How to audit revenue

To audit revenue, let’s first get an understanding of the types of revenue and the transactions directly associated with it.

Understanding revenue

Revenue is usually the largest single line item on the income statement, so the auditor needs to acquire a deep understanding of how the client generate sales. This can involve understanding the following:

• Client policies relating to credit, pricing, payment terms, acceptance of sales returns
• Types of customers
• Distribution channels that products and services are sold
• Sales returns in comparison to different types of sales
• Discounts and other allowances to obtain sales
• Compensation of salesperson to drive sales
• Extent to which seasonality & cyclical changes affect sales
• Revenue recognition practices within the industry
• Types of products and services

An organization can generate many kinds of revenue, so it makes sense to record them within different accounts. The accounts in which revenue transactions can be recorded depend upon the nature of the underlying transactions, for example:

• Product sales
• Service sales

Revenues may also be earned from activities that do not relate directly to operations. These earnings are recorded in separate accounts such as:

• Interest income
• Dividend income
• Royalties
• Rent income

These non-operating revenue accounts may be stated in the lower portion of the income statement, to keep them from being confused with the main operating revenue accounts.

Types of revenue fraud arrangements

Accelerated revenue recognition

A firm may be tempted to recognize a sale for a legitimate sales transaction, but which should not be recognized until a later period. For example, a customer sends in a deposit of $10,000 along with a purchase order, but the firm immediately recognize it as revenue – before the performance obligation has been fulfilled. Another example, a sales transaction may be contingent on an event that will not occur until a later date – such as a customer acceptance of a received good. But the client decides to recognize the revenue at once, despite the existence of the contingency. A less common variation is to ship goods sooner than the customers have asked for them, in situations where customers have requested delivery in a later period.

False sales

A perpetrator can create fake transactions to generate entirely false sales. For example, someone could create an order from a fake customer, enter it into the company’s order system, and even support the invoice with a falsified record that show the delivery of goods or services to the customer.

False sales are difficult to support over long period of time, since the receivables are never collected, resulting in an ongoing increase in the days sales outstanding ratio. However, false sales can be effectively hidden if they are subsequently written off in the following year.

Bill and hold transactions

A client may recognize revenue from a customer, despite still having the related goods on its premises. It uses as an excuse that the client and customer have entered into a bill and hold arrangement, where the customer accepts ownership of the goods but requests that the client hold the goods for a certain period of time, essentially acting as a storage facility for the customer.

The accounting rules for bill and hold arrangements are quite specific, as stated in FRS 115. In many cases, alleged bill and hold transactions should not result in the recognition of revenue.

Objectives and outcome of auditing revenue

Auditors develop their audit program for revenue to discern the internal controls over revenue, inherent risks associated with revenue and to gauge the risk of material misstatement of the revenue account. All these factors will affect the amount of substantive procedures to be done to collect sufficient audit evidence for the revenue account.

We would want to achieve the following outcome of auditing revenue:

• All sales included in the income statement represent the exchange of goods or services with customers for cash or other consideration during the period. All other revenues included in the income statement for the period have accrued to the entity at the balance sheet date. Revenues applicable to future periods have been deferred. (Existence, Measurement and Occurrence assertions)
• All sales and other revenues that accrued to the entity during the period are included in the income statement. (Completeness assertion)
• Sales and other revenues are stated in the income statement at the appropriate amounts. (Valuation assertions)
• Sales and other revenues are properly classified, described, and disclosed in the financial statements, including notes, in accordance with the applicable financial reporting framework. (Presentation and Disclosure assertion)

Assessing inherent risks and risks of material misstatement

Since revenue is often the largest line on the income statement, most clients should have a strong system of internal controls in place. Otherwise, there is a risk of material misstatement or fraud. Consequently, the auditor should look for a mix of the following internal controls when evaluating the client’s controls over revenue.

Control environment

There is a risk of misstating revenue when there is pressure on management to boost the reported profit level. Management must set the highest possible ethical standards for all employees, so that there is no temptation to inflate revenue. While it is not uncommon to tie incentives to profit level, proper safeguards have to be in place to control improper reporting.

