Common Fraud Schemes

Presented by R.Guruprakash

Fraud SchemeMechanism, scenario, sequence of actions

through which financial statements may be intentionally mis-stated.

If a fraud scheme is likely to exist, it is important that we develop appropriate audit responses which specifically addresses the fraud scheme.

Common Fraud Schemes

• Revenue Recognition• Management Estimates• Fair Value Measurements• Complex Transactions• Other Risks

Today’s Discussion

Fraud Scheme w.r.t. Revenue Recognition

Suggested Controls that may exist at the entity

vs

Suggested substantive procedures which can be performed to address the scheme

Revenue Recognition

Validity Recording Cut-off

Not every fraud scheme indicated here is to exist at all circumstances

ValidityRecording of fictitious revenues

Controls to consider:• Invoices are approved for processing based

on a comparison to priced order, shipping source documents, and signed customer acceptance.

• Statements are sent periodically to customers and queries are investigated.

ValidityRecording of fictitious revenues

Substantive procedures to consider:• Verify existence of customers using, for

example, trade directories, websites, phone book.

• Send confirmations for receivable balances or outstanding invoices.

• Make a selection of recorded sales transactions and examine relevant documentation to confirm validity.

ValidityRecording of fictitious revenues

Substantive procedures to consider:• Make a selection of debits to sales in the

following period and investigate the reasons. • Tailor information requested in confirmations

sent to customers to the identified risk and confirm there are no side agreements. Follow up non-replies by contacting the customer directly.

ValidityRecognition of revenue when:

• Products or services are not delivered, delivery is incomplete or delivered without customer acceptence

• Bill and hold• Channel stuffing• Collectibility is not reasonably assured• By a lessor from an operating lease as a

sale• Goods on consignment• Disputes or claims exist

ValidityRecognition of revenue when products not delivered

Controls to consider: • Invoices are approved for processing based

on a comparison to priced order, shipping source documents, and signed customer acceptance.

• Statements are sent periodically to customers and queries are investigated

ValidityRecognition of revenue when products not delivered

Substantive procedures to consider: • Make a selection of contracts that include

customer acceptance provisions and determine whether these provisions were met for revenue that has been recognized. Inspect shipping documents in support of invoices for missing, altered or incorrect information.

ValidityRecognition of revenue when products not delivered

Substantive procedures to consider: • Verify existence of customers using, for

example, trade directories, websites, phone book.

• Tailor information requested in confirmations sent to customers to the identified risk(s) and confirm there are no side agreements. Follow up non-replies by contacting the customer directly.

ValidityRecognition of revenue when “bill and hold”

“bill and hold” sales transactions billed, but not shipped

ValidityRecognition of revenue when “bill and hold”

Controls to consider: • Management has established a policy for

recognition of revenue from “bill and hold” transactions that complies with the requirements of accounting standards.

• Invoices are approved for processing based on a comparison to priced order, shipping source documents, and signed customer acceptance of receipt of order.

ValidityRecognition of revenue when “bill and hold”

Substantive procedures to consider: • Inquire of shipping department if shipments

to any customers have been shipped elsewhere or delayed. Examine shipping documents supporting sales transactions and investigate any shipped to a warehouse or carrier and not to the end customer.

ValidityRecognition of revenue when “bill and hold”

Substantive procedures to consider: • Verify existence of customers using, for

example, trade directories, websites, phone book

• Tailor information requested in confirmations sent to customers to the identified risk(s) and confirm there are no side agreements. Follow up non-replies by contacting the customer directly.

ValidityRecognition of revenue when “channel stuffing”

“channel stuffing” excessive shipments to resellers beyond actual demand

ValidityRecognition of revenue when “channel stuffing”

Controls to consider: • Rebates and incentives offered to

distributors are independently reviewed and approved.

• Returns for credit are independently reviewed and approved.

ValidityRecognition of revenue when “channel stuffing”

Substantive procedures to consider: • Examine rebates and other incentives paid to

distributors in the period and subsequently, and consider whether the motive was to entice distributors to order larger quantities than normal, which might be returned.

• Make a selection of returns in the following period and consider whether there is evidence of inappropriate recognition of revenue from channel stuffing.

