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To help clients avoid SEC violations, internal auditors need to understand the practices that can lead to material misstatements.
U.S. SECURITIES AND EXCHANGE COMMISSION (SEC) enforcement activity aimed at curbing earnings management and fraudulent financial reporting has increased markedly in recent years. In 2003, the SEC filed a record number of accounting and auditing enforcement actions against both companies and individuals. The individuals charged included senior managers and lower-level staff, accountants and sales managers, external auditors, and even customers. Most of these enforcement actions focused on earnings management, with violations of Generally Accepted Accounting Principles (GAAP) for revenue recognition constituting the most common offense. The SEC has also frequently cited violations of its Staff Accounting Bulletin (SAB) No. 101 revenue recognition guidelines.
Although media coverage of fraudulent revenue recognition has focused on large companies such as Gateway Inc., Xerox Corp., and Enron Corp., the SEC has taken action against public firms of all sizes. As high-profile corporate scandals have continued to unfold, Congress has increased funding and staffing for the SEC, ensuring that the pace of enforcement activity continues to be aggressive and intense.
The SEC has, in effect, notified internal auditors that revenue recognition is a high-risk area. Furthermore, the passage of the U.S. Sarbanes-Oxley Act of 2002 put management and audit committees on notice about their responsibilities regarding financial reporting.
Internal auditors have an important role to play in helping management and the audit committee safeguard the integrity of the financial reporting process. An awareness of the specific types of revenue transactions that violated GAAP and SAB No. 1, resulting in SEC enforcement action, can help internal auditors fulfill their responsibilities.
UNDERSTANDING REVENUE RECOGNITION
Corporate revenue recognition has long been vulnerable to illegal manipulation. In fact, according to a 1999 report by The Committee of Sponsoring Organizations of the Treadway Commission (COSO), Fraudulent Financial Reporting: 1987-1997 - An Analysis of U.S. Public Companies, more than half of financial reporting frauds in the study involved revenue misstatements. Improper revenue recognition has been an ongoing focus of SEC investigations, and it has been addressed in several GAAP pronouncements. GAAP revenue recognition guidelines, for example, are included in the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 48, Revenue Recognition When...