(a)    There are a number of reasons why there should be a presumption that there are risks of fraud in revenue recognition. One reason is that managers of companies are often under pressure, particularly in listed companies, to achieve certain performance targets. The achievement of those targets often impacts their job security and their compensation. These performance targets often include measures of revenue growth, providing an incentive for management to use earnings management techniques.

In other companies there may be incentives to understate revenues, for example, to reduce reported profits and, therefore, company taxation charges. This may be more relevant to private limited companies where management may not be under such pressure to achieve revenue based targets.

There is also usually a high volume of revenue transactions during a financial period. As the volume of transactions increases, the risk of failing to detect fraud and error using traditional, sample based auditing techniques also increases. This means that it is potentially easier for management to successfully manipulate these balances than other balances which are subject to a lower volume of transactions. Material misstatement through the manipulation of revenue recognition can be readily achieved by recording revenue in an earlier or later accounting period than is proper or by creating fictitious revenues.

Revenue recognition can also be a judgemental area. Examples include the recognition of revenues on long-term contracts, such as the construction of buildings, and from the provision of services. These require the estimation of the percentage of completion at the period end, increasing the scope for management to manipulate reported results.

As well as requiring judgement, revenue recognition can also be a complex issue. For example, some sales have multiple elements, such as the sale of goods and the separate sale of related maintenance contracts and warranties. This added complexity increases the risk of manipulation.

In some companies, for example, those in the retail industry, a high proportion of revenue may be earned through cash sales. This increases the risk of the theft of cash and the consequent manipulation of recorded revenues to conceal this crime.

Methods of revenue manipulation have also featured prominently in cases of accounting fraud, such as Enron and Worldcom. The prevalence of these methods in modern accounting frauds and the failure of auditors to detect this in these cases suggests that it is one of the more common methods of earnings management and one which auditors should rightly consider as high risk.

While revenue recognition in general may be considered a high risk area, it is not always the case; companies with simple revenue streams or a low volume of transactions may be considered at low risk of fraud through revenue manipulations. Accordingly ISA 240 The Auditor’s Responsibility Relating to Fraud in an Audit of Financial Statements permits the rebuttable of the fraud risk presumption for revenue recognition. One example of simple revenue streams would be where a company leases properties for fixed annual amounts over a fixed period of time. If this is the case, the reasons for not treating revenue as a high fraud risk area must be fully documented by the auditor.

(b)    (i) Cash transfers

This unusual, unexplained cash transfer into a foreign bank account may indicate that Phil Smith is using York Co to carry out money laundering. Money laundering is defined as the process by which criminals attempt to conceal the origin and ownership of the proceeds of their criminal activity, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate cover for the sources of their income.

It is possible that the proceeds of criminal activity have been placed into York Co’s bank account to enable them to transfer the funds into a foreign account, thus providing them with the appearance of legitimacy and creating a trail which is difficult to trace to the original source. This process is known as ‘layering’. According to ACCA’s Technical Factsheet 145 Anti-money laundering guidance for the accountancy sector, money laundering can result from a single transaction such as the cash placed into York Co’s bank account.

The fact that Mr Smith retains sole control over cash management and that the financial controller has no oversight or involvement in this indicates weak controls over cash, for example, there appears to be no segregation of duty which may be the intention of Mr Smith to facilitate illegal activity. That he has failed to provide any documentary evidence, despite the request to do so by the audit team, only arouses suspicion further. It is also possible that the company is being used as a vehicle for money laundering without Mr Smith’s knowledge. It is possible that the money has been accepted in good faith without the source of the funding being adequately verified.

The amount which has been transferred represents 1·3% of total assets, which is material to the financial statements. The engagement, and particularly matters relating to cash transactions, should now be considered as high risk and approached with a high degree of professional scepticism. The audit files should now be subject to an independent second partner review. The firm may also wish to seek legal advice given the potential legal implications of dealing with a client involved in money laundering.

To properly assess the impact of the transaction on the financial statements, the audit firm needs to understand the accounting entries which have been made. The debit side of the entry would be to cash, and the audit team should enquire as to where the credit side of the entry has been recognised. Possibly the credit has been recognised as revenue or possibly it has been contra’d against the cash payment which was made the next day.

The situation should be reported as soon as possible to the firm’s Money Laundering Reporting Officer (MLRO). The MLRO is responsible for receiving and evaluating reports of suspected money laundering from colleagues within the firm. They will make a decision as to whether further enquiries are required and, if necessary, will make reports to the appropriate authorities.

Finally, care must now be taken during the remaining audit that no-one ‘tips off’ the client that their activity is being treated as suspicious and that a report will be made to the MLRO. ‘Tipping off’ the client could prejudice any consequent investigation and may itself be considered a criminal offence, depending on relevant legislation. According to Technical Factsheet 145, a tipping off disclosure may be made in writing or verbally, and either directly or indirectly so the audit team must ensure that when discussing the matter with Mr Smith, he is not alerted to the suspicions of money laundering.

(ii) Legal dispute

The creation of provisions and their reversal in consequent years is a commonly used creative accounting technique. As such, this is a potentially high risk area of the audit. The reversal of the provision in the current year increases the reported profit before tax by $150,000, which represents 6·8% of profit. This is therefore material and should be treated with appropriate professional scepticism.

In accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the provision should only have been recorded originally if: York Co had an obligation as a result of a past event; if it was considered probable that an outflow of cash would occur; and if a reliable estimate of the amount was available. Given that this is a material amount, there should be audit evidence on the prior year file concerning the appropriateness of the original amount recorded.

It would be prudent to review the evidence held on the prior year audit file to assess the quality of evidence which was obtained relating to the assumptions made regarding the probability of payment. With legal disputes one would expect to see some documentary evidence from legal experts, such as the company’s lawyers. It is unlikely that management assumptions and a written representation would have been considered appropriate as evidence in a matter where legal expertise is required.

For the same reason it is unlikely that the opinions of Mr Smith are likely to be considered as sufficient justification for reversing the provision in the current year. The lack of additional documentary evidence and Mr Smith’s lack of availability to discuss the matter with the audit team further arouses suspicions of the validity of the decision to reverse the provision.

The audit manager should contact the client and request confirmation of Mr Smith’s opinions from the company lawyers, along with any relevant documentation of legal proceedings or agreements reached with the ex-employee.

If the client is unable to provide any further documentation, then the provision should be reinstated in full. This should be noted on the summary of proposed adjustments to the financial statements and sent to the client along with a request that they amend all the adjustments identified.