ValidityRecognition of revenue when “channel stuffing”

Substantive procedures to consider: • Perform analytical procedures to identify unusual

trends in the level of revenue (e.g., high revenues in the last month of the year and low revenues in the first month of the next year).

• Tailor information requested in confirmations sent to customers to the identified risk and confirm there are no side agreements. Follow up non-replies by contacting the customer directly.

ValidityRecognition of revenue from sales where collectability is not reasonably assured

Controls to consider: • Sales to customers who are in arrears or

who request extended terms of payment are independently approved. Accounting for sales to these customers is subject to review

Substantive procedures to consider: • Make inquiries of credit department of customers

unable or unwilling to pay, or who have asked for extended payment terms, and review revenue recorded for sales to these customers for collectability. Consider whether revenue should only be recognized upon payment.

• Review sales to customers whose accounts were written off to assess whether revenue should have been recognized in the first place

ValidityRecognition of revenue for goods on consignment

Controls to consider: • Management has established a policy for

recognition of revenue from customers that hold goods on consignment that complies with the requirements of accounting standards.

• Contracts with customers are independently reviewed to ensure that invoices are issued and revenue is recognized appropriately in cases of goods delivered on consignment

ValidityRecognition of revenue for goods on consignment

Substantive procedures to consider: • Examine documentation supporting sales

transactions to see if there are any conditions relating to consignment that would preclude recognition of revenue at the time of shipment.

• Tailor information requested in confirmations sent to customers to the identified risk and confirm there are no side agreements. Follow up non-replies by contacting the customer directly

ValidityRecognition of revenue when disputes or claims exist

Controls to consider: • Customer disputes and claims are

independently reviewed and adjustments are made to revenue as appropriate

ValidityRecognition of revenue when disputes or claims exist

Substantive procedures to consider: • Discuss with management, sales personnel,

credit department and legal counsel the existence of any disputes with or claims from customers.

• Investigate reason(s) for non-payment of long outstanding accounts.

• Tailor information requested in confirmations sent to customers to the identified risk. Follow up non-replies by contacting the customer directly.

ValidityRecognition by a lessor of revenue from an operating lease as a sale

Controls to consider: • Accounting for lease contracts is determined

by persons with knowledge of the contract conditions and adequate knowledge of lease accounting. The accounting for leases is subject to independent review and approval

ValidityRecognition by a lessor of revenue from an operating lease as a sale

Substantive procedures to consider: • Examine lease contracts and consider

whether they meet the conditions for a capital lease and recognition as a sale.

RecordingFailure to establish appropriate reserves for sales discounts and other allowances

Controls to consider: • Management has established a policy for

granting sales discounts and allowances. • Management monitors the level of reserves

in relation to the actual level of discounts and allowances granted

RecordingFailure to establish appropriate reserves for sales discounts and other allowances

Substantive procedures to consider: • Make a selection of discounts and

allowances booked in the subsequent period to determine whether any of them relate to sales in the period subject to audit.

• Perform analytical procedures on discounts and allowances and investigate any unusual trends.

RecordingFailure to establish appropriate reserves for “side agreements”

“side agreements” rights to refunds or exchange, cancellation or refusal rights, or liberal unconditional rights of return granted through undisclosed verbal or written agreement

RecordingFailure to establish appropriate reserves for “side agreements”

Controls to consider: • Management has established and

communicated to its customers policies for returns for refund or exchange and cancellation and refusal rights.

• Management monitors the level of reserves in relation to the actual and expected level of credit notes for returns, as well as for contracts with unusual refusal rights or liberal unconditional rights of return.

RecordingFailure to establish appropriate reserves for “side agreements”

Substantive procedures to consider: • Make a selection of refunds, credits or

exchanges booked in the subsequent period to determine whether any of them relate to sales in the period subject to audit.

• Perform analytical procedures on sales returns and investigate any unusual trends.

RecordingFailure to establish appropriate reserves for “side agreements”

Substantive procedures to consider: • Tailor information requested in confirmations

sent to customers to the identified risk and confirm there are no side agreements. Follow up non-replies by contacting the customer directly.

Recording

Recognizing inappropriate amount of revenue from swaps or barter arrangements

Controls to consider: • Management has established a list of

suppliers to whom sales require independent approval.

