Revenue and Accounts Receivable Recognition
The generally accepted accounting principles (GAAP) stipulate how firms should prepare their income statements at the end of a fiscal period. Under GAAP, revenue is recognized once the client receives a product or a service. Revenue is recognized when it has been realized or earned. The GAAP further advises that revenue should be entered into a company’s financial statements when (1) there is evidence of a transaction; (2) items/services have been delivered/performed; (3) transaction involves a determinable service fee; and (4) debt ‘collectibility’ is guaranteed. This implies that, as per GAAP principles, it is only when cash has been received by the service provider that revenue can be said to be realized. Moreover, it is presumed that the firm will not incur additional costs after the revenue has been recorded in its financial statements.
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Accounts receivable are short-term credit facilities payable within a specified period (usually 30 days) from the date an invoice has been issued. Accounts receivable are recorded in the balance sheet as net amount after deducting costs associated with bad debts. An invoice from a firm’s customer is issued as evidence of their existence. Accounts receivable are reported as current assets because they are usually converted into cash within a short period, usually three months. Just like revenue, a firm recognizes accounts receivable once it has delivered the goods or services to a client. Receivables are valued at their present value based on an interest rate agreed upon by both parties. For instance, accounts receivable worth $4000 that are payable within a period of 30 days would be valued at $4000, as this amount represents their present net value. The interest that will accrue over the entire period (30 days) is not recorded as sales revenue.
GAAP advises firms to report accounts receivable at their present value because the interest that accrues within the 30-day period is minimal. Thus, initially, the receivables are valued based on their present net value without the interest. However, the evaluation is subject to cash and trade discounts, which affect the amount that the credit customer will pay within the 30-day period. Therefore, accounts receivable and revenue are reported at their present value, less the cash/trade discount rate. If a customer pays within the 30-day period, the receivables account is credited while the cash account is debited. However, if no payment is made within this period, monthly interest is charged on the amount owed.
VSI’s Revenue Recognition Policies and GAAP Principles
As stated, VSI recognized revenue for its engineering services once a client project was completed. The firm recorded costs related to engineering projects on its inventory system as a reduction of the realizable value. GAAP counsels firms to recognize revenue after it has been actually earned. VSI also recognizes revenue after the completion of its engineering services or projects. However, initially, VSI recognized genuine and reliable customer orders as revenue but later included fabricated order to defraud Second Union bank. This negated the GAAP principles, which stipulate that firms should recognize revenue once the project has been completed or after certain performance measures have been met. In VSI’s case, the firm recognized revenue after rendering the services, but this only applied for short-duration projects.
VSI set no clear timelines for revenue recognition, which gave room for manipulation of the revenue and accounts receivable. GAAP stipulates that the accountants of a firm should use accrual accounting in revenue recognition, as this method captures all the issues surrounding the transaction. Based on accrual accounting principles, a firm, besides entering into a contract with a client, should recognize revenue after the services or products have been delivered or performed. Moreover, there must be an assurance that the firm will receive the payment. In VSI’s policy, there was no reasonable payment assurance, which increased the risk of incurring costs associated with bad debts. In addition, VSI recorded the costs incurred during the project as a reduction in its inventory, which had a significant bearing on its revenue. Accrual accounting requires prices to remain fixed throughout the contract period. Thus, VSI’s did not meet the accrual accounting principles as recommended under GAAP.
Accounts Receivable Balances
The overstatement of VSI’s accounts receivables meant that the firm reported more receivables in 2009 and 2010 than the actual outstanding amount. VSI’s total accounts receivable stood at $1,023,623 as of December 31, 2009. However, the net accounts receivable dropped from $934,209 in 2007 to $818,513 in 2008, representing a 7% decline. Over the same period, VSI recorded a loss of $279,931. Given that the accounts receivable were overstated to indicate a return to profitability in 2009, in the writer’s opinion, the actual amount owed did not change in the subsequent years as indicated in VSI’s financial statements. Thus, the $1,023,623 recorded in 2009 was overstated by $253,427, as this amount had not been received before the 2008 audit. In the writer’s opinion, since VSI’s actual accounts receivable in 2009 could not be verified, it can be concluded that the firm overstated its accounts receivable by $253,427.