Verifications

If customer billings are being created in a computerized billing module of an accounting software, include as much automatic data validation as possible. This can include comparison of prices to a standard price list, address checking and automated sales tax and freight charge.

Compare sales order total to invoice total. If the total amount does not match, it could probably be more items to be delivered at a later date. Which should trigger the filing of a copy of the sales order in a pending folder, in anticipation of more shipments. There should be an investigation of any filled sales order for which no corresponding invoice can be found.

Authorizations

Segregate shipping and billing functions, so that they cannot create fake shipping documentation to support the fake receivable. If they are not separate, the inherent risks will be higher, and more substantive work has to be done. Such as the monitoring of bad debt written off and receivables aging after year-end.

Methods used to audit revenue

Substantive procedures are intended to create evidence that an auditor collects to support the assertion that there is no material misstatement in regard to the completeness, accuracy and measurement of the financial records of the client.

Here are some substantive procedures you can perform when auditing revenue.

Sales cutoff

In most circumstances, when the client ships goods or performed the services to its customers, revenue can be recognized. They will then record a sale transaction in its books. Get the full listing of the client’s shipping documents or service order with the respective attached invoice, and tie it to the general ledger for completeness. Examine the date of the shipping documents and make sure that it falls within the year of the audit, not the subsequent year. Do the same for the after year-end listing as well to test for any late records.

Analytical procedures

Analytical procedures involve comparisons of different sets of financial and operational information, to see if historical relationships are continuing forward into the period under review. In most cases, these relationships should remain consistent over time. If not, it can imply that the financial records are incorrect, possibly due to errors or fraudulent reporting activity. We can apply the following analytical procedures to the revenue account:

• Monthly days sales outstanding (DSO). When plotted, DSO should be relatively consistent from month on month in the previous year. Since falsified sales cannot be collected, DSO will increase as false sales are added.
• Month on month absolute revenue. When plotted, the month on month revenue should not vary a lot when there is no significant change of business. Sudden jump or drop in revenue should be investigated.
• Gross margin percentage. When plotted, the percentage should be relatively consistent throughout the year. An increase could mean that there may be fake sales for which there were no accrued costs or costs for goods sold recorded.

Gross margin percentage testing should be combined with the audit of inventory count and to test if there is a slow-down in receivables turnover. This is because the client can create falsified accrued costs and costs of goods sold to artificially preserve the long-term gross margin percentage. However, it is also possible that the gross margin percentage can increase together with a slow-down of receivables turnover. This can be due to a change of pricing model of the products. A holistic view to understand the business and revenue recognition is needed to come to a conclusion.

When the results of these procedures are materially different from expectations, the auditor should discuss them with the management. A certain amount of scepticism is needed when having this discussion, since management may not want to spend the time to delve into a detailed explanation, or may be hiding fraudulent behaviour. Management’s responses should be documented, and could be valuable as a baseline when conducting the same analysis in the following year.

Examine supporting documentation

Every sale transaction should be supported by a customer order and evidence of delivery. Accordingly, the auditor should examine the supporting documentation for a selection of sales transactions. This examination should include verification that a customer order exists, that the item ordered were the same ones shipped and billed, and that the prices charged match the client’s standard price lists. If there is a concern that fictitious sales are being generated, examine the client’s perpetual inventory records to see if inventory items were removed from stock in support of each sale made.

The client may transfer the information on a customer purchase order to an internal sales order document. If so, it is possible that the sales order information does not match the customer purchase order. Therefore, it is important to trace the sale information all the way back to the originating purchase order, not just the sales order.

Summary

Management of some organizations may find themselves under pressure to achieve financial results. When their actual performance is not adequate, they sometimes engage in creative accounting, or outright fraud to portray better than actual results. In addition, some companies have weak controls over the recording revenue or do not have a clear understanding of when revenue can be recognized. These issues make revenue one of the key areas of concern for the auditor. The auditor must develop an audit plan that accounts for these risks, which will likely require an extensive examination of client controls, as well as substantive procedures.