Probably the most common financial statement fraud is the manipulation of sales (revenue) figures. It’s in the company’s best interest to report higher sales, as opposed to lower sales, so virtually every company runs the risk of overstating sales.
In some industries, it’s very clear when a sale has occurred. If a customer enters a retail store and purchases an item from a cashier, there is little doubt that a sale has occurred. In many businesses and industries, however, it’s not so straightforward and there is some “gray area” when it comes to deciding when a sale has occurred.
Consider the insurance industry: You pay your insurance premium in advance of receiving your policy. Money has changed hands, but the insurance company can’t record revenue yet because the company hasn’t yet done anything to earn that money. Calculations must be done to determine what revenue has actually been earned during the accounting period.
The more complex the sales agreements, the more difficult it can be to determine when a sale occurs. Consider a long-term sales contract in which a customer agrees to buy a certain amount of a product or service over several years. Varying contract terms can affect when revenue may be recognized from this type of transaction.
The waters become even more muddied when management is expected to make estimates about certain items on the financial statements. The accounting rules say they should be “conservative,” but that rule is often not followed. As business has become more complex, it is clear that the risk of misstating revenue is high. And the risk doesn’t really lie in understating a company’s revenue. There’s usually not much motivation to do that. The motivation is, instead, to inflate sales figures.
Revenue overstatement can also occur in a very straightforward fashion through booking revenue for sales that have not occurred. In this case, there is no gray area. This situation might include booking a completely fictitious sale. It could also include booking a sale of an item for which title has not passed.
It can be confusing in industries in which physical goods are being sold, and there is a question as to when the sale is complete. Is it complete when the manufacturer finishes making the product? Is the sale complete when the item leaves the plant? Or does the sale not become official until the customer receives the product? The answer to these questions can vary depending on the industry and the agreements between the manufacturer and the customer.
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