In January 2021, the Anti-Fraud Collaboration (AFC) released a commissioned report on fraud titled "Mitigating the Risk of Common Fraud Schemes: Insights from the SEC Enforcement Actions." The report found that the technology services industry was charged the most by the U.S. Securities and Exchange Commission (SEC) with fraud at 21% of reported cases. This result was largely driven by the complexity of the industry's revenue recognition issues.
This article highlights how technology companies may engage in fraudulent activity in response to issues around revenue recognition and asset impairments, which may have been brought on by economic conditions due to the pandemic. Additionally, we will explore what strategies tech companies can adopt to prevent fraud in these areas.
About the Anti-Fraud Collaboration Report
The AFC was formed over a decade ago by the Center for Audit Quality, Financial Executives Institute, the Institute of Internal Auditors and the National Association of Corporate Directors. The report used a methodology to classify common financial statement fraud schemes based on SEC Accounting and Auditing Enforcement Releases (AAER) over a five-and-a-half-year period through June 2019. The research was based on the 204 financial statement fraud cases from the 531 AAERs released by the SEC Enforcement Division during that time.
The AFC noted four prevalent financial reporting fraud schemes under their taxonomy for classifying the schemes:
- Improper revenue recognition (40 percent)
- Reserves related issues (28 percent)
- Inventory related issues (12 percent)
- Impairment related issues (8 percent)
Improper Revenue Recognition
According to the study, revenue recognition represented the greatest number of fraud schemes. Because some analysts evaluate companies using revenue trends, there may be pressure for management to manipulate that financial statement line. Other companies may be analyzed using net income or earnings per share. To improve those bottom-line results, one may need to look to the topline revenue for evidence of manipulation.
How Might Technology Companies Accomplish Revenue Fraud?
Technology companies might manipulate revenue recognition several ways:
- Recording sales transactions with fictitious customers.
- Accelerating revenue based on fraudulent documentation of meeting the revenue recognition criteria.
- Providing extraordinary return allowances or other financial incentives through undisclosed side agreements that make otherwise valid sales fail revenue recognition criteria.
- "Channel stuffing," or selling more to a customer than they can use while expecting a future return. Channel stuffing itself may not be improper, but failure to properly account for and disclose the basis for the sales is certainly questionable.
Impairment-related issues may gain more relevancy amid the COVID-19 era. These acts of fraud generally occur when companies fail to record asset impairments in order to avoid an unfavorable effect on the financial statements. The volatility of the COVID-19 environment could put additional pressure on a company to ignore or even distort indicators of impairment.
Identifying Root Causes of Fraud in the Technology Industry
To prevent fraud, companies must drill down to the "why" and "how" it happens. The ACF study noted three primary root causes:
- Tone at the Top - Leadership over-emphasizing results, creating unrealistic goals or even implicitly rewarding behaviors contrary to a stated code of ethics.
- Culture - A high-pressure environment that discourages sharing "bad news" that is perceived to threaten ongoing employment (or other retaliation) for the messenger.
- Lack of Experience - A lack of personnel with sufficient accounting training to identify issues in a timely manner and that are empowered to encourage the company to act.
DHG's Forensic and Valuation Services practice has also witnessed the following:
- Financial pressure - Financial pressure on employees is often one of the hardest things to identify, but remains an important element. Consider the pandemic environment, in which many families have gone from dual incomes to single earner, creating pressure on a spouse to make up for lost income.
- Variable compensation strategies - Executives, sales professionals, and others whose compensation is largely dependent on variable compensation, such as bonuses for company performance, may feel pressure to manipulate and overstate revenue to pad bonus or commission checks.
- Isolation - Employees working from home may feel separated from friends and co-workers, which can lead to unexpected behaviors such as gambling or substance abuse.
Strategies to Prevent Fraud
To help prevent fraud, the following should be in place at all levels of an organization:1
- Proper communication with employees is essential and establishing the proper tone from the top is paramount.
- Robust compliance and anti-fraud programs are equally important and should include an easily accessible "hot-line" with assurances of no retaliation.
- A control environment that takes into consideration how processes may have changed (such as a work-from-home environment)
- Boards should fulfill their responsibility to monitor the tone from the top by bringing a questioning mindset and professional skepticism to their discussions with management.
- Develop a culture where employees care for each other; this will go a long way when employees recognize that their colleagues need help.
- Invest in employee assistance programs; ensure employees know the programs exist, are confidential and that they are encouraged to use them.
For questions about identifying or preventing fraud within the technology industry, reach out to us at email@example.com.
- Note this is not an all-inclusive list of strategies.