Auditing revenue for fraud risk

When auditing for fraud in revenue transactions, auditors must understand the entities concerned, their environments and their assertions.

Consider this hypothetical situation: a practitioner has had a private manufacturer as an audit client for many years. The client has been profitable in the past and there have been no concerns about revenue misstatement in prior audits. During an inventory count, two units of large equipment, each generating $600,000 in profit margin, were segregated and marked as sold. These are material transactions. The practitioner inspected the invoices and purchase orders and found all documentation was in place. Still, he was skeptical about the sales.

Jane Bowen, a lecturer in financial accounting and auditing at the University of Ontario Institute of Technology, talks about the likelihood of this scenario taking place and what the auditor could do to mitigate the risk of fraud.

“It certainly could happen. The first step is to look at what’s happening in the broader environment,” she says. “For example, the slow economy is taking its toll on many companies, creating pressure to meet bank covenants. This may be an incentive to intentionally misstate revenue and receivables, which helps most covenants.”

So how do you find out if the misstatement is intentional? Start with the low-hanging fruit. In some circumstances, it can be as simple as taking a look at the company’s website or discussing the terms of sale with the sales team to realize there may be "special offers” allowing potential buyers to pay later and even return goods.

“These are factors that would affect the recognition of revenue or at least the measurement of the amount recognized,” Bowen says. “It surprises me that visiting the website is not one of the first procedures an auditor would complete when obtaining an understanding of the entity and its environment. If such special offers exist, the auditor must complete different procedures than simply inspecting documents.

“There can be a paper trail, but the owner’s ability to authorize the recognition of the sales by overriding any existing control can be a concern in some entities,” she says. “That’s why it’s so important to understand the entity, its environment and the assertions.”

Bowen offers a few key best practices for auditors to effectively audit for fraud in revenue transactions.

Understand the business and its environment. This includes how it earns and records revenue; the types of revenue and revenue transactions; what’s happening in the industry; and the overall economic situation. “Don’t bring last year’s mentality to this year’s audit,” Bowen says. “Preparers’ objectives and incentives are not consistent from year to year. Economic conditions can put pressures on a business. At the same time, the threat of familiarity is real.”

Professional skepticism is a manner of critical thinking that you develop; it is not intuitive. Put in practice a process that will alert you to factors that indicate fraud.

Understand which assertions may be affected by the potential fraud risk. In the scenario outlined above, the two assertions that proved particularly important were occurrence and cutoff because the sales had not actually occurred in the current reporting period.

Also, revenue recognition criteria were not met.

Once risks have been identified, design audit procedures to respond specifically to those risks. These procedures may be different for each type of revenue or revenue transaction.

“The auditor, especially when dealing with private companies, has to make sure he or she understands the environment well and avoids the threat of familiarity,” Bowen says. “In the scenario above, the preparer’s incentive, which previously may have been to minimize tax, changed. The practitioner wouldn't likely have anticipated an overstatement of revenue, but when a company is in financial difficulty, the risk of fraud changes.”

For more information about Canadian Auditing Standard 240 and the auditor’s responsibility relating to fraud in financial statements, see CPA Canada’s Implementation Tool for Auditors at