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SOX section 404 material weaknesses related to revenue recognition.

Previous research on restatements and financial statement fraud reveals that revenue recognition is perhaps the single greatest problem area in U.S. financial reporting. In response to a proliferation of revenue recognition problems in the late 1990s, the SEC offered additional guidance to companies on how to properly recognize revenue by issuing Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements, in 1999 (revised in SAB 104 in 2003). The Sarbanes-Oxley Act of 2002 (SOX) focused more attention on revenue-related internal controls.


Despite the efforts of regulators to provide guidance on revenue recognition practices and to improve controls in this area, problems with revenue recognition have persisted. A recent survey found that 55% of public companies changed their revenue recognition policies in order to comply with SOX, and that such changes often were considered "moderate" to "significant" ("Sarbanes-Oxley Has Widespread Impact on Revenue Recognition Policies," Business Wire, October 24, 2005). Furthermore, in 2005, nearly one out of every 12 U.S. public companies filed earnings restatements (G. A. Cheney, "Making Sense of Revenue Recognition," Financial Executive, July/August 2006), and revenue recognition issues were a leading cause of such restatements. Such restatements may be quite large. For instance, Computer Associates had a $2.2 billion restatement, and Lucent Technologies had a $1.5 billion problem related to revenue recognition issues (J. Marshall, "The Perils of Revenue Recognition," Financial Executive, July/August 2004). Other high-profile revenue recognition cases include Gateway, Xerox, and Enron.

Revenue recognition problems are further highlighted by the COSO-sponsored study "Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies" ( FFR_1987_1997.PDF), and the SEC's "Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002" (, both of which found that revenue issues are the most common problem underlying accounting enforcement actions brought by the SEC.

While previous studies have highlighted the role of revenue recognition in restatements and accounting frauds, the implementation of SOX section 404 provides another opportunity to examine revenue recognition issues--this time from the perspective of internal controls and remediation of control weaknesses. A September 2005 Accounting Horizons article by Weili Ge and Sarah E. McVay ("The Disclosure of Material Weaknesses in Internal Control After the Sarbanes-Oxley Act") examined material weakness disclosures under SOX section 302 and found that 55 of the 261 companies with material weakness disclosures under section 302 (from August 2002 to November 2004) had problems related to revenue recognition. The purpose of that study, however, was not to analyze the revenue recognition problems in detail.

This article examines disclosures of material weaknesses in internal control after the implementation of SOX section 404 and summarizes companies' efforts to remediate these material weaknesses.

SOX Section 404

SOX section 404 was effective for accelerated filers for fiscal year-ends on or after November 15, 2004. Under section 404, management must issue a report on the effectiveness of the company's internal control over financial reporting. The external auditor must also issue a report expressing an opinion on the effectiveness of internal control over financial reporting.

If the auditor and management determine that a material weakness exists as of the end of the fiscal year, then the auditor issues an adverse opinion. In such a case, the management report and the auditor's opinion must describe the nature of the material weaknesses. The management report also often discusses related remedial efforts to correct the problem.

Data Collection

The Audit Analytics database was used to identify companies with material weaknesses related to revenue recognition. During the period examined, there were 137 companies that disclosed material weaknesses related to revenue recognition. Those 137 sample companies had fiscal year-ends ranging from January 28, 2005, to January 5, 2006 (2005 year-ends), and the audit report dates ranged from May 12, 2005, to November 22, 2006.

This period represents the first complete year after the effective date of section 404. The 2005 sample period allows for a reasonably large sample of revenue-related material weaknesses. According to Audit Analytics, revenue-related material weaknesses dropped to 105 unique registrants in 2006, and 65 in 2007 (presumably, as large companies improved their controls).

The relevant 10-Ks of these 137 companies were examined to determine the exact nature of the material weaknesses and related remediation efforts. The material weaknesses and remediation efforts were also analyzed, categorized, and summarized.