In the writer’s view, VSI also bloated its accounts receivable in its December 31, 2010 balance sheet. The value of accounts receivable indicated in the December 31, 2010 statement was $1,744,807. In 2011, after Second Union bank became concerned about the rise in unpaid invoices, VSI’s James Roberts revealed that the value of the accounts receivable, as reported in 2010 (about $1.8 million), was fictitious. Thus, in the writer’s opinion, VSI’s accounts receivable in 2010 were overstated by $457,047.
Other Balance Sheet Accounts that Need Adjustments
The overstatement of accounts receivables increases the ‘current assets’ section of a firm’s balance sheet. Besides receivables, items such as prepaid expenses, inventories, and cash, which make up a firm’s current assets, are affected by the overstatement of accounts receivable—overstating the accounts receivable results in a decrease in a firm’s cash account, as receivables are deducted from a firm’s revenue (net income). Therefore, the exaggeration of accounts receivable in VSI’s case affected its cash account and operating income. It also affected VSI’s 2009 and 2010 prepaid expenses and inventories.
Thus, as of 31 December 2009, the accounts payable and the inventory should be both adjusted. The costs associated with subcontracted projects and engineering services should be deducted from the accounts payable. This should be done as follows:
- McDonald Douglas = $4577
- Nexus = $ 1655
- Penns Engineering = $1650
The sum total of the services rendered to these companies should be deducted from the accounts receivable. With regard to inventory, costs associated with engineering services or projects are recorded in the inventory at the expected or lower value. Thus, for 2009, inventory should be deducted by the realizable value as of December 31, 2009. For 2010, however, no adjustments should be made on both the inventory and the accounts payable, as there are no direct costs associated with the inventory.
Management Fraud: Collateral Reporting
James Roberts and William Jacobs were entrusted with the role of managing VSI. In any organization, the management has a responsibility of ensuring accurate financial reporting to partners and creditors (banks). From the audit report, it is evident that the two managers participated in fraudulent reporting by overstating VSI’s receivables in 2009 and 2010. They used bloated accounts receivable as collateral for obtaining further funding from Second Union. Following a decline in VSI’s revenues (by 7%) in 2008, the managers chose to falsify the firm’s receivables, which they used as collateral for additional funding.
William Jacobs, VSI’s founder, in 2008, sought a $1,000,000 loan from Second Union using accounts receivable as collateral. However, in the same year, uncollectible receivables and high administrative expenses led to a $279,931 loss. Although Jacobs promised to implement a number of measures to cut costs and reduce the burden of ageing receivables, evidence in the report shows that he schemed to fraud the bank. The fraud report shows that Jacobs signed a copy of the balance sheet given to the Union. VSI’s independent auditors, M&S auditors, also received the same document (exhibit III). This shows that Jacobs had full knowledge of the status of VSI’s customer receivables, but went ahead to defraud the Second Union bank by overstating them.
On his part, James Roberts, the Chief Finance Officer, intentionally misled Second Union through misrepresentation of VSI’s financial statements of May 2009. He showed that VSI had regained from its poor performance in 2008 by reporting a return to profitability in 2009. As a result, the Union increased its credit limit to the tune of $1.3 million. Even the financial statements that Roberts signed and gave to the Union in 2010 reflected an increase in profits. This shows that Roberts is guilty of fraudulent financial reporting.
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The Management’s Motives in the Fraud
Managers may be motivated to commit fraud when they are pressured to achieve certain goals or outcomes. In VSI’s case, Jacobs and Roberts conspired to defraud Second Union bank through fraudulent reporting of the firm’s accounts receivable. One of the motives behind their actions was the desire to achieve quick success. Jacobs, after losing his job in 2000, started VSI using his small savings. Due to the high demand for security services, VSI’s revenue grew rapidly hitting $5.4 million in a span of six years. This growth motivated Jacobs to seek for a loan to expand the firm. However, when VSI’s management failed to meet its financial targets, Jacobs resorted to financial fraud in a bid to keep his company solvent.
Another factor that motivated VSI’s management to defraud Union was the lack of stringent internal control mechanisms. Jacobs and Roberts knew that the firm’s audit system was inadequate and could not detect the overstatements of the accounts receivables. Moreover, they supplied M&S auditors and Union with certified incorrect reports by circumventing VSI’s internal control systems. Their position (CEO and CFO) allowed them to circumvent the audit system and misrepresent VSI’s statements. They took advantage of these inherent weaknesses to develop fictitious statements, which they certified and gave to the bank and the independent auditors. Initially, the fraud was difficult to detect because it involved deliberate misrepresentations of records and collusion between the two top managers.