• Sales to suppliers are independently reviewed so the nature can be investigated and the amount of revenue determined in the case of barter transactions.

• The accounting for sales of inventory previously written down is subject to independent review.

Substantive procedures to consider: • Identify entities that are both suppliers and

customers and investigate the accounting for situations where similar products were bought and sold.

• Make inquiries of warehouse personnel about sales of obsolete inventory and investigate whether any may be barter transactions with another party.

Recording

Recognizing inappropriate amount of revenue from transactions involving the receipt of equity or other securities as payment

Controls to consider: • Management has established a policy

regarding payment in forms other than cash. • Revenue from payments in forms other than

cash is determined based on a proper valuation of the securities received.

Substantive procedures to consider: • Inquire into the reasons for accepting a form of

payment other than cash and consider whether the revenue should be recognized.

• Consider whether the security has been appropriately valued to determine the amount of revenue to be recorded.

• Tailor information requested in confirmations sent to customers to the identified risk and confirm there are no side agreements. Follow up non-replies by contacting the customer directly

Recording

Improper recognition of revenue from long-term contacts (including those accounted for using percentage of completion)

Controls to consider: • Management only uses the percentage of

completion method when the stage of contract completion and cost estimates to complete can be reasonably estimated.

• Management uses independent consultants to determine percentage of completion of long term contracts and amount of revenue to be recognized

Substantive procedures to consider: • Visit contract sites and discuss stage of

completion with project management, site personnel or outside consultants. Consider whether billings reflect the actual stage of completion.

Substantive procedures to consider: • Test costs charged to contracts in progress

and determine that they have been allocated to the correct contract. Examine detailed cost estimates to complete the contracts and compare with actual costs incurred after year end; consider whether the stage of completion used to determine revenue is appropriate in relation to percentage of costs incurred

Cut-offRecognition of revenue in the wrong period either by holding the books open after period-end or by closing the books prior to period-end

Controls to consider: • Goods shipped at, before, or after the end of

an accounting period are reviewed and/or reconciled to ensure complete and consistent recording in the appropriate accounting period.

Substantive procedures to consider: • Make a selection of sales recorded in the

periods immediately before and after the period end and examine supporting documentation to determine whether the revenue has been recorded in the correct period.

• Investigate the reasons for journal entries that appear to move revenues from one period to another.

Substantive procedures to consider: • Perform analytical procedures to identify

unusual trends in the level of revenue (e.g., high revenues in the last month of the year and low revenues in the first month of the next year)

Cut-off

Recognition of revenue where there are contingencies associated with the transaction that have not yet been resolved

Controls to consider: • Management has established a policy for

recognition of revenue from transactions with contingencies that complies with the requirements of accounting standards.

• Revenue from sales that have contingencies is not recorded until it is confirmed that the contingency has been resolved.

Substantive procedures to consider: • Examine documentation to support sales

transactions to see if there are any contingencies that would preclude recognition of revenue.

• Tailor information requested in confirmations sent to customers to the identified risk and confirm there are no side agreements. Follow up non-replies by contacting the customer directly

Cut-offRecognition of revenue associated with undelivered elements of “bundled contracts”

“bundled contracts” multiple-element contracts

Cut-off“bundled contracts”

Controls to consider: • Management has established a policy for

recognition of revenue from multiple element contracts that complies with the requirements of accounting standards.

• Accounting for bundled contracts is determined by persons with knowledge of the contract arrangements and an understanding of accounting for multiple element contracts. The accounting is subject to independent review and approval.

Cut-off“bundled contracts”

Substantive procedures to consider: • For sales that require installation or

subsequent service or have other multiple-element characteristics, examine supporting documentation including contracts to determine that revenue has been recognized appropriately.

Cut-off“bundled contracts”

Substantive procedures to consider: • Tailor information requested in confirmations

sent to customers to the identified risk and confirm which elements of the sale have been completed, and that there are no side agreements. Follow up non-replies by contacting the customer directly

Further more fraud schemes?

Any other possible fraud schemes w.r.t. Revenue Recognition could be brought into the discussion

!! THANK YOU !!for your valuable time