Now that FASB’s new revenue recognition standard is effective, it is worth considering how well the guidance meets the goals originally set by the board. One of the original motives for the standard was to prevent fraud and abuse in the recognition of revenue. The author examines the standard in light of its potential impact on fraud, noting where it closes off some avenues for abuse and where it leaves others open.
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FASB had many goals in issuing Accounting Standards Codification (ASC) Topic 606, “Revenue Recognition from Contracts with Customers,” including removing inconsistencies in multiple sources of guidance, providing a more robust comprehensive framework for addressing revenue recognition issues, and improving the comparability and usefulness of financial information. Concern about fraud was also one of the original motivations for the project, as illustrated in the sidebar, Timeline of How Revenue Fraud and Abuse Motivated the New Guidance. Improper revenue recognition has been a major source of restatements and prominently identified in SEC enforcement actions. Given this concern, CPAs might ask how the new guidance will affect revenue recognition fraud or abuse.
This article explores that issue, including both the positive and negative impacts of the new guidance on potential fraud and abuse. While Topic 606 reduces the risk related to several types of revenue recognition frauds perpetrated previously, it also introduces other new risks.
Rejected and Adopted Models
FASB’s concern with reducing fraud and abuse is apparent in its rejection of two approaches that would have increased opportunities for such in the recognition of revenue. Specifically, FASB rejected an activities model for revenue recognition because revenue could have been accelerated at the end of a reporting period simply by increasing activities, such as production of inventory.
FASB also rejected the measurement of performance obligations assumed in a contract with a customer directly at current exit prices. This approach could have resulted in recognizing revenue at the very inception of a contract when, as is typical, the transaction price included an amount to recover the cost of obtaining the contract. Instead, FASB chose to measure those obligations at the same amount as the contract rights at inception, that is, allocating the transaction price to performance obligations. By doing so, FASB precluded one possible approach to upfront recognition of revenue prematurely before performance. Thus, FASB seems to have been well aware of the potential for revenue fraud and abuse and to have deliberately avoided a model that would invite improper revenue recognition.
Instead, FASB adopted a five-step model for revenue recognition that is compared to the four-criteria model the SEC staff presented in Staff Accounting Bulletin (SAB) 101, Revenue Recognition in Financial Statements, in the sidebar, Comparison of FASB ASC 606 with SAB 101/104. The SEC’s model was directed specifically at combatting frauds and abuses in revenue recognition; thus, a comparison of the two models provides a useful background to assess how the new accounting guidance may affect the potential for same. The three primary points of comparison are contract existence (including structuring and combining contracts), identification and satisfaction of performance obligations, and determination and allocation of transaction price. This article weighs each on the fraud scale, describes previous frauds of the type associated with that point, and considers the implications for combatting fraud and abuse.
FASB concluded that revenue from a contract with a customer cannot be recognized until a contract exists. [FASB’s conclusions can be drawn from the “Background Information and Basis for Conclusions” issued with ASU 2014-09, Revenue from Contracts with Customers (Topic 606); the conclusions cited here and below are drawn from that source.] Topic 606 specifies five criteria for contract existence. The first four criteria—approval and commitment of the parties, identification of rights, identification of payment terms, and commercial substance—require an entity to “assess whether the contract is valid and represents a genuine transaction.” The fifth criterion, establishing a collectability threshold, is also relevant to contract existence because assessing a customer’s credit risk is part of determining whether a contract is valid.
FASB required that a contract have commercial substance for revenue to be recognized in order to preclude entities from artificially inflating revenue by transferring goods or services back and forth to each other for little or no cash consideration. FASB made this requirement applicable to all contracts, not just those with nonmonetary exchanges; in other words, it “decided that all contracts should have commercial substance before an entity can apply the other guidance in the revenue recognition model” (ASU 2014-09, BC 41).
FASB’s intent in establishing the five criteria was “to filter out contracts that may not be valid and that do not represent genuine transactions” (BC 48). Recognizing revenue for arrangements that do not meet the criteria “would not provide a faithful representation of such transactions” (BC 48). Thus, the requirements for contract existence are relevant to the large number of cases of improper revenue recognition involving fake contracts or contracts that were not legally enforceable.