Error and Fraud in Auditing
Fraud is a deliberate action involving top company executives that results in the swindling of a business partner or an external party. Company executives are entrusted with the responsibility of managing the firm. In fraud cases, the executives use their influence and knowledge to defraud unsuspecting clients, business partners, or financial institutions by misrepresenting the firms’ financial statements. An error is similar to fraud, but it is not intentional. An error occurs when a finance officer unintentionally fails to disclose or omits certain elements in the certified financial statements. In contrast, fraud is intentional, as it involves deliberate cover-ups and collusion to avoid detection.
In VSI’s case, the management actions amount to fraud. Roberts and Jacobs made a deliberate overstatement of the firm’s receivables in VSI’s financial statements for the year 2009 and 2010. Incorrect financial statements were certified and given to M&S auditors as well as Second Union. Moreover, the two executives included fictitious figures about the VSI’s improved profitability in 2009 after reporting a 7% decline in revenues in 2008. In addition, the 2010 financial statement indicated that VSI had regained and its business was profitable. It revealed a remarkable improvement in revenue and operating profits. It is evident that after the Union threatened to discontinue further funding following the operating losses incurred in 2008, VSI’s management decided to defraud the bank by presenting it with incorrect financial statements.
To conceal their actions, the management colluded in coming up with a turnaround strategy that promised to cut down costs through layoffs and salary cuts. It is evident that VSI’s management actions were deliberate and involved planning and thus, amount to a fraud. In VSI’s case, fraudulent financial reporting was done. It involved the manipulation of accounts in the firm’s 2009 and 2010 financial statements (sales revenue, operating profit, and net income). The fraud also involved a wrongful application of GAAP principles in relation to financial disclosure and accrual accounting.
Auditors have a responsibility of detecting an error or fraud in a firm’s financial records. Often, fraud or error results in misrepresentations in financial records. An auditor inspects a firm’s accounts to detect any fraudulent acts or errors. In inspecting the accounts, auditors evaluate the risk associated with the error or fraud. To identify the fraud risk, an auditor would normally scrutinize the specific transactions included in a firm’s financial statements. The detection of fraud in any of the transactions raises concerns about the integrity and reliability of the other records provided by the management.
Fraud Risk Factors in VSI’s Case
One of the fraud risk factor apparent in VSI’s case is the aggressive sales forecasts that the management presented to the Union’s loan officer, Ron Gray. VSI, which a year earlier had incurred a pre-tax loss amounting to $279,931 made a quick recovery and even reported a $122,764 in operating profits. This impressive performance was a fraud risk factor, as it is often difficult for a firm to turn around a negative growth (loss) into profits within one year. Nevertheless, Union’s loan officer, obviously impressed by VSI’s financial statements, decided to increase VSI’s loan to $1.3 million.
Another apparent risk factor is the dominance of VSI by two people, Jacobs and Roberts. They wielded a lot of influence in the firm, which affected the ability of the firm’s internal control systems to offer oversight. Jacobs unilaterally approached Union bank for a loan in 2008. He was notified of Union’s intention to terminate the loan lent to VSI if he did not implement measures to reduce the firm’s operating losses. It is at this point that he consulted the VSI’s management committee. After a heated discussion, a set of turnaround measures was hatched. However, the decision to overstate the account receivables involved consultations between Roberts and Jacobs with the rest of the management kept in the dark. Thus, Jacobs wielded much control and was not subject to internal oversight. The lack of oversight motivated him to collude with Roberts (CFO) in committing the fraud.
The inability of VSI to achieve sufficient cash flows was another indicator of fraud at VSI. Despite VSI reporting an increase in operating profits in 2009 and 2010, its cash flows continued to decline over the same period. Its 2007 cash account was $16,803, but dropped drastically to $1,700 in 2010. The drastic change was an indicator that there was something wrong with the firm’s cash flows. The accounts receivable were overstated over the same period, but this did not translate into improved cash flows. The dependence on credit was also an indicator that VSI’s management was propagating a fraud. Initially, the credit limit was set at $l million. However, following the firm’s poor performance in 2008, VSI requested an additional $300,000, which brought the credit limit to $1.3 million. Thus, the request for credit extension was another fraud risk.
