment
terms, no repayment schedule, or loans to help nance the purchase.
G. Round tripping. Sales activity between parties where there is no
measurable economic benet. The main purpose is to increase sales with
no measurable benet to the bottom line. No cash has transferred
between the parties.
H. Barter. Sales transaction occurs through a swap of products or
services.
III. Creation of revenue through journal entries. This fraud scheme
is easy because none of the revenue assertions need to be achieved.
Revenue is misstated simply through one or more journal entries. No
customer accounts are impacted. The journal entries maybe recorded in
the general ledger or in top-sided journal entries.
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IV. Misapplication of GAAP. This can be related to:

A. Misapplication of the fundamental revenue assertions.
Here, the management team intentionally misapplies one of the four
key criteria to recognize revenue. The auditor needs to identify the
specic criteria and determine how management could manipulate
the criteria and then conceal the truth.
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A transaction has to occur entailing an exchange.
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The conversion of income to revenue is essentially complete.
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The price is xed and determinable.
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Collection is reasonably assured.
B. Misapplication of industry GAAP. As stated above, there are a
number of specic GAAP pronouncements covering revenue. Here, the
management team intentionally misapplies the criteria established
under the specic accounting pronouncement. The auditor needs to
identify the specic criteria and determine how management could
manipulate the criteria and then conceal the truth.
C. Improper and inadequate disclosures.
D. Illustrative of GAAP-specic. With this transaction, a legitimate
sales order is received and executed. However, the terms require the
seller to hold the goods until the purchaser is ready to take acceptance. SEC Staff Accounting Bulletin 14 states bill-and-hold transactions can be booked as revenue only after the following criteria
are met:
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The risks of ownership must have passed to the buyer.
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The customer must have made a xed commitment to purchase the
goods, preferably in written documentation.
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The buyer, not the seller, must request that the transaction be on a
bill-and-hold basis.
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The buyer must have a substantial business purpose for ordering
goods on a bill-and-hold basis.
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There must be a xed schedule for the delivery of goods based on
what is customary in the buyers business.
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The seller must not have retained any specic performance obligations such that the earnings process is not complete.
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The ordered goods must have been segregated from the sellers
inventory and not subject to being used to ll other customer orders.
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The products must be complete and ready for shipment.

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FRAUD CONCEALMENT STRATEGY

When an individual decides to commit internal fraud, how to conceal the true
nature of the transaction is a critical aspect of his or her plan. The goal is to
have the business transaction look like a real transaction.
Each fraud scheme has a typical way to conceal it. However, how the
individual implements the concealment strategy varies, based on the persons
position (opportunity) and the companys internal procedures. The auditor
should give consideration to the opportunity list in relation to the system
under audit.
Methods to conceal the true nature of the transaction will vary with the
business system, employee position, and computerized systems versus manual systems, required documents, internal controls, and corporate governance issues.
In some instances, the individual may use more than one layer of
concealment techniques to hide the true nature of the business transaction.
The auditor should design an audit approach based on the mechanics of the
fraud scheme and the concealment strategy.
1. Fictitious delivery of the product or service. This will occur through the
creation of false documentation.
2. Real delivery to false or hidden locations. Here, the company ships product
to non-customers for the illusion of sale through the use of freight
forwarders, other company warehouses and concealed or false locations,
or consignment locations. Or the company ships to distributors without
title transfer.
3. Shipment of nonexistent or incomplete product. This occurs through the
actual shipment of a container that is either empty, lled for weight
purposes, or an incomplete product.
4. Shipment to a real customer that did not order the product. Management
ships an actual product to a customer that never ordered the item.
5. Concealment of returns. This requires the delaying of the return after the
audit period, recording the return as something other than a return, or a
combination of efforts to conceal the return and the adjustment.
6. Subsequent credits or adjustments. Since the ctitious revenue cannot be
realized, the receivable must be cleared through credit memos or actual
adjusting entries.

