Is your profit real?

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RICK DANAO

RICK DANAO

Our clients often turn to us for help in identifying operational, accounting, tax, legal and other issues of which they may not be aware of and could present serious problems to their businesses. We are honored that The Manila Times has provided our PwC Partners a venue to bring to light significant but often undetected issues affecting businesses of every size and scale through this weekly column, PwC’s Needles in a Haystack.

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Over the past several months, there have been news about a foreign company that has allegedly misstated its reported economic performance or profit. Only the regulators, perhaps after a long process of investigation, can conclude if the reports are true. In my line of work as an auditor, I have encountered a number of incidents involving errors or misstatements in the financial statements. Some involve human errors, while a few involve deliberate manipulation of profit.

Let us take a look at the case of Company A. It provides services and earns a margin of not more than 15 percent. On paper, Company A appears to be making profit. It pays bonuses and gives key officers annual merit increases. One day, a key supplier unexpectedly stopped doing business, placing the sustainability of Company A’s business in danger. The reason is a fundamental business issue: unpaid overdue invoices. Although the company has been growing, the discovery of serious cash flow problems raises big questions. Is the reported profit real? How can they have profit yet be unable to pay their suppliers?

Now, the senior management is seeking to uncover what is wrong with the business. The company has no cash and is facing significant unpaid obligations. Company A’s balance sheet shows a combined uncollected and unbilled income (reflected as Accounts Receivable), which is more than six months’ worth of sales. To illustrate, let us assume that the reported sales have averaged P1,000 while the average net profit after tax over a period of three years have stood at P150. The cumulative profit for three years would be P450. However, the uncollected revenue is equivalent to six months’ sales, or P500. Clearly, the company has a negative cash flow.

Six months’ worth of uncollected revenue appears excessive because the company’s typical delivery-to-collection cycle is not more than two months. Company A pays bonus and incentives to key officers based only on revenue performance. Management does not seem to measure performance based on a balanced scorecard. There is no consequence to the concerned officers if the revenue is not eventually collected. Given these, my instinct tells me that the probable reason behind the cash flow challenges of Company A is artificially inflated income and profit! One cannot expect to collect if the revenue is not real.

Here are some facts to consider regarding the revenue of Company A:

1) Uninvoiced income equivalent to five months of revenue (in the above example, roughly P417) for periods ranging from one to three years.

2) For the uncollected and uninvoiced revenues, there is no proof that actual services have been rendered, so invoice cannot be issued and collection cannot be enforced.

3) Revenue was just recognized based on the internal advice from sales group.

The above case is a classic example of fraud over revenue recognition. Under the accounting rules, revenue from sale of services is recognized when certain criteria are met. Two most crucial criteria in my view are the following:

1) Services have been rendered and accepted by customers.

2) Cash collection is probable at the time the sales are recorded.

Applying the above important criteria to the unbilled income of Company A, at least five months’ equivalent of income recorded in prior years does not meet the definition of revenue; hence, it should not have been recognized. This cannot be just a case of inefficient or lack of collection. There are no supporting documents to prove that service is delivered, thus collection cannot be enforced. After a thorough internal investigation, it was concluded that the above case involves recording of non-existent revenues. Company A paid a heavy price as it granted bonuses based on artificially inflated profit, overpaid income taxes and encountered serious cash flow crisis.

Some of my friends who own small- to medium-sized businesses often ask me what performance indicators they need to monitor and measure to improve their businesses. There are a number of possible business performance reviews they can do, but I can share the following points to spot possible red flags when dealing with revenue:

1) Excessive balance of uncollected invoices. This is presented as Accounts Receivable in the balance sheet. If the usual credit term is 30 days and you have four to five months of receivables, you need to do something. It can be an indicator of inefficient collection or in the above example, non- existent revenue.

2) Delivery volume of goods and services at year-end is beyond normal. In some cases, look for continuous deliveries to delinquent customers. This can be serious.

3) High volume of goods returned or service invoices cancelled after year-end.

4) High volume of credit memos for cancelled or adjusted invoices.

5) Existence of unbilled or uninvoiced sales for a prolonged period of time.

6) Unusual movement in gross margin despite stable price of goods purchased and sold.

7) Customer disputes.

Now, let us discuss possible solutions. Can fraud be prevented? Solutions may vary, depending on the complexity or size of the business, the culture of management and its personnel, the overall competence of the finance and accounting teams, the IT environment, among others. Note that connivance may undermine a policy or control so it is important that integrity and values are enforced. In the above example, the following practical solutions can be implemented to detect, if not, prevent possible recording of non-existent revenues:

1) Hire a competent finance lead.

2) Implement a balanced scorecard (sales volume, cash collection, bad debts and credit risk management). In some companies, bonus is not given until collection is made. If you want to protect your investments, these have to be measured to increase accountability.

3) Adopt a robust, easy-to-implement controls and accounting documents. For example, revenue cannot be recorded if not supported by forms such as signed agreements, service delivery reports signed and acknowledged by authorized representatives of customers. Periodic reconciliation of accounts with customers also helps to resolve disputes as they arise.

We primarily engage in business to earn profit. By being aware of the fraud indicators related to revenue recognition and implementing the relevant controls to prevent and detect such as those discussed above, management, shareholders and other stakeholders can get comfort that operations are sound and that reported profits are real. More solutions next time.

Roderick M. Danao is the vice chairman and assurance managing partner of Isla Lipana & Co./PwC Philippines. Email your comments and questions to markets@ph.pwc.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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