Company Characteristics

Exhibit 1 presents information on the characteristics of the 137 companies. The companies are generally mid-sized public companies, with median market values, revenues, and assets under $500 million. The companies are concentrated in the services and manufacturing industries. Of particular note is that 30 of the companies are in the computer services and software industries, consistent with a previous finding that such companies are primary perpetrators of revenue fraud (Mark S. Beasley, Joseph V. Carcello, Dana R. Hermanson, and Paul D. Lapides, "Fraudulent Financial Reporting: Consideration of Industry Traits and Corporate Governance Mechanisms," Accounting Horizons, December 2000). Most of the sample companies have Big Four auditors, and they typically have a total of three material weaknesses (ranging from one to 18).
Companies with Materials Weaknesses Related to Revenue Recognition

Panel A: Company Size (in thousands)


Market Value                                      $314,981
Revenues                                          $327,595
Assets                                            $457,023

Panel B: SIC Codes

1000-1999 Mining and Construction                        6
2000-3999 Manufacturing                                 45
4000-4999 Transportation and Communication              11
5000-5999 Wholesale and Retail                          11
6000-6999 Financial, Insurance, and Real Estate         13
7000-8999 Services                                      51
Total                                                  137

Panel C: External Audit Firm

Big Four                                               108
Other National Firms                                    18
Local Firms                                             11
Total                                                  137

Panel D: Total Number of Material Weaknesses

Median number of material weaknesses per company         3
Range of material weaknesses per company              1-18

Material Weaknesses

Exhibit 2 summarizes the most commonly identified material weaknesses related to revenue recognition. General weaknesses in revenue-related controls were the most common type of weakness (35 companies). The problems cited typically involved a lack of controls or ineffective controls governing revenue recognition.
Material Weaknesses Related to Revenue Recognition: Categories with
10 or More Companies Represented

No.  Type of Weakness     Selected Examples

35   Generally lacked     * Company did not establish or maintain
     proper controls      adequate policies and procedures over the
     over the             selection and application of appropriate
     recognition and      accounting policies, resulting in the
     recording of         underreporting of revenues and direct costs
     revenues             * Deficiencies revealed in revenue
                          recognition process, which constitute
                          amaterial weakness in the aggregate.
                          * Did not maintain effective controls over
                          the accuracy and
                          validity of service and revenue.

26   Failed to properly   * Company did not maintain effective controls
     record the elements  to ensure compliance with established
     of specific          policies by personnel entering into contracts
     contractual          and other commitments.
     arrangements with    * The controls were not adequate to ensure
     customers or third   the capture and analysis of the terms and
     parties              conditions of contracts, contract changes,
                          reimbursable costs, and payment
                          terms which affect the
                          timing and amount of revenue to be
                          * On some contracts, revenues
                          were initially recorded on change
                          orders/claims without proper support or
                          * Did not ensure that
                          appropriate evidence of sales agreements with
                          customers existed and that all aspects of
                          sales agreements were considered in the
                          determination of the appropriate accounting.

26   Failed to property   * Company had insufficient controls over the
     account for          timely identification of all elements of a
     revenues in          multiple-element arrangement with a specific
     multi-element or     customer.
     nonstandard          * Did not maintain effective controls over
     arrangements         the determination of revenue recognition for
                          a nonroutine, complex revenuetransaction.
                          * Did not have effective
                          secondary review policies and procedures to
                          ensure that multiple-element software
                          arrangements with nonstandard terms were
                          recognized in accordance with U.S. GAAP.
                          * Revenue should have been deferred and
                          recognized over the period during which
                          certain services within the multiple-element
                          arrangements are expected to be performed.

24   Did not properly     * Company did not monitor in a timely fashion
     account for          nor properly analyze some previously deferred
     deferred revenues    transactions. This resulted in revenue
                          accounting errors, including previously
                          deferred revenue being recognized improperly.
                          * Incorrectly recorded license revenue
                          related to one customer arrangement with
                          nonstandard terms and did not identify
                          improperly deferred revenue balances for the
                          maintenance portion of two customer
                          arrangements with nonstandard terms.
                          * Failed to effectively perform and document
                          a periodic evaluation of the reasonableness
                          of assumptions, with respect to the deferral
                          of revenue associated with personal training
                          * Control deficiencies and
                          restatements related to the company's
                          deferral of revenue associated with extended
                          service contracts purchased by certain
                          customers at the time of equipment sale.

