common fraud schemes

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Common Fraud

Schemes


Common Fraud Schemes

Revenue Recognition Schemes

Reserve Manipulation

Improper Expense Capitalization


Revenue Recognition

Revenue should be recognized when it is earned and realizable

Revenue is generally realizable and earned when all of the following conditions are met:

Persuasive evidence of an arrangement exists

Delivery has occurred or services have been rendered

The seller's price to the buyer is fixed or determinable

Collectability is reasonably assured


Revenue Recognition

Common revenue fraud schemes often include one or more of the following characteristics which attempt to bypass the GAAP recognition

requirements:

Excessive Rights of Return

Side Letter Arrangements (written or oral)

Channel Stuffing

Guaranteed Sales

Consignment Sales

Holding the Quarter Open

Improper Bill and Hold Transactions

Round-Trip / Barter Transactions

Fictitious Sales


Revenue Recognition: Example

Background

A manufacturer of high-tech equipment conducting all sales through

distributors. It launched its IPO recently.

Multiple schemes employed to improperly increase Revenue including:

Excessive Rights of Return / Side-Letter Arrangements

Round-Trip Investment-Related Sale

Manufacturer Multiple Schemes


Revenue Recognition: Example

Excessive Rights of Return / Side Letter Arrangements

Provided distributors a letter with terms that would jeopardize full and immediate revenue recognition.

To satisfy auditors, a revised letter without problematic terms was sent

Management contacted distributor via email confirming the intent of the original letter agreement.

Round-Trip Investment-Related Sales

Manufacturer invested millions of its cash in the equity or debt of start-up companies

Investees used the cash they received to purchase equipment through distributors and manufacturer recorded revenue

The value of consideration (equity and debt instruments) received quickly deteriorated (or was not supportable to begin with) but these

losses were recorded below the line

Manufacturer Multiple Schemes


Possible Indicators and Detection Methods of

Revenue Recognition Fraud

Absence of valid business purpose for transactions

Significant transactions at quarter-end

Existence of side-letters, verbal agreements or emails that appear to alter the standard terms of sale

Product returns in excess of standard policies

Changes in customer purchasing and payment trends

Unusual distributor inventory activity



Revenue Recognition Fraud (Continued)

Data Analytics

Compare customer listing to vendor listing

Filter for manual journal entries to Revenue accounts

Review A/R aging for deterioration

o A/R Turnover = Net Revenue / Average A/R Balance

o Days Sales Outstanding = 365 / A/R Turnover

Review significant sales where no commission was paid


Reserves

Companies book reserves for a variety of things:

Accounts Receivable

Sales Returns

Warranties

Restructuring

Aging Inventory

Setting a reserve entails a certain amount of judgment by management

with regards to what will potentially happen in the future.



Reserves Liability accounts (credits) on the balance sheet. Reserves must meet the definition of liabilities and therefore MUST be specific.

General, excess, rainy-day, cookie-jar, cushion and unallocated reserves are not allowable under GAAP

These improper reserve accounts often include excess reserves which can be reversed to inflate earnings in order to:

Meet profitability targets

Avoid net losses

Smooth operating results



It was the best of times

Companies experiencing

fantastic operating performance

may seek to defer earnings into

future periods

To reduce market expectations

of future performance, and

To establish reserves for use

in covering future period

expenses

It was the worst of times

Companies may decide to take

a Big Bath during periods of

poor financial performance.

To describe current year

performance as fluke

Reserves often established

through non-recurring

expenses


Reserve Manipulation Illustration

Dr. Expense $1,500

Cr. Liability $1,500

Creation of excess reserve

Actual expenses incurred of $1,000,

however company

books expenses of

$1,500

Payment of actual liability

Settles actual liability of $1,000 by paying

cash, however $500

remains in the liability

account as a credit

Year 1 Year 2 Year 3

Dr. Liability $1,000

Cr. Cash $1,000

Release of excess reserve

Releases excess liability and

improperly CREDITS

expense, which

increases net

income in Period 3

Dr. Liability $ 500

Cr. Expense $ 500

The market expects net income of $3,000, but preliminary results show net

income to be $3,500. The management decides to create cookie jar reserve of $500.



Not accruing for known expenses, for which invoices have not been received

Deferring the recognition of expenses that belong in the current period to future periods by capitalizing them

Record lower expenses than actually incurred

Hiding invoices

Inflate inventory cost by creating fake documentation (e.g., invoices)

Inflate sale price and quantity in order to justify not recording an obsolescence reserve


Possible Indicators and Detection Methods

of Reserve Manipulation

Poor financial performance followed by period of outstanding results

Significant, unexpected financial losses in the period

Upcoming acquisition or IPO

Existence of new reserve accounts, general reserve accounts, or increased activity in previously dormant accounts

Post-closing and top-side entries creating credits on balance sheet

Booking expenses to budget




Data Analytics

Analyze significant CREDITS to expense/loss accounts on the income statement and review offsetting DEBITS for reasonableness

Isolate manual journal entries, and sort by user

Review for post-closing adjusting journal entries that have no or vague supporting documentation

Debits to the reserve accounts and credits to the expense accounts


Improper Capitalization of Expenses

Capitalized Expenses

Under GAAP certain costs are allowed to be capitalized on the balance sheet as assets and expensed over time if they will contribute to the production of

revenue in the future (i.e. property, machinery, patents).

These assets are expensed through the income statement over the course of their estimated useful lives using Depreciation or Amortization expense.

Example Company purchases a piece of equipment for use in production of its inventory for $500,000. It is expected to be productive for 10 years, after

which it will have no estimated residual value.

Date of purchase

End of first year (and consecutive years)

Dr. Machinery (Asset) $ 500,000

Cr. Cash (Asset) $ 500,000

Dr. Depreciation Expense $ 50,000

Cr. Accumulated Depreciation (Asset) $ 50,000




Occurs when a company capitalizes certain costs that do not meet the criteria established by GAAP.

Occurs when expenses are effectively deferred over the useful life of the asset as opposed to being charged to the income

statement immediately.




Unexplained increase in fixed assets such as property, plant, and equipment.

Related increase in depreciation / amortization

Review additions to these accounts that were NOT processed through standard purchasing process

Lower than expected expenses

As percentage of revenue (vertical analysis)

As compared to prior periods (horizontal analysis)

Manual journal entries posting increases to capital asset accounts where systematic process exists

Unexplained significant variances between actual capital expenditures and budgeted amounts




Data Analytics

Analyze significant CREDITS to expense/loss accounts on the income statement and review offsetting DEBITS for reasonableness

Isolate manual journal entries, and sort by user

Review for post-closing adjusting journal entries that bring the company into line with earnings expectations

Management does not usually know what the consolidated earnings are until after period-end

Late, manual journal entries are often posted to tweak earnings to meet expectations


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