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Are Risks Hiding in the way your Revenues and “Expenses” are Reported?

Are you concerned about how your employees can get around your accounting policies or what unintended impact they might have? Here are two areas where accounting policies may pose a risk.

Revenue Recognition

Revenue recognition is always on the mind of your auditors. You have also carefully set revenue targets for your team. Can your employees satisfy the auditor’s tests and still inflate revenue?

Employees can be very creative when it comes to hitting a target or making that bonus. This behaviour can introduce risk that did not previously exist. This discussion focuses on methods which may not technically be fraud, but may harm your business.

One method of bolstering revenue prior to a deadline is offering discounts to customers to purchase a product or service early. This creates the risk of reduced revenue from the discounts, since the customers would have otherwise paid full price, and additional costs incurred to deliver product, such as overtime wages or expediting costs. Another revenue “booster” is shipping product to customers early, or shipping more than ordered. This can lead to the risk of dissatisfied customers and loss of reputation, as well as added costs incurred to deliver product, such as overtime wages or expediting costs.

The red flags for these types of behaviours are similar and include: abnormal discounts to long-time customers; higher (or lower) sales volume prior to (or after) a deadline; lower inventory than normal at the end of the period; and reduced gross profit immediately prior to a deadline

These actions can pose a more significant risk in the long-run. Customers may begin to expect these discounts (or wait until the end of a period to place orders). This will hurt the bottom line in terms of lower revenue and increased inventory carrying costs (more storage space needed, more financing needed, etc.). If successful in these methods, employees may move on to more devious methods.

Although these techniques technically comply with the revenue recognition policies, they could have an unintended impact on your business.

Capitalizing vs. Expensing

There are pros and cons to choosing any accounting policy. Capitalizing vs. expensing is no exception.

For small to medium-sized private businesses, expensing is more attractive since it is the most simplistic method. It is also common to use the same policies as required for income tax purposes, which results in fewer year-end adjustments and lower accounting fees.

Accounting policies and tax laws have different objectives. Accounting policies are designed to present fairly the financial position of a company. Tax laws have different priorities. For example, the government uses tax laws as a vehicle to encourage capital investment and promote research and development. A common method employed to do this is to allow a company to expense (as opposed to capitalize) certain costs.

From an accounting perspective, an expenditure should be capitalized (set up as an asset) versus being expensed if it will provide the business with future benefits. Then, the asset will be amortized over future years to match the period of the benefits enjoyed.

Envisioning your balance sheet, the effect of expensing costs is that it reduces your reported assets and net income (which also directly reduces your equity value).

Who cares about lower asset and equity values? The most obvious answer would be your bank’s loan officer. Higher asset value and higher equity value are beneficial when trying to obtain financing. If your expensing policy has been driving down your equity value, it could create undue financing risk.

Inappropriate policies can also degrade the relevance of the financial statements since many accounts are directly impacted. This increases the risk of making poor management decisions.

I encourage you to critically assess your accounting policies to determine what risks are hiding there and if your business can afford it.

Published in Corporate Risk Canada – Winter 2012 Edition.

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