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Revenue and related accounts receivable and cash accounts are especially susceptible to manipulation and theft. A study sponsored by the Committee of Sponsoring Organizations (COSO) found that more than half of financial statement frauds involve revenues and accounts receivable. Similarly, because sales are often made for cash or are quickly converted to cash, cash is also highly susceptible to theft.

Fraudulent Financial Reporting Risk for Revenue
As a result of the frequency of financial reporting frauds involving revenue recognition, the AICPA and SEC issued guidance dealing with revenue recognition. Auditing standards specifically require auditors to identify revenue recognition as a fraud risk in most audits.

Several reasons make revenue susceptible to manipulation. Most important, revenue is almost always the largest account on the income statement; therefore a misstatement only representing a small percentage of revenues can still have a large effect on income. An overstatement of revenues often increases net income by an equal amount, because related costs of sales are usually not recognized on fictitious or prematurely recognized revenues. Revenue growth is often a key performance indicator for analysts and investors, providing an even greater incentive to inflate revenue. Another reason revenue is susceptible to manipulation is the difficulty of determining the appropriate timing of revenue recognition in many situations.
Three main types of revenue manipulations are:

Fictitious revenues
Premature revenue recognition
Manipulation of adjustments to revenues
Fictitious Revenues
The most egregious forms of revenue fraud involve creating fictitious revenues. You may be aware of several recent cases involving fictitious revenues, but this type of fraud is not new. The 1931 Ultramares case described in Chapter 5 involved fictitious revenue entries in the general ledger.

Fraud perpetrators often go to great lengths to support fictitious revenue. Fraudulent activity at Equity Funding Corp. of America, which involved issuing fictitious insurance policies, lasted nearly a decade (from 1964 to 1973) and involved dozens of company employees. The perpetrators held filestuffing parties to create the fictitious policies.

Premature Revenue Recognition
Companies often accelerate the timing of revenue recognition to meet earnings or sales forecasts. Premature revenue recognition, the recognition of revenue before accounting standards requirements for recording revenue have been met, should be distinguished from cutoff errors, in which transactions are inadvertently recorded in the incorrect period. In the simplest form of accelerated revenue recognition, sales that should have been recorded in the subsequent period are recorded as current period sales.

One method of fraudulently accelerating revenue is through violating accounting rules related to “billandhold” sales. Sales are normally recognized at the time goods are shipped, but in a billandhold sale, the goods are invoiced before they are shipped. These types of sales can be legitimate depending on the contract terms, but can violate accounting standards if the required terms are not met. Another method involves issuing side agreements that modify the terms of the sales transaction. For example, revenue recognition is likely to be inappropriate if a major customer agrees to “buy” a significant amount of inventory at yearend, but a side agreement provides for more favorable pricing and unrestricted return of the goods if not sold by the customer. In some cases, as a result of the terms of the side agreement, the transaction does not qualify as a sale under accounting standards.

Two notable examples of premature revenue recognition involve Bausch and Lomb and Xerox Corporation. In the Bausch and Lomb case, items were shipped that were not ordered by customers, with unrestricted right of return and promises that the goods did not have to be paid for until sold. The revenue recognition issues at Xerox were more complex. Capital equipment leases include sales, financing, and service components. Because the sales component is recognized immediately, Xerox attempted to maximize the amount allocated to this aspect of the transaction.
Manipulation of Adjustments to Revenues
The most common adjustment to revenue involves sales returns and allowances. A company may hide sales returns from the auditor to overstate net sales and income. If the returned goods are counted as part of physical inventory, the return may increase reported income.