Frauds and abuses.
Manipulation of contracts has been a common element in revenue recognition frauds. Some cases, such as those against ZZZZ Best and Satyam, have involved fictitious contracts. Gemstar purportedly used expired and disputed as well as nonexistent contracts; others, such as Computer Associates, MicroStrategy, and Autonomy, backdated contracts to prematurely recognize revenue. In other instances, such as the matter of Peregrine Systems, material contingencies added in oral or concealed written side agreements resulted in non-binding arrangements. No accounting guidance can prevent fraudulent contract practices, but Topic 606 should focus significant renewed attention on establishing the existence of a valid contract.
FASB’s specific requirements for evidence of contract existence should result in renewed attention to controls and procedures to provide reasonable assurance that revenue is recognized only on contracts that actually exist.
Implications of new guidance.
The increased focus in the accounting guidance on contract existence should enable auditors to better exercise professional skepticism and provide a basis for obtaining more persuasive evidence of whether there is a valid contract with a customer. Management will need to ensure that the controls over the contracting process provide assurance that contracts meet the five criteria for contract existence, and auditors will need to understand and test those controls. Auditors will be able to obtain a deeper understanding of entities’ contracting processes and customary business practices. Because contract terms may be oral or implied by customary practices, auditors will need to understand both explicit and implicit contract terms. As a result, auditors may need to apply procedures specifically directed to contract existence beyond reading written contracts, such as confirmation with customers of contract terms, approvals, acceptance, and the absence of written or oral side agreements.
Accounting guidance by itself cannot eliminate the risk of fake contracts, back-dated contracts, or undisclosed side agreements, but the first step in FASB’s model puts the spotlight on whether there is persuasive evidence that a valid, genuine contract exists. FASB’s specific requirements for evidence of contract existence should result in management and auditors’ renewed attention to controls and procedures to provide reasonable assurance that revenue is recognized only on contracts that actually exist.
Contract Structure and Combination of Contracts
One of FASB’s objectives in developing the new guidance on revenue recognition was that accounting for a contract should depend on an entity’s rights and obligations rather than how the entity structures the contract. As part of this concern, FASB requires that contracts entered into at or near the same time must be combined when one or more of three criteria are met. The three criteria are: negotiation as a package with a single commercial objective, price interdependence, and interdependence of promised goods or services. This is a significant change from prior guidance, in which the combination of contracts was voluntary and permitted only in certain circumstances. This change seems to be aimed at precluding fraud or abuse, such as round-trip transactions.
Frauds and abuses.
In a round-trip transaction, an entity recognizes revenue in one transaction with the customer and, in a separately structured transaction, provides the consideration to the customer that offsets the amount to be received in the revenue transaction. Some well-known examples are Qwest and Global Crossing buying and selling line capacity between them in what was, in substance, a nonmonetary exchange. In other examples, AOL inflated online revenue recognized by paying counter-parties more than the fair value of software, hardware, or other operating equipment acquired, and Peregrine Systems paid for its customers’ software purchases by investing stock or cash in them contemporaneously.
FASB has headed off a possible argument that in a round-trip transaction structured as two separate contracts, the counterparty is a customer on the revenue side while a vendor or supplier on the other side. FASB defines a customer as “a party that has contracted with the entity to obtain goods or services that are an output of the entity’s ordinary activities.” FASB notes that the counterparty is a customer if it meets the definition of a customer “for some or all of the terms of the arrangement.” Topic 606 would thus require combination of the contracts, because investees were customers for some of the terms of the arrangement.
Implications of new guidance.
The new accounting guidance recognizes that contract structuring has been used to improperly recognize revenue and imposes specific requirements aimed at combatting those frauds or abuses. Similar to the central requirements for contract existence, the new guidance should focus the attention of management and auditors on controls and procedures to identify contracts that must be combined. These controls and procedures should be designed to identify contracts that are linked in substance but structured as separate legal contracts.
