Improper revenue recognition: to help clients avoid SEC violations, internal auditors need to understand the revenue management practices that can lead to material misstatements

Internal Auditor, June, 2004 by H. Lynn Stallworth, Dean Digregorio

U.S. SECURITIES AND EXCHANGE COMMISSION (SEC) enforcement activity aimed at curbing earnings management and fraudulent financial reporting has increased markedly in recent years. In 2003, the SEC filed a record number of accounting and auditing enforcement actions against both companies and individuals. The individuals charged included senior managers and lower-level staff, accountants and sales managers, external auditors, and even customers. Most of these enforcement actions focused on earnings management, with violations of Generally Accepted Accounting Principles (GAAP) for revenue recognition constituting the most common offense. The SEC has also frequently cited violations of its Staff Accounting Bulletin (SAB) No. 101 revenue recognition guidelines.

Although media coverage of fraudulent revenue recognition has focused on large companies such as Gateway Inc., Xerox Corp., and Enron Corp., the SEC has taken action against public firms of all sizes. As high-profile corporate scandals have continued to unfold, Congress has increased funding and staffing for the SEC, ensuring that the pace of enforcement activity continues to be aggressive and intense.

The SEC has, in effect, notified internal auditors that revenue recognition is a high-risk area. Furthermore, the passage of the U.S. Sarbanes-Oxley Act of 2002 put management and audit committees on notice about their responsibilities regarding financial reporting.

Internal auditors have an important role to play in helping management and the audit committee safeguard the integrity of the financial reporting process. An awareness of the specific types of revenue transactions that violated GAAP and SAB No. 1, resulting in SEC enforcement action, can help internal auditors fulfill their responsibilities.

UNDERSTANDING REVENUE RECOGNITION

Corporate revenue recognition has long been vulnerable to illegal manipulation. In fact, according to a 1999 report by The Committee of Sponsoring Organizations of the Treadway Commission (COSO), Fraudulent Financial Reporting: 1987-1997--An Analysis of U.S. Public Companies, more than half of financial reporting frauds in the study involved revenue misstatements. Improper revenue recognition has been an ongoing focus of SEC investigations, and it has been addressed in several GAAP pronouncements. GAAP revenue recognition guidelines, for example, are included in the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists, and No. 49, Accounting for Product Financing Arrangements, as well as FASB's Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. The accounting literature also includes industry-specific guidelines.

In recent years, revenue recognition has become increasingly complex due to factors such as international competition and rapidly evolving business models. Constant process and technology innovation also create challenges, as both Internet-based and traditional brick-and-mortar businesses continue to develop innovative distribution channels and sales agreements that complicate revenue recognition. For example, Web-based companies must determine how revenue should be recognized for online sales, licensing, subscription, service, and maintenance agreements. Unless effective controls are in place, the real-time nature of online transactions can easily lead to accounting violations such as recording revenues before goods are actually shipped or services are provided. Progressive fulfillment practices such as outsourcing and drop-shipping can also cause revenue-recognition problems due to delays in recording liabilities and related expenses.

In an effort to specifically target problems associated with revenue recognition within complex business environments, the FASB's Emerging Issues Task Force (EITF) has issued pronouncements such as EITF 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent and EITF 00-21, Revenue Arrangements With Multiple Deliverables. FASB is also working in conjunction with the International Accounting Standards Board on a comprehensive statement on revenue recognition.

In the meantime, the SEC has issued SAB No. 101 to provide additional guidance on applying GAAP to revenue recognition. The bulletin states that revenue is generally realized, or realizable and earned, when 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.

* Collectibility is reasonably assured.

The guidance presents a series of questions and answers pertaining to revenue recognition, using context-specific examples of various scenarios including consignment, bill-and-hold, and layaway sales, as well as prepaid fees and sales returns. In December 2003, the SEC issued SAB No. 104, which clarified the SAB No. 101 guidelines to conform to recent EITF pronouncements on revenue recognition issues.