Revenue Recognition Practices Under SEC Scrutiny: Enforcement Risks

Revenue Recognition Practices Under SEC Scrutiny: Enforcement Risks

Revenue recognition has been a hot topic for the Securities and Exchange Commission (SEC) lately. The SEC has been cracking down on improper revenue recognition practices, which can be a form of accounting fraud. This increased scrutiny from the SEC creates enforcement risks that public companies need to be aware of.

Let’s break down what’s been happening with SEC enforcement around revenue recognition, what are some common schemes the SEC targets, and what companies can do to mitigate risks in this area.

Trends in SEC Enforcement Actions Related to Revenue Recognition

The SEC has made it clear that revenue recognition violations are a priority for its enforcement program. In recent years, the SEC has brought dozens of enforcement actions against public companies related to improper revenue recognition practices [4]. For example, a 2021 report found that about one-third of the SEC’s accounting and auditing enforcement actions in 2020 involved revenue recognition issues [2].

This focus from the SEC makes sense when you consider that over half of financial reporting frauds involve revenue recognition issues, according to a major study on financial statement fraud [1]. The SEC views revenue as a high-risk area, so they devote significant resources to investigating and enforcing securities laws violations related to revenue.

Common Revenue Recognition Schemes Targeted by the SEC

The SEC often sees certain types of improper revenue recognition practices. Here are some of the most common schemes that draw SEC scrutiny:

• Improper timing – Recognizing revenue in the wrong period, such as recording it too early before it is earned.
• Fictitious revenue – Recording revenue from sales or services that did not actually occur.
• Channel stuffing – Flooding distribution channels with excess inventory to record it as revenue.
• Fraudulent management estimates – Tweaking estimates like reserves or valuations to manipulate revenue.

Many cases involve accelerating the timing of revenue recognition in order to inflate revenue or meet analyst expectations. While the motivation may differ, the end result of misstating revenue is the same – a violation of securities laws that concerns the SEC [2].

Recent SEC Enforcement Actions Related to Revenue

To understand the types of revenue recognition issues drawing SEC scrutiny, let’s look at some recent enforcement actions:

• In September 2022, the SEC charged eyewear company Warby Parker with improper revenue recognition practices that resulted in overstating revenue by nearly $8 million over three years [3].
• In June 2022, the SEC charged AgEagle Aerial Systems with improperly recognizing over $3 million in revenue from contracts that had performance obligations that were not complete .
• In April 2022, the SEC charged electric vehicle company Nikola Corporation with misleading investors by misrepresenting its revenue and in-kind benefits in order to appear further along in development .

These cases illustrate some of the ways companies cross the line into improper revenue recognition. Even well-known, reputable companies can face SEC scrutiny if their revenue recognition practices are questionable.

Steps for Mitigating Revenue Recognition Risks

Given the SEC’s focus on revenue recognition, what should companies do to mitigate their risks? Here are some best practices:

• Review revenue recognition policies – Scrutinize all revenue recognition policies and procedures to ensure compliance with GAAP.
• Improve internal controls – Implement strong internal controls around revenue processes and address any control deficiencies.
• Provide training – Educate finance and sales teams on the company’s revenue recognition policies and SEC requirements.
• Perform thorough reviews – Conduct rigorous reviews of significant unusual transactions that may impact revenue recognition.
• Monitor channel partners – Closely monitor activities of channel partners to detect potential channel stuffing issues.
• Watch for red flags – Identify and investigate any revenue-related red flags that could indicate improper accounting.

A proactive approach focused on compliance, controls, transparency, and risk monitoring is key to avoiding the pitfalls of improper revenue recognition. It also helps demonstrate the integrity of the financial statements if questions ever arise.

Role of Auditors and Audit Committees

External auditors and audit committees also play a critical oversight role when it comes to revenue recognition risks. Under auditing standards, auditors must presume there is a fraud risk associated with revenue recognition [5]. They are expected to respond to this risk by altering the nature, timing, and extent of audit procedures.

Areas for auditors to focus on include understanding the company’s revenue recognition policies, testing internal controls around revenue, and performing substantive testing of revenue transactions. Audit committees should engage with auditors on their risk assessment and make sure adequate audit attention is devoted to revenue.

If auditors or audit committees detect any red flags or potential improper accounting, they should perform additional investigation and question management assumptions and estimates. Do not simply accept questionable revenue recognition practices – dig deeper.

SEC Whistleblower Program

The SEC Whistleblower Program provides monetary incentives for individuals to report potential securities laws violations to the SEC. The program allows whistleblowers to report anonymously and provides protections against retaliation.

Whistleblowers who provide original information that leads to a successful SEC enforcement action resulting in over $1 million in sanctions may be eligible for an award of 10-30% of the money collected. Hundreds of millions of dollars have been awarded to whistleblowers under this program.

Revenue recognition issues are among the most common accounting problems reported by SEC whistleblowers [4]. Those with knowledge of potential improper revenue recognition practices at public companies should consider reporting it to the SEC in order to qualify for a potentially sizable whistleblower award.

Conclusion

Revenue recognition has become a front and center issue for the SEC enforcement program. The SEC scrutinizes revenue closely because misstating revenue is a common method of accounting fraud. This means public companies face heightened risks and obligations when it comes to compliance in revenue recognition.

By focusing on GAAP compliance, strong internal controls, risk monitoring, and working collaboratively with auditors, companies can mitigate these risks. But if issues do exist, whistleblowers also have an opportunity to report them to the SEC in exchange for potentially large financial awards.

With the SEC continuing to devote significant resources to investigating revenue recognition practices, companies need to ensure they are buttoned up in this critical area of financial reporting.

References

[1] SEC Speech: Revenue Recognition, https://www.sec.gov/news/speech/spch495.htm

[2] Improper revenue recognition tops SEC fraud cases, https://www.cfodive.com/news/improper-revenue-recognition-sec-fraud-cases/583889/

[3] SEC Charges Eyewear Company Warby Parker With Improper Revenue Recognition, https://www.sec.gov/files/litigation/admin/2022/34-95948.pdf

[4] Report Improper Revenue Recognition and Qualify for an SEC Whistleblower Award, https://www.zuckermanlaw.com/report-improper-revenue-recognition-sec-whistleblower-award/amp/

[5] Revenue recognition: 4 top concerns noted by peer reviewers, https://www.journalofaccountancy.com/issues/2021/nov/revenue-recognition-concerns-peer-reviewers.html

[6] Accounting & Financial Reporting Enforcement Round-Up, https://www.debevoise.com/-/media/files/insights/publications/2019/10/20191028-accounting-and-financial-reporting.pdf?rev=1759aee36305481fa185651d2655513c

SEC Charges Drone Company AgEagle Aerial Systems With Improper Revenue Recognition and Misleading Investors, https://www.sec.gov/news/press-release/2022-102

SEC Charges Nikola Corporation for Misleading Investors With Inflated Revenue and In-Kind Benefits, https://www.sec.gov/news/press-release/2022-61