By far the most common way that executives manipulate financial statements is through the overstatement of revenue. The reason is simple: It’s the easiest way to improve the appearance of the company’s financial condition.
Revenue can be inflated by doing things such as:
- Booking fictitious sales
- Holding the books open at the end of a period
- Recognizing legitimate sales early
- Shipping items not ordered by customers and booking the sales
- Booking revenue before it has been earned on projects in progress
- Recording sales for items produced but not yet shipped, or only partially shipped
- Booking sales but delaying shipment to customers (bill-and-hold schemes)
- Not properly recording allowances for returned goods
Revenue overstatement is detected by examining revenue patterns and looking for irregularities. Unusual changes in cost of goods sold might signal a problem, as companies that book fictitious revenue do not always book corresponding expenses. Revenue overstatement may also be suspected when a company has consistent cash flow problems, even in light of apparently increasing sales and profits.
One irregularity that may not often be considered as such is a suspiciously constant increase in sales or profits from period to period. Remember that especially for public companies, there is a high expectation that revenues will grow by a certain percentage, and that profits will increase accordingly. Executives know the “acceptable” parameters for their numbers. Anything outside those ranges will raise questions. So it is not a stretch to believe that revenue and expenses could be manipulated to conform with those expectations.
Other indicators of fraudulent manipulation of revenue include: existence of unusual ratios related to inventory or accounts receivable, rebooking receivables so unpaid amounts related to phony sales do not look so old, or recording large write-offs shortly after the close of a period. An internal report (a tip from an employee) of revenue manipulation may be necessary in order for auditors or other professionals to become aware of the fraud, as schemes to manipulate revenue are often carefully crafted and covered up.