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7. Disguised customer remittances. The documentation supporting the

source of the remittance is altered or created to provide the illusion of
realization.
8. Use of company funds to provide illusion of customer remittances. Here,
the company uses multiple bank accounts, subsidiary bank accounts, or
foreign bank accounts.
9. Lapping scheme to provide illusion of customer remittances. Other customers remittances or credit balances are applied to the ctitious revenue.
10. Undisclosed terms and conditions. The customer is offered verbal terms or
side agreements that are not disclosed to the auditor. Or, the auditor can
also be given draft documents, altered copies, or false documents.
11. Right of return not disclosed. The customer is provided the opportunity to
return the product through a trial period, approval period, or some other
program.
12. Created, altered, or ctitious documentation.
13. No documentation supporting verbal representations.
14. Falsifying company reports to provide an illusion of an event or
representation.
15. Control over conrmations. With ctitious customers, the customer
addresses are under the control of management. With real customers,
the management team must exert some control over the response. In
certain industries, obtaining responses can be difcult, so management
offers assistance in obtaining the response.
16. There are cases in which the customer conspired against the auditor to
falsely respond to the conrmation.
17. Intentional misrepresentation by management.
18. Improper criteria used in estimates.
19. Collusion with outside experts to provide false representations.

PLANNING THE REVENUE AUDIT

During planning, the auditor should consider the following:
1. Structure the brainstorming session to include a discussion of the revenue
fraud schemes in relation to the specic client industry and client accounting practices. This discussion should:
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Using the Fraud Risk Structure as a guide, identify how the inherent
revenue schemes would occur.

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3.
4.

5.
6.
7.

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Using the Fraud Concealment Strategy as a guide, identify how the

inherent revenue scheme would be concealed.
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Identify any client practices that may create problems, such as right of
return or distributorship arrangements.
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Review industry-specic fraud schemes, such as front-loading for a
construction contractor.
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Include any past problems with the client.
Using the fraud theory, understand managements motivation for underor overstatement of revenue. This facilitates where and how to search for
the fraud.
Understand how the key revenue assertions occur within the company by
revenue source.
Obtain a thorough understanding of the revenue cycle and types of
revenue transactions. The auditor should inquire about:
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Earnings process in relation to the general rule for revenue recognition;
there are four elements:
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An exchange transaction has taken place.
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The earnings process is essentially complete.
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The sellers price to the buyer is xed and determinable.
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Collectability is reasonably assured.
Discuss how those assertions could be falsied and subsequently concealed.
Determine if there are any specic GAAP pronouncements for revenue
recognition.
Develop global-based analytical analysis around the relevant fraud
schemes:
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Understand the sources of revenue.
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Differentiate revenue created through the billing system and revenue
created through other sources.
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Differentiate revenue recorded through the sales system and revenue
recorded via journal entry.
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Identify revenue via new customers versus existing customers.
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Identify revenue recorded at the end of an accounting period.
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Identify revenue recorded after a signicant business event.
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Identify new customers or new accounts.
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Identify revenue recorded through noncustomer accounts.
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Identify revenue by product line. The goal should be a disaggregated
analysis at the lowest level practical.
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Analyze credit activity by customer as to cash, adjustments, or returns.
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Search for activity by ship-to address.
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8. Develop questions for the interviewing of management.

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Understand how the key revenue assertions occur in the company.
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Identify which revenue schemes relate to the individual being
interviewed.
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Understand what impact the individual has on the documentation
supporting the revenue assertion.
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Inquire as to negotiation strategies with customers.
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Identify customers controlled by non-sales force personnel.
9. Discuss improper revenue recognition for the company. Remember the
identication of a risk of material misstatement due to fraud involves the
application of professional judgment and includes consideration of:
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The type of risk that may exist. As mentioned above, the auditor should
consider how management would misstate revenue, rst at a top-side
level, then at the specic scheme level.
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The signicance of the risk; that is, whether it is of a magnitude that could
result in a possible material misstatement of the nancial statements.
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The likelihood of the risk or schemes occurring within the industry and
organization.
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The pervasiveness of the risk; that is, whether the potential risk is
pervasive to the nancial statements as a whole or specically related
to a particular assertion, account, or class of transactions.

