An analysis of corporate disclosures of enforcement actions and internal investigations highlights the increased risk that those who are investigating other forms of fraud, for example accounting fraud, may find a regulator’s interests expanding beyond the initial scope into areas of corruption.
Not surprisingly, this is most prevalent if initial investigations involve revenue recognition — especially when previously issued financial statements are restated.
As of the end of August 2018, FCPA Tracker reported approximately 156 open or recently closed investigations into corruption, six of which also reported prior or continuing investigations into allegations of accounting errors or fraud. Five of the six cases involve revenue recognition practices and material weaknesses of internal controls at foreign subsidiaries, three of which resulted in restatements of previously issued accounts.
Although perhaps less prevalent than in the past, revenue recognition remains a mainstay of financial reporting fraud. Incorrect revenue recognition enhances both the profitability and assets of a corporation. Investors look to revenue growth as a key performance indicator in many industries, and senior executives often refer to revenue growth as a guide to future earnings.
Financial reporting fraud has also historically been the most costly to investors as companies experience considerable stock price drops upon disclosure. Regulators, therefore, are quick to assess whether there are practices that result in “channel stuffing” or premature recognition of revenue.
As part of such an investigation, regulators will seek to understand: the customers, the sales channels deployed, marketing and promotional activities, contractual provisions (including rights of return, product substitution rights, discounts offered, promotional support etc.), compensation arrangements (e.g., commissions), and internal controls and procedures for accurately recording sales.
In particular, regulators may scrutinize third parties that co-market, promote, sell and/or distribute products.
While much of this information can be obtained through an assessment of regular corporate records (e.g., contracts, purchase orders, shipping documents, invoices and accounting records), the identification of customer side agreements and other “unofficial” arrangements are often found in email records, or verbal agreements unearthed through interviews. It is within these same sources that potential corruption concerns may be identified that expand the scope and focus of the investigation.
The CPA Journal recently posted an article written by Fatima Alai, PhD and Sophia I-Ling, PhD, both of California State University, Fullerton, titled “Characteristics of Financial Restatements and Frauds” that analyzed financial restatements between 2000 and 2014.
While the number of restatements has decreased during the period of the study (from a peak in 2006), their analysis shows that approximately eight percent (8 percent) of total reporting companies per year since 2007 have restated previously issued reports. Revenue recognition was a leading cause in a significant number of restatements the study analyzed. While not as prevalent as the days of Enron and Worldcom, financial fraud and subsequent restatements exist, and will continue to do so, even if not to the same extent or individual magnitude.
Restatements, revenue recognition, and the FCPA are closely aligned. A company addressing potential revenue recognition allegations in a foreign jurisdiction, especially a jurisdiction that serves government customers, should consider the possibility, at the outset of the investigation, that corruption-related concerns should be addressed. If it doesn’t, regulators very well may.
Neil Keenan, pictured above left, is a partner at Forensic Risk Alliance based in Washington, DC. He is a forensic accountant with over 20 years’ experience investigating and advising clients on financial fraud, corruption and the design of compliance programs. He can be contacted here.
Michael Trahar, above right, is a Director at Forensic Risk Alliance based in Washington, DC. He is an experienced attorney who has conducted global investigations for multinational companies in more than 30 countries across a number of industries. He can be contacted here.