Fraudulent Revenue Schemes and How to Detect Them

Written By Barry Epstein

Of the two major sub-categories of revenue recognition financial reporting fraud – premature recognition of real revenue, and recordation of wholly bogus revenue – the latter should, by all rights, be the easiest to detect, since extraordinary accounting measures have to be taken to perpetuate concealment of what are, after all, nonexistent claims to customer cash.  Furthermore, as with most financial reporting frauds, the perpetrators’ perceived need to “up the ante” from period to period – in order, e.g., to be able to report continuing trends of greater sales volumes and profitability – means that what may have begun as a small matter easily concealed and below most external auditors’ materiality thresholds eventually grows, like the proverbial dirt swept under a rug, to an impossible-to-miss hill which even the most sanguine managers and mediocre auditors will eventually have to metaphorically trip over.

Article Highlights

  • “Red flags” for attempted revenue fraud include transfers of customer receivable balances between or among balance sheet accounts.

  • Returns and allowances may contain signs of fraudulent sales to non-existent customers.

  • Auditors must maintain absolute control over the auditing process.

  • The element of surprise is a key instrument in the auditors’ toolkit.

  • Sophisticated analytical techniques can help to uncover revenue fraud.

Testing Receivables with Audit Confirmations

Wholly fictitious sales transactions may, if they constitute only a modest fraction of total revenues, escape immediate detection, but – thanks to the strictures of double-entry bookkeeping – will have to be accompanied by the creation of bogus receivables from non-existent customers, and this is the thread that will, if pulled upon, cause the entire scheme to unravel.  Because these “customers” will not acknowledge an obligation to the company, selection of these receivables for audit confirmation (a required procedure in most, if not all, routine audits under domestic and international auditing standards applicable to either publicly-held and private companies) cannot be permitted.  Management engaging in fraud will have two choices if such frauds are not to be revealed:  intervene in the confirmation process so that phony responses can be sent to the auditors, or create journal entries that effectively move the fictitious receivables into other balance sheet accounts that won’t be subject to the same level of audit scrutiny.

Regarding the first of these, experience sadly has shown that auditors can be surprisingly obtuse concerning management’s efforts to “assist” in the confirmation process, so as to gain access to those being directed at non-customers who will, presumably, object to the auditors and thus reveal the iceberg’s tip of the scheme.

For example, in the case of a fraud involving a futures commission merchant (FCM) dealing in foreign currencies and regulated by the Commodity Futures Trading Commission (“CFTC”), the client generously offered to e-mail confirmations to its customers, with copies being directed to the auditors, who willingly accepted this proffer of assistance – junior auditors never having much enjoyed licking envelopes and stamps and carrying the confirms to the mailbox, anyhow!  Unbeknownst to the auditors, the set of confirms included a sizeable component of wholly sham receivables having equally spurious e-mail addresses.  These disingenuous attempts to communicate with fictitious customers of course “bounced back” to the sender – i.e., to management – as undeliverable.  However, bounce-backs are not simultaneously directed to the parties “cc’d” on the original e-mail, and thus the auditors never were informed of delivery failures, a situation that the perpetrators of the fraud had accurately understood.  This, coupled with the fact that these were so-called “negative confirmations,” the apparently innocent non-responses to which were taken as indicia of the absence of disputes regarding amounts, resulted in the auditors concluding that the amounts were properly stated and agreed to by the customers.

It should be noted that utilization of negative confirmations is limited under the standards (U.S. Auditing Standards, AU-C Section 505, and PCAOB Interim Auditing Standard AU Section 330) to those circumstances where the auditors have assessed the risk of material misstatement as low and have obtained sufficient appropriate audit evidence regarding the operating effectiveness of controls relevant to the assertion.

The FCM case underscores the fact that even seemingly trivial elements of the audit, such as physical delivery of confirmation requests, present a risk of fraud and have to be given the attention they deserve.  Any breach in the auditors’ absolute control over the auditing process affords management, if it so intends, to intercede and commit fraudulent acts in furtherance of a scheme to remove company assets or create materially false and misleading financial statements.

Other arrangements designed to interfere with the auditors’ attempts to confirm receivables commonly require that allies of the perpetrator serve as would-be customers, who will respond favorably to the auditors’ inquiries regarding amounts ostensibly owed to the company (if positive confirmations are used).  At the very least, having actual street addressees (if not genuine customers) ensures that auditors won’t receive “unknown addressee” mail returns, which almost always would create enough suspicion to trigger expanded procedures.

Recommended Mandatory Audit Steps

Auditors can avoid falling victim to phony addressee schemes by controlling the confirmation mailing or e-mailing process, including, on a sample basis, verifying the actual existence of the addressee using telephone books, business directories, or other reference materials.  Computerized routines to compare putative customers’ addresses with addresses for company employees (a common fraud being to use workers as allies in such schemes, either on some pretense of legitimacy or for a small share of the ill-gotten gains) should also be a mandatory audit step.

Also, as trite as it sounds, simply being alert and using common sense would often be sufficient to detect fraud.  In another substantial case involving fraudulent sales to non-existent customers, the auditors failed to notice, over several consecutive years, that certain confirmations were being mailed to the auditee’s very own address!  Although the address was a multi-tenant industrial facility, and thus could have been the home of a customer or two, the odds of that were remote, and the auditors could have, with the expending of almost no effort, attempted to visit the purported customer.  This never happened.