Timeline of How Revenue Fraud and Abuse Motivated the New Guidance
- September 1998: SEC Chairman Arthur Levitt chastises management and auditors for using “accounting gimmicks,” particularly manipulating revenue, and promises Staff Accounting Bulletins (SAB) that will combat the abuses.
- October 1998: SEC Chief Accountant Lynn Turner sends a letter to the AICPA identifying inappropriate revenue recognition practices being seen by the SEC staff and calling for existing AICPA guidance on software revenue recognition to be applied by other industries.
- December 1999: The SEC staff issues SAB 101, Revenue Recognition in Financial Statements, which extends the criteria for software revenue recognition to all SEC registrants. SAB 101 notes that studies of SEC enforcement actions indicate over half of financial reporting frauds involve overstatement of revenue. (In 2003, SAB 104 expanded the guidance in SAB 101.)
- July 2001: Turner writes FASB, calling for it, in partnership with the IASB, to develop a high-quality comprehensive standard that would provide adequate investor protection.
- May 2002: FASB adds the revenue recognition project to its agenda, noting that revenue recognition issues top the list of reasons for financial reporting restatements.
- June 2005: The Financial Accounting Standards Advisory Council discusses several of the practical reasons for the project, including that revenue recognition is a primary source of restatement due to application errors and fraud.
- December 2008: FASB issues a discussion paper on the project; an exposure draft in June 2010; and another in November 2011.
- May 2014: ASU 2014-09 is finally issued. It became effective for public entities for annual periods beginning after December 15, 2017, and one year later for other entities.
Identification and Satisfaction of Performance Obligations
Topic 606 introduces the concept of performance obligations to distinguish between the promise or obligation to provide goods and services to a customer, and any other obligations to a customer. This concept is similar to the idea of elements or deliverables in prior guidance. FASB regards the concept of performance obligations to be of fundamental importance for the purpose of recognizing revenue on a basis that faithfully depicts an entity’s performance in transferring the promised goods or services to the customer (ASU 2014-09, BC 84–85).
The distinction between satisfying a performance obligation and other necessary activities is a critical aspect of Topic 606 for combatting premature recognition of revenue. FASB has made clear that an entity should not recognize revenue for activities that it needs to perform but that do not themselves transfer control of goods or services to the customer (BC 93). Activities such as account setup or mobilization of resources may be necessary at the inception of a contract before an entity can successfully transfer goods or services, but they do not directly transfer goods or services to the customer. These types of activities are not performance obligations, and undertaking them is not a basis for recognizing revenue.
Another critical step in determining the recognition of revenue is assessing whether an entity has satisfied an identified performance obligation by transferring control of a promised good or service to the customer. This replaces the concept of assessing whether an entity has transferred an appropriate level of the risks and rewards of ownership of a good or service; thus, an assessment of the transfer of risks and rewards becomes only one of several indicators used in assessing control (BC 118–119).
FASB concluded that transfer of control should be assessed from the perspective of the customer; that is, when the customer obtains control of the good or service. Because of possible difficulties in applying the concept of control for services and construction-type contracts, FASB focused on the attribute of timing of satisfaction. FASB concluded that the concept of control should apply equally to both goods and services, and provided different types of criteria for performance obligations satisfied over time versus at a point in time. As explained below, many prior revenue recognition frauds have involved manipulations related to identification of the elements of an arrangement (performance obligations) or the delivery (transfer of control) of goods or services.
Frauds and abuses.
Schemes related to the identification of the elements of an arrangement have been common in premature recognition of revenue. In some cases, such as that of MicroStrategy, management failed to identify that contracts required providing unspecified future products over the term of the project or significant customization of the software being delivered; in other cases, such as that of National Student Marketing, management recognized revenue on activities of setting up an arrangement before any services were delivered. As a third example, a computer training school recognized revenue on a nonexistent activity of designing a specialized curriculum for each student when all students followed identical programs.
Auditors must focus on validating contract terms, including those created by oral side agreements or implied by customary business practices.
