The risk of material misstatement in the revenue and collection cycle arises primarily due to improper revenue recognition, which has been a major source of financial fraud.

Key Risks in Revenue Recognition

Auditors assess the risk of material misstatement using the "What Could Go Wrong?" (WCGW) approach. Three major concerns include:

• Timing of Revenue Recognition – Ensuring revenue is recognized only when earned.

• Possibility of Customer Returns – Assessing the impact of potential returns on revenue.

• Collectability of Receivables – Evaluating whether accounts receivable balances are likely to be collected.

Common Fraud Schemes in Revenue Recognition

Improper revenue recognition often involves:

• Fictitious Sales – Recording nonexistent sales to inflate revenue.

• Premature Revenue Recognition – Recognizing revenue before meeting accounting criteria.

• Holding the Books Open – Recording sales in the current period when they should be in the next.

• Side Agreements – Undisclosed terms that affect the validity of sales.

• Bill-and-Hold Sales – Recognizing revenue without transferring goods/services to customers.

GAAP and SEC Guidance

Revenue is recognized when there is persuasive evidence of an arrangement.

• Delivery has occurred, or services have been rendered.

• The seller’s price is fixed or determinable.

• Collectability is reasonably assured.

FASB's ASC 606 outlines the five-step model for revenue recognition:

1. Identify the contract with the customer.

2. Identify performance obligations.

3. Determine the transaction price.

4. Allocate the price to performance obligations.

5. Recognize revenue when (or as) the entity satisfies performance obligations​.

Audit Response to Revenue Recognition Risks

Auditors use substantive analytical procedures and tests of details:

• Cutoff Testing – Examining transactions near period-end.

• Sales Returns Review – Checking post-year-end returns.

• Accounts Receivable Confirmations – Validating customer balances.

• Revenue Trend Analysis – Comparing revenue trends to industry norms.

Due to the high fraud risk, professional standards presume revenue recognition to be a significant audit risk, requiring specific substantive procedures to detect misstatements​.