AUDIT AREAS FOR FALSE BILLING SCHEMES

1. Customer master le. False billing schemes require the revenue transaction to be recorded in a customer account.
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Creation of a ctitious customer.
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Real customers with no current sales activity.
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Real customers with multiple accounts.
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Look-alike customer.
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Real customer that is not a knowing participant.
Data Analysis
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New customers with large sales activity at the end of a reporting

period.
Dormant customers with large sales activity at the end of a
reporting period.
Large customers with multiple bill-to addresses.

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House accounts with large sales activity at the end of a reporting

period.
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Match customer database to personnel or vendor database for name,
address, telephone number, and federal identication number.
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Missing credit terms amounts or large credit terms for new
customer.
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Missing key identifying information, such as contact name, identication number, etc.
2. Sales transaction. The scheme requires the creation of a sales transaction, such as:
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Sales to ctitious customers.
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Sales to real customers.
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Sales to noncustomer accounts.
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Sales to related parties. Fictitious sales to ctitious customers, real
customers, noncustomer accounts, or related parties.
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Incomplete sales.
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Disputed sales.
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Data Analysis
Sales with no commission or assigned to a sales representative or
territory.
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Sales to a noncustomer account.
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Missing customer information, i.e., sales order number.
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Search on ship-to address.
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Same address for more than one customer.
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No recorded ship-to address.
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Frequency of sales activity at the end of a reporting period.
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Large sales transaction at end of reporting period.
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New customers at end of reporting period.
3. Realization of revenue. The scheme requires the illusion of a customers
paying the receivable.
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Credits to a customers account originating from noncash receipts.
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Deposit of personal funds to provide realization.
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Creation of false documents to provide the illusion of a cash receipt.
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Misapplication of customer cash receipts to provide the illusion of
realization.
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Early or false recognition of returns and adjustments.
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Realization through loans.
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Realization through circular transactions.
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Data Analysis
Search for customers with no or limited cash receipts in relation to
customer sales.
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Search for returns, adjustments, voids, and write-offs.
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Search for customers with large cash receipts transaction.
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Search for cash receipts transaction missing identifying information.
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Search for cash receipt transaction from nontraditional sources.
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Use of controlled addresses to respond to conrmations or
correspondence.
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When lapping is used, consider the following data analyses:
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Search for customer remittances check numbers that do not follow a
logical date sequence.
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Search for accounts with frequent credit memos and other credit adjustments to the account.
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Search for account transfers.
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Search for noncustomer accounts.
4. Fictitious revenue to real customer. Here the scheme involves:
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Shipping products to customers that did not order the product.
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Shipping products to customers that agree to hold the product.
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Data Analysis
Search for excessive returns, credits, voids after the end of the
reporting period.
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Search for customer accounts with high sales volume and limited
cash receipts activity.
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Search for aged returns and adjustments.
5. Delivery of product to customer. Some schemes include:
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False ship-to address.
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Creation of a ship-to address.
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Nondelivery of the product or service.
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Shipping unnished products.
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Distributors and consignment.
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Trial and evaluation purpose.
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Bill-and-hold transactions.
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Data Analysis
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Month-by-month comparison of sales to detect pump up and

reversal of transactions.
Inspect shipping documents to see if company employees signed
rather than shipping company.