Frauds and abuses in which revenue was recognized prior to delivery of goods or services are a common means of prematurely or falsely recognizing revenue. Bill-and-hold schemes, such as those by Sunbeam, Nortel, and Maxwell Technologies, have been widely reported. Cutoff schemes recognize revenues for goods or services in the current period when they are delivered in the next reporting period. These schemes, such as those by Computer Associates, Sensormatic, and Peregrine Systems, have been described as “December 37 year-ends” and “35-day months.” Similar schemes, such as those by Autonomy and U.S. Surgical, have involved shipping goods to entities other than customers, where they were parked until eventual sale or return.
For entities using contract accounting and recognizing revenue over time, a common scheme has been to manipulate the measure of progress toward completion. The cases of Golden Bear and, in the United Kingdom, Carillion involved using a subjective output measure of progress determined by top management that overstated progress, inflated costs incurred, or understated costs to complete for input measures.
Implications of new guidance.
These types of frauds and abuses will, of course, continue to be possible under Topic 606. Perpetrators may fail to identify all material performance obligations or disguise a setup activity as a performance obligation. Failure to identify performance obligations may be accomplished by ignoring oral side agreements or obligations implied by customary practices, which also implicate the issue of contract existence. As explained above, FASB’s focus on the necessity of determining whether there is a valid, enforceable contract that represents a genuine transaction is also likely to affect the identification of performance obligations.
Additional scrutiny by management and auditors of the contracting process and controls over that process should be accompanied by additional scrutiny of contract terms to identify all significant performance obligations. Auditors must focus on validating contract terms, including those created by oral side agreements or implied by customary business practices.
Perpetrators of fraud will also likely continue their schemes to recognize revenue before performance obligations have been satisfied. Here, FASB’s focus on whether a transfer of control from the customer’s perspective has been achieved is a distinct improvement. Validating the transfer of control puts the focus on the substance of making a transfer rather than the appearance of physical delivery. Auditors must seek objective evidence of an actual transfer of control and assess several indicators, such as rights to payment, legal title, physical possession, risks and rewards of ownership, and customer acceptance, rather than just the shipment of goods.
Topic 606 requires use of a reasonable measure of progress for situations in which revenue is recognized over time. FASB’s guidance on input and output measures does not differ significantly from prior guidance, but the objective of depicting an entity’s performance in transferring control of promised goods or services places the focus on whether an actual transfer has occurred.
Determination and Allocation of Transaction Price
FASB decided that an entity should measure revenue using an allocated transaction price approach. This approach eliminates the prior criterion of a fixed or determinable price and entails three steps: determining the transaction price for the contract, allocating it to identified performance obligations, and recognizing revenue at the amount allocated to satisfied performance obligations (ASU 2014-09, BC 181–183).
FASB defines the transaction price as the amount of consideration to which the entity expects to be entitled in exchange for transferring goods or services. Using this approach, determining the transaction price requires predicting the total amount of consideration to which the entity will be entitled. The determination may involve more than simply using the transaction price written in the contract. FASB’s new approach requires estimating variable consideration—that is, all the circumstances that may cause the expected consideration to differ from the basic contract price. Examples of variable consideration include refunds, credits, discounts, rebates, price concessions, incentives, penalties, performance bonuses, claims, and similar matters in which the promised consideration can vary or is contingent on whether a future event occurs. Topic 606 requires an entity to use one of two estimation methods—expected value or most likely amount—depending upon which is a better predictor.
Comparison of FASB ASC 606 with SAB 101/104
In addition to predicting an amount of variable consideration, an entity must predict whether the cumulative amount of revenue recognized on a contract is likely to require a significant reversal when uncertainties are resolved. This estimate is generally referred to as the constraint. Thus, two estimates are required each period: the predicted amount of variable consideration, and the magnitude and likelihood of significant reversal of revenue previously recognized.
The next step is to allocate the transaction price to the identified performance obligations based on the relative standalone selling price of those performance obligations. If the entity does not have an observable price for a performance obligation, that price must be estimated. Topic 606 indicates that an entity should maximize observable inputs and consider all reasonably available information, but FASB does not specify a particular estimation method nor provide a hierarchy of evidence for possible inputs.
