However, while the introduction of additional judgments and estimates may provide greater opportunity for fraud, the additional disclosures required by the standard theoretically would make it more difficult for the fraudsters to cover their tracks when justifying certain financial reporting practices.
Clamping Down on Potential Revenue Recognition Fraud
The additional professional judgment required by the new revenue recognition standard could expose companies to an increased level of fraud given the inherent opportunity for bias created by a principles-based framework.
The new standard moves companies away from a rules-based framework to a more principles-based approach as it relates to the way they report financial information. In some cases, that could increase exposure to fraud or noncompliance during the transitional period, as well as the first few years after adoption.
For years, revenue recognition fraud has been a focus of U.S. regulators, due in large part to revenue being a primary category that affects an entity’s financial position and results of operations. In addition, there may be an incentive for management to inflate revenue given bonus payouts are often determined by these metrics. The manipulation of revenue could result in a misstatement of an entity’s EBITDA* and other profitability ratios, which investors and the public rely on when making investment decisions. Reliance on fraudulent information could eventually misstate the share price.
According to the COSO study, the two most common schemes identified were related to fictitious sales or revenue and timing issues, which together accounted for 83 percent of the revenue recognition schemes investigated by the SEC. The reporting of fictitious revenue or recognizing revenue at an improper time may affect more than one financial element, statement, and/or period.