By: George M. Wilson, SEC Institute
Revenue recognition is an all-time favorite area for cooking a company’s books. For sixteen years Boston-based public company intelligence service Audit Analytics has consistently found revenue recognition near the top of the list in their annual restatement study.
An interesting question many accounting professionals (or geeks as the case may be!) have been wondering is how adoption of the new revenue recognition model in ASC 606 might affect revenue recognition fraud.
No one will know the answer to this question for a while, but a recent SEC enforcement case provides an interesting perspective. In an enforcement action against Maxwell Technologies, the SEC alleges that a former senior sales executive entered into secret side agreements with customers and acted to conceal these agreements from the company’s financial reporting personnel. The SEC also alleges that the former CEO and former CAO did not adequately respond to “red flags” surrounding this activity. All the parties paid fines and the sales executive consented to a five-year officer and director bar.
Software accounting under legacy GAAP was based in large part on contract form. Fraud surrounding contracts, and in particular undisclosed side agreements, was near the list of all-time favorite areas to cook the books under this old GAAP. However, California-based Maxwell manufactures energy storage and power delivery products and is clearly not a software company, but the opportunity to cook the books using contract manipulation still existed.
How does this relate to the new revenue recognition model? As most of us likely know, the first of the five steps in the new model is to identify a company’s contract with a customer. From ASC 605-10-05-4:
- Step 1: Identify the contract(s) with a customer—A contractis an agreement between two or more parties that creates enforceable rights and obligations. The guidance in this Topic applies to each contract that has been agreed upon with a customer and meets specified criteria.
In this new GAAP contracts have a significant impact on revenue recognition. Contract terms determine the amount and timing of revenue recognition. Even contract modifications can change the amount and timing of revenue recognition. If it is easy to conceal contract terms it will be easy to manipulate revenue recognition.
The Maxwell case points to the importance of considering the need for new or different kinds of controls over the new revenue recognition process. In the software industry controls over contracts have long been a focus area. For example, many software companies periodically require sales personnel to provide certifications dealing with contract completeness and disclosure of all arrangements with a customer. In the new revenue recognition process these and other kinds of controls may become more relevant for companies outside the software world. In particular, controls over estimates and judgments will become crucial to the reasonableness of revenue recognition. This could be a new challenge in many areas.
Lastly, here is one more cautionary note. As is becoming more and more common in these types of enforcements, there was also a disgorgement by an officer who was not named in the action. Maxwell’s former CFO Kevin Royal, reimbursed the company $135,800 for incentive-based compensation he received while the fraud was being committed.
As always, your thoughts and comments are welcome!