As part of a financial audit, the auditor must assess the inherent risk associated with the revenue cycle and perform tests to determine it is relatively free of error or fraud. The inherent risk for this cycle is related to the cutoff dates for particular types of sales and the pressures from management to misstate revenues. By conducting so-called substantive tests and tests of controls, the auditor can provide some assurance that the revenues of the company are recorded accurately. Show
The Revenue and Receipts CycleRevenue recognition issues usually stem from consignment sales, round-trip sales, refund and return rights, gross sales and bill and hold transactions. Sometimes management feels pressure to misstate revenues to encourage investors or impress upper-level management or the board of directors. Other times it is simply a case of human error and recording the revenue at the wrong time, reports CPA Charles Hall. Before performing the audit, the auditor should develop an understanding of both the entity and industry in which the organization operates so he can better assess the outcome of the auditing procedures. Analytical ProceduresAnalytical procedures often include running various financial ratios and comparing them to industry benchmarks. For the revenue cycle, the auditor examines the gross profit margin and the amount of growth that the company has experienced in one year. As part of the revenue cycle audit checklist, he should analyze the organization's maximum capacity for sales if its facility and employees were fully utilized. He must also examine the accounts receivable account to ensure it is not outgrowing sales. If it is, this could indicate that the company is a credit risk and may have cash flow problems in the future. Tests of ControlsThe main component for the internal controls of an organization, no matter which cycle they are pertinent to, is management's adoption and adherence to high ethical standards and strong controls. According to professional services firm Kaufman Rossin, tests of controls for the revenue cycle include:
Substantive TestsOther audit procedures for the revenue cycle journal include the performance of substantive tests. This will help to find any errors or misstatements within the accounts or documentation associated with the revenue cycle. These tests include checking the trial balance that the accountant creates at the end of the cycle, confirming receivable amounts with the company or person who owes money and evaluating the accuracy of the allowance for uncollectible accounts by reviewing the history of the entity. They also include vouching, tracing and performing cutoff tests for all sales, sales returns and cash receipts. To do this, the auditor examines all documentation related to a customer and also examines a journal entry; she then either works forward from the initial sales order to the journal entry or backward from journal entry to initial sales order to determine accuracy. On Dec. 2, 2001, energy behemoth Enron shocked the world with its widely-publicized bankruptcy after the firm was busted for committing egregious accounting fraud. Its dubious tactics were aimed at artificially improving the appearance of the firm's financial outlook by creating off-balance-sheet special purpose vehicles (SPVs) that hid liabilities and inflated earnings. But in late 2000, The Wall Street Journalcaught wind of the firm's shady dealings, which ultimately led to the then-largest U.S. bankruptcy in history. And after the dust settled, a new regulatory infrastructure was created to mitigate future fraudulent dealings. Key Takeaways
Detecting Financial Statement FraudWhat Is Financial Statement Fraud?The Association of Certified Fraud Examiners (ACFE) defines accounting fraud as "deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some unauthorized benefit to the individual or to the entity or some other party." Put simply, financial statement fraud occurs when a company alters the figures on its financial statements to make it appear more profitable than it actually is, which is what happened in the case of Enron. Financial statement fraud is a deliberate action wherein an individual "cooks the books" to either mislead investors. According to the ACFE, financial statement fraud is the least common type of fraud in the corporate world, accounting for only 10% of detected cases. But when it does occur, it is the most costly type of crime, resulting in a median loss of $954,000. Compare this to the most common and least costly type of fraud—asset misappropriation, which accounts for 85% of cases and a median loss of only $100,000. Nearly one-third of all fraud cases were the result of insufficient internal controls. About half of all the fraud reported in the world were executed in the United States and Canada, with a total of 895 reported cases or 46%. The FBI counts corporate fraud, including financial statement fraud, among the major threats that contribute to white-collar crime. The agency states that most cases involve accounting schemes where share prices, financial data, and other valuation methods are manipulated to make a public company appear more profitable. Types of Financial Statement FraudAnd then there's the outright fabrication of statements. This, for instance, famously occurred when disgraced investment advisor Bernie Madoff collectively bilked some 4,800 clients out of nearly $65 billion by conducting an elaborate Ponzi scheme that involved wholly falsifying account statements. Financial statement fraud can take multiple forms, including:
Another type of financial statement fraud involves cookie-jar accounting practices, where firms understate revenues in one accounting period and maintain them as a reserve for future periods with worse performances, in a broader effort to temper the appearance of volatility. The Sarbanes-Oxley Act of 2002The Sarbanes-Oxley Act of 2002 is a federal law that expands reporting requirements for all U.S. public company boards, management, and public accounting firms. The Act, often abbreviated as Sarbanes–Oxley or SOX, was established by Congress to ensure that companies report their financials honestly and to protect investors. The rules and policies outlined in SOX are enforced by the Securities and Exchange Commission (SEC) and broadly focus on the following principal areas:
The law is not voluntary., which means that all companies must comply. Those that don't adhere to the are subject to fines, penalties, and even prosecution. Financial Statement Fraud Red FlagsFinancial statement red flags can signal potentially fraudulent practices. The most common warning signs include:
Financial Statement Fraud Detection MethodsWhile spotting red flags is difficult, vertical and horizontal financial statement analysis introduces a straightforward approach to fraud detection. Vertical analysis involves taking every item in the income statement as a percentage of revenue and comparing the year-over-year trends that could be a potential flag cause of concern. A similar approach can also be applied to the balance sheet, using total assets as the comparison benchmark, to monitor significant deviations from normal activity. Horizontal analysis implements a similar approach, whereby rather than having an account serve as the point of reference, financial information is represented as a percentage of the base years' figures. Comparative ratio analysis likewise helps analysts and auditors spot accounting irregularities. By analyzing ratios, information regarding day's sales in receivables, leverage multiples, and other vital metrics can be determined and analyzed for inconsistencies. A mathematical approach known as the Beneish Model evaluates eight ratios to determine the likelihood of earnings manipulation, including asset quality, depreciation, gross margin, and leverage. After combining the variables into the model, an M-score is calculated. A value greater than -2.22 warrants further investigation, while an M-score less than -2.22 suggests that the company is not a manipulator. The Bottom LineFederal authorities have put laws in place that make sure companies report their financials truthfully while protecting the best interests of investors. But while there are protections in place, it also helps that investors know what they need to look out for when reviewing a company's financial statements. Knowing the red flags can help individuals detect unscrupulous accounting practices and stay one step ahead of bad actors attempting to hide losses, launder money, or otherwise defraud unsuspecting investors. What are the risks associated with the revenue cycle?Common risks associated with the revenue cycle include the authorization or accuracy of sales contracts with clients. You must ensure prices are quoted correctly following your sales pricing policy.
What could go wrong in the revenue and receipt cycle?Incorrect goods or quantities could be despatched. Goods despatched may not be invoiced. Invoices could be duplicated in the sales journal. Payments received from customers may not be deposited in the bank due to theft or carelessness.
What are the four activities in the revenue cycles?Four basic business activities are performed in the revenue cycle: sales order entry, shipping, billing, and cash collection.
What are the controls of revenue cycle?They are authorization, supervision, segregation of duties, access control, independent verification, and accounting records.
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