VSI’s management also did not implement adequate monitoring controls to detect errors in its financial statements. This allowed the CEO and CFO to falsify the firm’s accounts receivable without being detected. Moreover, the independent auditor, M&S, did not scrutinize VSI’s internal control systems and trading activities. No follow-ups were made on VSI’s customer receivables despite the failure by VSI to verify some of them. Moreover, there was no sufficient supervision, and counterchecking of the accounts entered in the firm’s financial statements.
The rapid developments in the security industry constituted another fraud risk factor. VSI primarily focused on security personnel training. However, the audit report revealed that by 2008 the security training market had become saturated. A subsequent downsizing of the industry had significant implications on VSI’s profit margins. This motivated VSI to diversify into large engineering projects in order to sustain its growth. Thus, the stiff competition in the security industry and VSI’s limited competitiveness was an indicator that the firm was not going to do well in 2008. Moreover, most of VSI’s customers were not willing to extend their contracts beyond 2008. Therefore, competition in this market, coupled with a decline in clientele was a fraud risk factor.
A Review of VSI’s Financial Statements and Receivables
In VSI’s balance sheet (exhibit I), the accounts receivable rose rapidly within a very short duration. As of 31 December 2007, the customer receivables were $934,209, but dropped to $818,513 in 2008. The accounts receivables for 2009 and 2010 were $1,023,623 and $1,744,807 respectively. The sharp rise after the 2008 slump begs many questions, especially since some of VSI’s customers had reportedly declined to extend their contracts beyond 2008. Thus, the rapid changes in accounts receivables within a short time should have alerted auditors that VSI’s management was involved in fraud. Moreover, the fact that balances were not paid within a 30-day period would have alerted the auditors of potential fraud.
Furthermore, scrutiny of VSI’s balance sheet shows that the firm had no inventory in 2007, which, however, rose to 42,305 in 2008. A rapid increase in inventory is seen in 2009 (125,112) and 2010 (229,023). The sharp rise in VSI’s inventory could have alerted the auditors to investigate VSI’s financial statements. Another discrepancy that could have alerted the auditors is VSI’s cash accounts. VSI’s balance sheets showed that the firm’s cash flows were dwindling. As of 31 December 2007, VSI’s cash flow stood at $16,803, which, however, dropped sharply to only $6,455 in 2008. It further declined to $1,898 and $1,700 in 2009 and 2010 respectively. This sharp drop in cash flow was an indication that the firm had overstated its receivables. Receivables are deducted from the net income, which results in a corresponding decline in cash flows.
The company’s sales averaged 100% over the 2007-2010 period (exhibit I). However, VSI had reported a 7% decline in revenues in 2008 and an increase in administrative expenses. A decline in sales could have led to a corresponding decrease in sales. Additionally, the statements display a decline in VSI’s administrative expenses from a high of 29% in 2007 to 24% in 2008. However, VSI had reported an increase in administrative expenses. Thus, these irregularities would have alerted the auditors of possible misrepresentations in VSI’s financial statements. Moreover, the proportion of ageing receivables would have elicited concerns among M&S’s auditors. The ageing receivables rose 11% in 2007 to 42% in 2010. Thus, VSI’s ageing account receivables became uncollectible (bad debts) after the end of the 2010 financial year. Bad debts affect a firm’s sales revenue. The auditors would have raised concerns over the increasing ageing receivables. A further investigation would have revealed that the receivables recorded in VSI’s financial statements were overstated.
Estimates of Second Union’s Losses
In May 2008, Union extended a loan of $1,000,000 to VSI and extended it to $1.3 million in 2010. However, a year later, the bank terminated its relationship with VSI, and in June 2011, it took all VSI’s assets. As of 31 December 2010, VSI’s total assets were $2,007,448.
Assuming a zero net liquidation value for all assets besides receivables and cash, the asset value that the Union would have obtained from VSI is as follows:
December 31, 2009
The bank will not incur any costs or damages because the sale of the accounts receivable can be used to pay up the loan.
December 31, 2010
The sale of VSI’s receivables will not be sufficient to offset the loan. As a result, Union will incur damages amounting to $163,180, which is the difference between the amount owed as of December 31, 2009, and the value of collectable receivables. Additional costs, including legal costs, will increase the costs incurred by the Union.