A company can falsify its financial statements by implementing creative accounting practices, most common being inventory manipulation, revenue recognition frauds, malicious mergers or acquisitions, incorrect capitalisation of expenses and so on and so forth.
Revenue recognition fraud has been a major focus, revenue is a large part of financial statement thus it becomes a primary category that affects an entity’s financial position and results of operations. The manipulation of revenue could result in a misstatement of an entity’s EBITDA (Earnings before interest, tax, depreciation and amortization) 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.
Ind AS 115 Model for Revenue Recognition:
Ind AS 115 is based on a core principle that requires an entity to recognise revenue:
- In a manner that depicts the transfer of goods or services to customers
- At an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services.
Applying this core principle involves the following five steps:
Revenue recognition frauds usually falls under two following categories:
1] Fabricating Revenue:
Recording a revenue intentionally in the wrong accounting period, is a management technique, whereby the management manipulates the timing of the revenue for possibly a number of reasons. These reasons could include meeting performance levels and also to achieve target bonus levels for the top management, as well as boosting stock values for holders of shares and possibilities of options on shares.
Following are few tools used for fabricating revenue:
Cookie Jar Practice:
Although the revenue is real, by recognizing it in the wrong accounting period or in a different time cycle, (also known as Cookie Jar practice) i.e., in the earlier period it can be used to project a healthier growth than the real trend, projecting future continued success, which in fact can often be maintained only by continued, ever-growing fraudulent acceleration of revenue. By “borrowing forward” from future revenues creates what is ultimately an unsustainable aura of growth. When this is no longer possible to continue such a practice, the fraud gets exposed, usually with disastrous consequences for the stock price and for the management.
Bill and Hold Arrangement:
One variation on this scheme involves a so-called “bill and hold” arrangement, whereby customers are encouraged to place larger-than-needed orders, usually near the end of a reporting period. The sales are recorded, but the goods are held by the reporting entity for release to the customer in later periods.
Side agreements is used as another modus operandi where the goods are actually delivered, but permitting them with abnormal levels of returns for unsold goods. In other cases, delivery is made, not to the ostensible customer, but instead to a warehouse or other facility controlled by the seller, which typically is done to deceive auditors examining shipping documents to find support for purported revenue transactions.
Warning signs for identifying fabricated revenue:
- Identify if there is any mismatch between working capital & registered sales;
- Identify in the trailing year if any excessive sales returns;
- Mis-match in the revenue trend should be looked out for.
2] Fictitious Revenue:
An even more fundamental form of revenue fraud involves booking entirely fictitious revenue. The objective is similar – namely, (a) to exaggerate current period revenues and profits, or (b) to distort growth or profitability patterns, thereby impacting stock valuation, executive bonuses, and so forth. There have been a number of frauds in India as well as abroad on fictitious revenue recognition to name a few major scandals: Satyam Scam, Luckin Coffee scam and many others. Where the whole objective is to inflate market cap with the help of window dressing the revenue figures.
In this situation, bogus (not just premature) receivables are recorded and as such receivables are never collectable, such receivables are bogus. Concealing fictitious revenue will later on necessitate reversal or elimination of such fabricated receivables. Achieving a successful fictitious revenue fraud will often involve “refreshing” the old receivables by transferring the balances to other, equally fictitious customers. An alternative is to engage in “lapping” the receivables, or crediting collections on real receivables against the bogus ones.
A walk through the renowned fraud cases of Satyam & Luckin Coffee to understand how fictitious revenue recognition frauds can be used as a tool for carrying out huge scandals.
Satyam Computers, an IT company based in Hyderabad started by Byrraju Ramalinga Raju in 1987. The company got listed on NSE/BSE IN 1991 and further onto NYSE in 2001. The company was doing very well initially. During those days housing and properties, sector was at a boom, Raju decided to invest in that sector and started buying more and more properties and invested all his money. He even made a new company named MAYTAS which was his company for infra projects and properties. When he required more and more money for investments he started manipulating SATYAM company accounts to get money.
The fictitious income recorded were as following:
Fictitious revenue to the tune of Rs.5,352.8Cr.
Fictitious interest income recorded: Rs.899.8Cr
Fictitious foreign exchange gain: Rs.206.1Cr
He installed the following modus operands to fudge its revenue, profits and cash position:
Fake invoices and bills were created using software applications such as ‘Ontime’ that was used for calculating hours put in by an employee. A secret programme was allegedly planted in the source code of the official invoice management system creating a user id ‘Super User’ with the power to hide or show the invoices in the system.
A web of 356 investment companies was used to allegedly divert funds from Satyam. These companies had several transactions in the form of inter-corporate investments, advances and loans within and among them. One such company, with a paid up capital of Rs 5 lakh, had made an investment of Rs 90.25 crore and received unsecured loans of Rs 600 crore.
Satyam made a last ditch attempt to fill the ‘fictitious’ assets with real ones through acquisitions of Maytas. The acquisition plan was rejected by the institutional investor. This is when the Chairman resigned after allegedly confessing that the company’s profits and cash reserves have been doctored for several years.
Luckin Coffee Scam:
Chinese coffee chain super-brand Luckin Coffee has been under spotlight after the company revealed in an SEC filing that it has undertaken an internal investigation into an alleged $300 million fraud on the part of its former COO. As per the reports the company registered fictitious sales to the tune of $310 million in sales last year.
The modus operandi followed by the company was to jump orders. In simple terms orders for Luckin were placed online & the orders collected offline by their customers, so a receipt in each store carried a delivery number which served as a barometer for the staff to keep track of the orders. So if the first customer is served order number 1, the 200th customer will likely have the number 200 printed on his purchase receipt. So jumping orders was a simple way around to inflate the sales figure. And Luckin wasn’t just fudging order numbers, they were also overstating their average selling price (on each order). So to cover up the mismatch between sales figure & cash they diverted the funds towards fake advertising expenses. This scam was revealed by Muddy Waters Research through a research report. And within 2 months of the report becoming public, the company admitted the fraud.
Warning signs for identifying fabricated revenue:
- Look for mismatch between inventory and sales;
- Keep note of trend of trade receivables and provisions for bad debts;
- Keep an eye on inter-company transfers and sales under the related party schedule of Balance sheet;
- Keep track of fictitious expenses through keeping an eye on trend of other expense bifurcation given in the notes;
- The lesson to learn from the aforementioned scams is that tall claims warrant great skepticism.
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