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Inspect shipping documents to see if shipped to warehouse rather

than customers regular shipping address.
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Inspect invoices to see if shipping information is missing.
6. Other data analysis techniques. Some to consider are:
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Review past revenue trends to see that they make sense. Consider
seasonality, as well as economic changes.
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Compare past revenue trends with similar businesses in the same
industry. Investigate large uctuations.
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Review changes in deferred revenue. A decrease could signal a decrease
in business or a release of reserves.
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Compare revenue with physical capacity. Is it possible to have the sales
volume recorded with the capacity?
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Compare industry statistics such as revenue per employee, revenue per
unit of production, revenue per square foot, revenue for dollar of PP&E.
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Compare receivables to revenue:
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Rate of changeare receivables increasing with at or lower sales?
In many well-known frauds, the buildup in accounts receivable grew
as the revenue recognition policies became more aggressive.
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Changes in days sales outstanding. Sudden changes up or down
may be indicative of fraudulent activities.
7. Terms and conditions. As applied to:
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Undisclosed terms and conditions, including terms written in a side
letter, verbal terms, or the nonenforcement of written terms.
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Interpretation of the terms and conditions.
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Terms and conditions are not xed and agreed to by both parties.
8. False documentation. Some examples are:
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Create documents.
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Alter or change documents.
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False dating of documents.
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False verbal representations.
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Providing draft documents as the properly executed documents.
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AUDIT AREAS FOR IMPROPER RECOGNITION SCHEMES

For improper recognition the audit should focus on the outcome of the revenue
transaction versus the occurrence of the transaction. There are two basic
outcomes:
1. The revenue is not realized and is eventually returned. The audit
should focus on events that occur after year-end.

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Data Analysis
Credits to customer accounts resulting from returns and adjustments are
indicative of improper recognition.
2. The revenue is eventually recognized. The audit should focus on the
delivery and terms and conditions of the revenue transactions.
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Data Analysis
Sales order. The documentation should show a clear intent to order the
product.
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Created sales orders.
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Altered sales orders.
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Back-dated sales orders.
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Sales terms. The terms and conditions support the recognition of the
revenue. Fraud schemes in the past have used undisclosed terms and
conditions.
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Unconditional right to return product.
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Ease of return of product.
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Ability to cancel the order.
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Open payment terms.
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Extension of payment terms.
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Negotiation of terms and conditions are open.
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Future performance terms.
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Contingent on performance.
Resale
Refund for unsold product
Future performance
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Delivery of product. The shipment is awed in some aspect.
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Deliver incomplete product as nal product.
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Partial shipments represented as complete delivery.
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Approval, trial, demo sales.
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Future, trial, demo sales.
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Future performance of services.
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Recognizing up-front payments as revenue.
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Shipments to company-controlled facilities.
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Shipment before customer nalizes order/contract.
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Shipments to freight forwarders.
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Shipments to other company warehouses.
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Manipulation of the closing of the year-end books. Depending on the

intent of management, the books are closed early or late. Understanding the fraud risk factors related to the pressure the organization is
facing is an indicator of which way the scheme will occur.
3. Revenue created through recording journal entries. The starting
point is to understand which revenue accounts are impacted by journal
entries, other than posting source journals.
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In the brainstorming session discuss:
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Characteristics of fraudulent journal entries.
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Characteristics of misstated revenue accounts.
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Obtain an understanding of the entitys nancial reporting process and
controls over journal entries and period ending adjusting entries.
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Determine the use and the extent of top-sided journal entries.
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Determine the nature and type of journal entries impacting the
account.
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Determine extent of account balance impacted by adjusting, reclassifying, or consolidating entries.
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Determine the nature, timing, and extent of auditing procedures.
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Nature: The type of entry will impact the nature of the audit
procedures.
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Adjusting. Validate the assumption of the adjustment
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Reclassifying. Movement of the revenue steam to a different account is
consistent with the transaction. Reclassication between operating and
nonoperating should be scrutinized.
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Consolidating. Determine whether related party or intercompany revenue
is properly reported and disclosed.
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Extent: The analysis of revenue created by journal entries will be a
determining factor.
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Timing: Revenue misstatement, by its nature occurs at the end of a
reporting period.
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