Risks of Computer-Based Auditing

Ironically, the use of “computer-based auditing” has biased auditors toward remaining seated in front of their computers during most of their field work, rather than actively engaging with client personnel by, e.g., walking around, observing, talking with operating

[i.e., non-financial] personnel, and using intuitive approaches either to gain comfort with client assertions [e.g., regarding volume of activity] or to take note of “red flags” suggesting lack of veracity in management’s proclamations regarding the scope of the business.  Auditing needs to be understood as an active, not a passive, pursuit.

Finding Fictitious Receivables in Returns or Allowances

The other avenue by which wholly fraudulent sales can be disguised and hidden from auditors requires that the corresponding amounts recorded as receivables be eliminated from the books before accounts are selected for confirmation.  Most commonly, this is accomplished by posting bogus journal entries that transfer the bogus balances.  For example, receivables balances may be eliminated by means of recording fictitious returns or, more often, allowances, which are then explained as being “goodwill” non-cash credits to mollify unhappy customers.  (Falsifying returns are more challenging, particularly if the company has reasonable internal controls that require the matching of receiving reports with customer credit memo requests.)  In other instances, relieving fictitious receivables will be accomplished by moving the debit to another balance sheet account, such as long-lived assets, where corroboration via the confirmation process will not be a threat.

Obviously, any of these ploys are subject to almost certain discovery, if the auditors rigorously review all general journal entries made each period.  This is not a burdensome demand, because there should only be a relative handful of such entries – such as accrual and deferral adjustments at period-end – and any transfers between or among balance sheet accounts are almost certainly “red flags” of attempted fraud.  Once detected, a preponderance of frauds has been shown to involve, at least in part, what should have been seen as inexplicable general journal entries.  Had these been timely observed and understood by the auditors, the application of expanded audit procedures could have nipped these frauds in the bud.  Consider, for example, WorldCom’s transfer of billions of dollars of “line charges” (which are current period operating expenses) to long-lived asset accounts, subject to amortization over a number of years.  Transfers of this sort should have appeared strange; with a little effort, the utter lack of rationale for such accounting would have been revealed, leading to discovery of the other two major accounting anomalies which, in total, resulted in recognition of about $11 billion of fabricated earnings.

In other cases, as the bogus receivable ages – and thus grows more likely to be examined by the auditors – it is “freshened up” by moving it to another customer account, where it will be born again as a seemingly routine, current balance, and thus less likely to be chosen for examination.  Clearly, any unusual entries in the subsidiary customer receivables ledger (i.e., any debit entry not arising from a sale, or any credit entry not arising from a cash receipt or authorized return or allowance) would be cause for expanded testing and risk assessment review.  Also, notwithstanding that auditing depends on sample testing, no portion of a population (e.g., current-dated, small receivables balances) can be entirely immune to sample selection.  If any part of an accounting population (e.g., current-dated receivables) is exempt from testing, this fact will become known and fraudulent journal entries can be used to exploit this inadvertent safe harbor to conceal fraud.

Using the Element of Surprise to Detect Fraudulent Revenue

It is important to remember that the element of surprise is a key instrument in the auditors’ toolkit.  For example, “surprise” confirmations sent at interim dates, when management would normally not expend much energy to conceal fraudulent receivables, are more likely to be effective than are the predictable year-end audit procedures.  Indeed, the mere knowledge that the auditors might employ such procedures may dissuade those otherwise intending to commit revenue fraud, in the same manner that placing “dummy” cameras in the plant discourages theft of materials.

As mentioned in a related article, the use of sophisticated analytical techniques can prove very effective in uncovering a wide range of financial reporting frauds.  In the instance of bogus revenues, comparisons, made on a weekly or monthly basis, of customer allowances (and also, if controls are weak, of customer returns) to total revenues would be one tactic that could be used to flag possibly fraudulent non-cash credits that are being used to eliminate recorded receivables that, in truth, never existed and therefore could never be collected.

Similarly, aging analyses performed at various interim dates may reveal year-end anomalies arising when the fraud perpetrator scrambles to hide these uncollectible balances, assuming (usually, correctly) that the auditors will fail to notice the accumulation of bogus receivables at interim dates.  Unless random, interim-date analytical data is obtained, there will be no “base line” for contrasting to the year-end amounts or relationships, which will be where the actual fraud will reside.

Even for clients maintaining good controls over their financial reporting procedures, the occasional application of these atypical (in terms of either timing or nature) procedures will serve multiple purposes:  they will keep the audit intellectually interesting and thus keep staff more effectively engaged in the process; they will communicate to the client that it cannot fully anticipate what the auditors might choose to do, or when they might do it, on any given audit; and – who knows? – these unorthodox tests and other procedures might even uncover fraud.

January, 2015

ABOUT THE AUTHOR: Accounting expert Barry Jay Epstein, Ph.D., CPA, CFF, is a Chicago-based forensic accountant, author and frequent expert witness who works with securities attorneys and U.S. regulatory agencies in the areas of white-collar defense, financial reporting, fraud, securities litigation, and auditor liability. He can be reached at barry.epstein@ene.llc.

NOTE: Readers of this article may also be interested in related articles and white papers published by Dr. Epstein. Click on a link below to read more:

Barry Epstein
Previous

An Auditor’s Guide to Uncovering Under-Reported Income in Cash Businesses
Next

Fraud Modeling and Financial Reporting Fraud