Revenue Recognition Essay

The revenue recognition principle is a foundation of accrual accounting and one of the main principles of GAAP. The revenue recognition principle is a set of guidelines that helps accountants to identify when a revenue event has taken place and how to appropriately record cash exchanges before, during, and after the revenue event. According to the revenue recognition principal, revenue must (1) be realized or realizable and (2) earned, in order to be recognized. According to the SEC revenue is realized when (1) Persuasive evidence of an arrangement exists, (2) Delivery has occurred or services have been rendered, (3) The seller’s price to the buyer is fixed or determinable, and (4) Collectability is reasonably assured. It is essential for the users of financial statements to know that the real revenues are recorded and disclosed and not fraudulent revenues. A constraint of GAAP that is relevant to the revenue recognition principle is the materiality principle. Fraudulent revenues will create misstatements that could have a material effect on the decisions of financial statement users. In 2002, WorldCom a telecommunication company, filed for bankruptcy. It was later revealed that the company was involved with improper accounting in two major forms. First WorldCom inflated revenues to increase profits, thereby increasing stock prices, and increasing the satisfaction of stakeholders. Second, the company understated line costs. Revenue is important to users of financial statements because it helps them evaluate a company’s performance and prospects. WorldCom violated the revenue recognition principle by creating an account that did not come from the operating activities of the company’s sales channel. WorldCom named this fictitious schedule corporate unallocated account. This action was unethical and illegal, and gave the company a very bad reputation. According to paragraph 25 of PCAOB Auditing Standard No. 5, because of its importance to effective internal control over financial reporting, the auditor must evaluate the control environment at the company. As part of evaluating the control environment, the auditor should assess the following, †¢Does management’s philosophy and operating style promote effective internal control over financial reporting? Has the company developed sound integrity and ethical values, and more importantly, do all employees understand these values, particularly top management? †¢Does the Board or audit committee understands and exercises oversight responsibility over financial reporting and internal control? The control environment is what sets the tone for an organization and is the foundation for all other components of internal control. It provides discipline and structure and reflects the ethical values, integrity and competencies of the organization. The control environment is very important to effective internal control over financial reporting to an audit client like WorldCom, because good designs can prevent and detect frauds and errors. But because WorldCom had such a poor control environment, the company would require more testing for an audit. This shows that the board did not exercise oversight responsibilities over financial reporting or internal controls. According to PCAOB Auditing Standard No. 5 paragraphs 26 & 27, the top-side adjusting journal entries are when the executives record the entries, or when the accountants are asked by the executives to record the entries. A valid use of top-side journal entries is to allocate income or expenses from a parent company to its subsidiaries. However, top-side adjustments can also be used to improperly reduce liability accounts and increase revenue or decrease expenses. Companies undergoing mergers, acquisitions or restructuring are particularly susceptible to the fraudulent misuse of top-side journal entries. Necessary evidence to obtain include sales invoices, credit memos, customer master file list, analytical procedures, and accounting systems. In the auditing of WorldCom, we would require adjusting journal entries, the MonRev spreadsheets detailing revenue, the corporate unallocated schedule, the automated process for closing and consolidating operational revenue numbers, and propriety of a top-side journal entry made to their revenue account. We would also need the authorization of the CFO or any officers. Good ethics is very significant for an organization. When ethical dilemmas are not recognized there could be serious consequences that could lead to imprisonment. In addition, a company will lose its reputation instantly. Assuming that Lorenzo and Taranto knew that the entries being proposed by Scott Sullivan were fraudulent they should not have recorded the journal entries as they were directed. If WorldCom had a control environment where it took more than three employees to conspire to commit such a large fraud, and where the board checked on the corporate adjusting entries, this could have been prevented. Employees should be trained and guided by a code of ethics and observed with appropriate influences for violation