17   Lacked sufficient    * Did not have personnel with adequate
     finance and          technical expertise to effectively carry out
     accounting staff     the company's policies and procedures related
     with appropriate     to the review of technical accounting matters
     skills to deal with  and to ensure adequate management review of
     revenue recognition  information supporting the financial
     problems             statements, resulting in the underreporting
                          of revenues and direct costs.
                          * Did not employ personnel with the
                          appropriate level of technical knowledge
                          and experience to prepare, document,
                          and review its accounting
                          for revenue to ensure that such accounting
                          complied with U.S. GAAP.

13   Failed to provide    * Company policies and procedures did not
     documented controls  provide for adequate management oversight and
     and consistent       review of the accounting implications of the
     management review    terms and conditions of certain third-party
     and approval of      agreements.
     transactions         * Calculations were not being reviewed by
     involving revenue    appropriate accounting personnel to
     recognition          determine that revenue was recognized in
                          accordance with company policy and U.S. GAAP.
                          * Detailed review of key financial
                          spreadsheets found to be lacking, including
                          spreadsheets supporting journal entries
                          affecting revenue, such as unbilled revenue
                          and deferred revenue.

10   Failed to properly   * Company demonstrated deficient controls
     account for billing  over the timely issuance of invoice
     disputes,            adjustments, the initiation of customer
     inaccuracies, and    master records and contracts to ensure
     other billing        consistent billing of periodic chargers, the
     problems             collection of accurate meter readings from
                          equipment to ensure the accurate generation
                          of customer invoices, and the segregation of
                          incompatible duties within the billing
                          * Controls that reasonably assure
                          the accurate and timely capture of customer
                          contract billing information and billing of
                          customers in accordance with contract terms
                          were not designed or operating effectively.
                          * Did not maintain effective controls related
                          to the invoicing of customers with credit
                          terms and the collection and application of
                          payments and credits to accounts receivable.

10   Failed to properly   * Company did not maintain sufficient
     account for passing  controls over existence, completeness, and
     of title, given      accuracy in the invoicing process regarding
     certain shipping     shipment information received from third
     terms and shipping   parties upon which the company relied to
     dates                record revenue within certain classes of
                          * Failed to ensure the correct
                          application of SEC SAB 104, when certain sale
                          transactions were entered into with
                          international customers with shipping terms
                          of delivered duty paid.
                          * Recognized revenue
                          on shipments that were made available to the
                          buyer but not picked up by the buyer or the
                          buyer's carrier at the specified location.

Note: The wording above is quoted or adapted from various companies
public' public filings.

The next categories related to the complexities surrounding revenue recognition. For instance, 26 companies cited weaknesses related to recording contractual arrangements with customers or third parties. In these cases, control weaknesses affected the ability of companies to properly consider the provisions, terms, conditions, and costs associated with revenue/sales contracts in determining when to recognize revenue. Similarly, 26 companies reported weaknesses related to recognizing multi-element or nonstandard arrangements. For example, many of these companies lacked controls to ensure that "multiple element software arrangements with nonstandard terms" were recognized in accordance with generally accepted accounting principles (GAAP), or the staff was not able to understand and account for these transactions. Finally, 24 companies had difficulty properly recognizing deferred revenue. It appears that complex sales arrangements--whether due to complex contracts, bundles of goods and services, or payment patterns that create deferred revenues--can create difficulties in revenue recognition. Although SABs 101 and 104 were intended to help clarify revenue recognition in more complex situations, problems persist.

The next two categories related to management--inadequate financial staff expertise (17 companies) and inadequate management review and approval of revenue transactions (13 companies). In these cases, both the quantity and me skill level of personnel in accounting and finance were found to be lacking. Furthermore, the personnel who were employed did not appear to provide sufficient oversight and review. It is critical for the financial staff to be fully knowledgeable about revenue recognition principles and rules, and it is important that such knowledgeable managers review the recording of revenue transactions, as well as the underlying calculations.

The final two categories were more specific. Several companies reported mat they had weaknesses in billing and invoicing (10 companies). Such problems typically were associated with control deficiencies in the accounts receivable, credit, and billing functions. Anomer group of companies reported weaknesses related to shipping terms and the passage of title (10 companies). These difficulties were typically associated with improper cutoff procedures and failing to identify when title passed in a transaction.