The allocated transaction price approach has similarities to the prior guidance on multiple-element arrangements, but it involves more measurement uncertainties. Management does not have a free choice of estimation methods, but does have considerable flexibility as long as the chosen methods for a particular performance obligation are applied consistently.
Frauds and abuses.
Under prior guidance, some of the variables that are regarded as variable consideration under Topic 606 also had to be estimated in measuring revenue. A common scheme was channel stuffing, in which goods were pushed on resellers (distribution channels) when there was not an adequate basis for estimating refund liabilities, such as in the Sunbeam and Autonomy cases. This same pattern was used with respect to other contract terms that are considered variable consideration under Topic 606; for example, the recognition of returns, credits, and price concessions was delayed until they occurred in subsequent periods. In another example, in recording revenue on a percentage-of-completion basis, JWP Inc. included as revenue contract claims that did not meet GAAP requirements for recognition.
Implications of new guidance.
Similar to the above-discussed frauds and abuses, the new guidance has both positive and negative implications for the perpetration of revenue fraud. The requirements to identify all features of contracts that involve variable consideration and consider all reasonably available information to identify a reasonable number of possible consideration amounts should have a positive influence. Instead of being isolated estimates, factors such as returns, refunds, and claims must be carefully considered at contract inception and every subsequent reporting period as part of determining the transaction price.
Management and auditors will need to be thorough in identifying whether customary business practices and viewing transactions from the customer’s perspective result in uncertainties that will cause expected consideration to vary. The requirement to include variable consideration focuses greater attention at the inception of a contract on uncertainties that may reduce revenue from the stated transaction price. Auditors will need to challenge whether historical, current, and forecasted information that is reasonably available has been appropriately considered in estimating expected consideration and evaluate the reasonableness and support for the information management has used and the underlying factors and assumptions.
On the other hand, Topic 606 requires new estimates of variable consideration, the magnitude and likelihood of reversal of those estimated amounts, and stand-alone selling prices that create new opportunities for manipulation and biased judgments to manipulate the amount of revenue recognized. Auditors will need to incorporate these new possibilities for fraud and abuse in brainstorming sessions and plan appropriate responses.
Frauds Not Addressed by New Guidance
Certain types of revenue recognition frauds are not, and never could be, addressed by improvements in accounting guidance. Management override to enter false journal entries to credit revenue, such as used by HealthSouth and WorldCom, is one major example. Another is use of an undisclosed related party to inflate a transaction price or create a transaction that may never have occurred, such as used by Bonneville Pacific. Cendant accelerated revenue by transferring valid contracts from its database that should have been recognized over time to an Excel spreadsheet and manipulated the data to recategorize them as services delivered immediately. These approaches to falsifying revenue continue to be serious risks that auditors should be aware of.
The Implications of Topic 606 on Revenue Frauds and Abuses
Improvements in accounting guidance alone will never eliminate revenue frauds and abuses, but careful attention to compliance with the new accounting guidance can make the successful perpetration of several types of fraud and abuse less likely. Management will need to implement and diligently monitor new policies, practices, and procedures to faithfully comply with the new guidance, while auditors will need to make modifications to risk assessments, audit planning, and audit approaches and procedures.
In addition to the normal attention to validating revenue, there will be an increased focus on the contracting process and greater scrutiny of contracts with customers. Auditors may need to assign more experienced personnel with knowledge of customary business practices of the entity and industry, as well as understand customers’ objectives. Both management and auditors will need to focus increased attention to the design and operating effectiveness of new or modified controls that address the new accounting requirements. Expanded brainstorming sessions will need to identify the susceptibility to fraud and abuse in management’s compliance with each of the five steps in the new revenue recognition model, particularly potential manipulation and bias in estimating variable consideration or stand-alone selling price. Auditors will then need to plan and implement an appropriate response. There may be less reliance on the confirmation of receivable balances in favor of increased use of the confirmation of transactions in order to obtain evidence that is more directly relevant to revenue recognition, such as contract terms—including oral or implicit terms—contract approval, and customer acceptance of goods or services. Auditors might also expand their use of tests of details of individual revenue transactions.