In today’s “earnings crazed” environment, there are times when management, in an effort to whitewash a company’s (or a division’s) poor performance, may attempt to boost sales by the improper premature recognition of sales. Such decisions may be based on pressures to meet budget projections and goals, or management’s compensation may be tied to achieving specified sales targets in the form of bonuses or options, or perhaps the expectations of securities analysts for the company’s stock were overly optimistic. A downturn in the economy may contribute to a company’s deteriorating financial condition, causing well-meaning management to “cook the books” in order to keep the company afloat, thereby saving their jobs and the jobs of their employees. Whatever the reason, early revenue recognition is a distortion intended to mislead the users of the financial statements.
Common inventory schemes to “pump-up” revenues. A simple early revenue recognition scheme may entail shipping excess (or unordered) inventory to customers and recording fictitious sales prior to the closing of the books for the period. Since the shipment occurred during the period, the accounting records will reflect them as sales, thereby increasing total sales for that period. When the customers return the unwanted goods (as they surely will), the returns are recorded in the subsequent period.
A similar, but more complex variation of accelerated revenue recognition found in the retail industry is the “bill and hold” scheme. In this scheme, outdated or slow-moving inventory is shipped from the company warehouse to an off-site, third party warehouse. The shipment is treated as a sale and a corresponding receivable is recorded.
Since the Sarbanes-Oxley Act of 2002 (SOA) was signed into law, the halls of executive suites of public companies have seen tremendous activity as CEOs and CFOs address their corporate accountability and financial reporting oversight responsibilities. They now realize that such efforts are more than just good business practice, as they have always been, but also are matters that carry severe penalties under the law. Likewise, audit committee responsibilities have expanded such that membership has become an invitation to delve into a company’s affairs at an unprecedented level of depth, subject to the scrutiny of the external auditors as well as investors. This "new era of corporate accountability and responsibility" means that the checks and balances of the system of internal controls are now clearly in the purview of corporate management, including the company’s chief legal officer or general counsel (GC).
This shift has raised the bar for many GCs to a higher level of visibility and accountability. For many companies, internal control over financial reporting, especially the related anti-fraud controls, were previously the responsibility of the controller, middle management functions and various process owners, and subject to review and testing by internal audit. The focus has often been limited to third party fraud. Now that the game has been expanded to fraudulent financial reporting, it requires a referee. Documentation requirements, particularly policies and procedures regarding the anti-fraud program and the internal reporting and escalation of internal control deficiencies, could potentially now fall to the GC to define.
In order to meet the challenges of this significant role in corporate governance, GCs need access to resources and tools that will enable them to make informed decisions when establishing corporate policies and, more importantly, when dealing with situations where there has been a breakdown in internal controls and the possibility of fraud exists. Without proper anti-fraud controls, incidents of fraud can impact a company’s financial performance, permanently damage its reputation and result in shareholder lawsuits. All of these circumstances refocus the company resources away from their primary purpose – the operations of the organization for the benefit of the shareholders.
While the major "eye-popping," headline-grabbing financial statement frauds have captured the attention of the investing public in recent years, little heed has been given to the smaller dollar, repetitive frauds that occur in organizations year in, year out. These unauthorized transactions can deplete the resources of an organization in much the same way that wind and water can reshape large boulders - gradually, unnoticeably over time, until the scheme is either discontinued or it is uncovered and brought into focus.
In the 2004 Report to the Nation on Occupational Fraud and Abuse, the Association of Certified Fraud Examiners estimates that six percent of revenues will be lost to fraud. When viewed in a vacuum, six percent may seem to be an immaterial amount to many larger entities, but when it is considered as a percentage of the total Gross Domestic Product of $11 trillion, this "immaterial percentage" now translates into $660 billion lost to fraud annually.
According to a November 2003 fraud survey released by KPMG, financial reporting fraud cost the most per incident, however employee fraud was the most prevalent, occurring in 60% of the companies surveyed. Even more troubling are the trends behind that statistic - over the past five years, theft of assets and expense account abuse, already high in 1998 (the last time the survey was conducted) more than doubled in 2003.