Remediation Efforts

To mitigate the control weaknesses reported in Exhibit 2, companies undertook various remedial efforts to strengthen their controls. Exhibit 3 summarizes the most commonly identified remedial efforts related to material weaknesses in revenue recognition. The most commonly cited remedial step reflected fundamental changes in revenue recognition policies and controls (66 companies). Companies typically developed or redefined their processes, often in writing, regarding specific aspects of revenue recognition.
Remedical Effors to Address Revenue Recognition Weaknesses: Categories
with 10 or More Companies Represented

No.  Type of              Selected Examples

66   Revised current      * Company is redefining its processes to
     policies or          ensure that all significant revenue
     implemented new      transactions are processed through its
     general policies,    computerized information systems, ensuring
     procedures,          that they are properly reflected in the
     processes, or        company's consolidated financial
     controls regarding   statements.
     revenue              * Amended existing indirect channel revenue
     recognition          recognition policy and related written
                          confirmation process to
                          require additional information regarding
                          terms and conditions between the indirect
                          channel partner and the related end user.
                          * Developing standard reporting for each
                          business unit, including exception reports
                          to assist in error detection.
                          * Directing internal resource attention,
                          including internal audit efforts, to sales
                          order processing and revenue accounting

58   Instituted reviews   * Company is increasing review of
     and monitoring of    maintenance and professional services
     complex,             contracts at the time of order entry.
     nonroutine, or       * Adopted a more thorough review process with
     significant revenue  the management of the division in
     transactions, such   evaluating transactions with multiple
     as those involving   elements in any given period.
     contracts            * Began processes to independently review all
                          sponsorship and "nonstandard" impression
                          contracts to make sure they are captured
                          and accounted for correctly.
                          * Improving the monitoring of deferred
                          contracts where recognition is dependent on
                          the occurrence of one or more events.

54   Conducted            * Company has provided training and
     additional training  instruction to accounting staff to enhance
     regarding revenue    their understanding of relevant U.S.
     recognition          accounting principles.
                          * Expecting to implement new training courses
                          for senior personnel throughout the company,
                          attended by chief executive officer.
                          * Maintaining
                          an ongoing program of continuing
                          professional education for financial
                          employees in various areas and disciplines,
                          including revenue recognition.

38   Hired additional     * Company hired a number of skilled and
     accounting or        experienced employees in the accounting and
     finance personnel    finance section of the organization,
                          including various people in the revenue and
                          project accounting area.
                          * Continued to add
                          and retain technical accounting personnel
                          and enhance supervision with regard to,
                          among other things, timely account analysis
                          and review and approval of significant
                          revenue transactions.
                          * Hiring an
                          experienced chief information officer to
                          help oversee the system enhancements
                          required to remediate the control

23   Improved             * Company improved documentation of
     documentation of     reconciliations of invoicing.
     policies,            * Formulated checklists to define revenue
     procedures, and      recognition criteria and to document related
     controls regarding   transactional information.
     revenue              * Established standard global manual
     recognition          documentation requirements at the local
                          reporting levels
                          for the assessment of processing and
                          monitoring of intercompany transactions and
                          appropriate revenue recognition.

16   Communicated         * Company modified alignment of the billing
     policies,            function within the organization so that
     procedures, and      the finance organization has better insight
     controls regarding   into these types of revenue transactions
     revenue              and so that the appropriate information is
     recognition          available for accounting at period end.
                          * Reiterate to all financial controllers the
                          requirements of AICPA Statement of Position
                          (SOP) 81-1, "Accounting for Performance of
                          Construction-Type and Certain
                          Production-Type Contracts."
                          * Advise senior
                          management and division personnel on the
                          various business models for pricing before
                          new products and new bundles are brought to
                          market, in an effort to clarify revenue

13   Introduced and       * Student information system has been
     monitored new        updated to reflect the change in the
     software to          revenue recognition policy, with regard to
     automate the         diploma programs with externships.
     recording of         * Company converted three of the remaining
     certain revenue      six stand-alone revenue systems over to the
     transactions         corporate revenue platform in fiscal year
                          2005. The company intended to convert the
                          remaining three stand-alone revenue systems
                          to the corporate platform by the end of
                          fiscal year 2006.
                          * Entered into an
                          agreement with a software vendor to
                          configure and implement revenue recognition

12   Used third-party     * Company is entering into arrangements
     consultants          with third-party accounting and reporting
                          experts to consult with and train
                          management in these areas and to provide
                          additional U.S. GAAP resources for
                          nonroutine or complex accounting matters
                          that may arise in the future.
                          * Used legal
                          counsel specializing in pharmaceutical
                          matters to provide interpretations of all
                          customer contracts.
                          * With assistance of
                          outside expert consultants, developed
                          accounting models to recognize sales of
                          domestic products under the sell-through
                          revenue recognition method in accordance
                          with U.S. GAAP.

Note: The wording above is quoted or adapted from various companies'
public filings.

The second most commonly cited remediation was the enhanced review and monitoring of complex, nonroutine sales transactions (58 companies). In these cases, companies typically expanded monitoring, implemented new review processes, or increased the nature and quality of review procedures.

Better training regarding revenue recognition (54 companies) was the third most common type of remediation. Examples of better training included establishing and maintaining continuing professional education programs and other types of instruction to ensure that senior personnel and other relevant employees were educated in the technical aspects of revenue recognition. Interestingly, one company specifically stated that its CEO would attend the training session.

Another common remedial step was for companies to hire additional personnel to address the problems (36 companies). These new employees were typically in the accounting and finance or information technology areas. The additional personnel should assist in improving supervision, review, approval, and analysis of revenue transactions.

The next two categories of remedial efforts were related to improved documentation of controls (23 companies) and enhanced communication within the organization regarding revenue recognition (16 companies). The documentation efforts often consisted of the creation of formal manuals or checklists regarding revenue recognition, while the communication efforts could be directed toward financial personnel or operating personnel.

Finally, two additional tools were used to improve companies' internal controls: software (13 companies) and outside consultants (12 companies). New software can automate new revenue recognition policies, and outside consultants can provide additional expertise and new perspectives.

Improving Revenue Recognition

This analysis provides insight into the types of material weaknesses that accelerated filers have faced with respect to revenue recognition, as well as the remedial efforts companies have adopted to address such problems. Despite the efforts by the SEC to clarify the rules for revenue recognition in SABs 101 and 104, this study shows that revenue recognition problems continued to trouble public companies even after the implementation of SOX section 404.

Given the findings of this study, it is clear that many companies had not yet developed strong enough control systems to ensure that revenue is only recognized when the following criteria have been met (SABs 101 and 104):

Persuasive evidence of a sales arrangement exists.

The price is fixed or determinable.

Collectibility is reasonably assured.

Delivery has occurred or services have been rendered.

While now on the decline for larger companies, internal control weaknesses related to revenue recognition are not likely to disappear anytime soon. Nonaccelerated filers are soon to adopt the provisions of section 404, most likely in 2009, and such smaller companies have traditionally been involved in the majority of public company accounting frauds (see "Fraudulent Financial Reporting: 1987-1997"), including those involving revenue recognition. Financial managers and auditors of smaller public companies, as well as to those working with accelerated filers, should consider this analysis when developing controls and strategies designed to appropriately manage risks related to revenue recognition.

Dana R. Hermanson, PhD, is the Dinos Eminent Scholar Chair of Private Enterprise in the school of accountancy at Kennesaw State University, Kennesaw, Ga.; Daniel M. Ivancevich, PhD, and Susan H. Ivancevich, PhD, are both Dixon Hughes Faculty Fellows in the department of accountancy and business law at the Cameron School of Business,

University of North Carolina Wilmington. The authors acknowledge the comments of Roger Hermanson and an anonymous reviewer and the contributions of two UNCW students, Tim IIs and Jeff Seremak Dan and Susan Ivancevich thank Dixon Hughes PLLC and the Cameron School of Business Summer Grant Program for financial support.
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Title Annotation:financial reporting; Sarbanes-Oxley Act of 2002
Author:Hermanson, Dana R.; Ivancevich, Daniel M.; Ivancevich, Susan H.
Publication:The CPA Journal
Geographic Code:1USA
Date:Oct 1, 2008
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