Risks of Material Misstatement of Revenues

What is Revenue?

Revenues that the entity recognizes in the income statement during the year are the income that the entity sells the goods or services to its customers. These revenues are recognized when the control is passed from the entity to its customers.

It is recognized either when the customer pays immediately or is sold on credit which means the goods or services are sold but the payments will be collected later.

In general, revenue is one of the key performance indicators that not only the entity itself want to archive, but the board of director as well as the management of the entity want to accomplish.

That is the main reason why revenues are generally set as the high risks of material misstatement when it comes to auditing due to its nature and the amount recognizes in the income statement.

In this article, we will discuss the risks of material misstatements related to revenues.

Inherent Risk:

Inherent risks are the risks that are not related to the control, but it is highly related to the nature of the account itself, the level of judgment involve in the management, and the complexity of accounts and transactions.

The inherent risk of the revenues is normally considered as high due to the revenues having many criteria with significant judgments involved by the management of the entity.

Here are the examples of inherent risk related to the revenues that the auditor should pay attention to during the audit:

  • Management manipulates the figure to achieve the target set by the board. For example, the budget sales are set by the board or shareholders,s and at the end of the year, the actual sales almost reach the budget. Management might try to manipulate the sales so that the budget will be achieved and management could entitle to receive the bonus that might agree upon upfront with the board or shareholders.
  • Risk of recognizing the revenues that do not occur during the period. These might happen in the middle management where a fake sales account is mad at the end of the year and sales are canceled after the year so that their performance is met.
  • Due to the complexity of sales terms, revenues might be incorrectly recognized for those goods that are in transit or consign at the customers’ store.
  • The company might fail to derecognize the sales return and result in the overstatement of sales as well as account receivables.
  • Due to the complexity of sales terms and a large amount of sales transactions, revenues might be incorrectly sold in a different period than be recognized. For example, the revenues are recognized in December 2020 for those transactions that occurred in January 2021.
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Therefore, there is a significant risk of material misstatement for the revenue recognition that links to inherent risks of the revenues.

Fraud Risk:

It is obvious or default that fraud risks relate to the revenues are always high. It is due to its nature. The fraud could be committed by entity staff or at the top management level.

And the form of fraud could be the form of misappropriation of assets and fraud over financial reporting. For example, fake sales transactions are created by the sales team by creating fake customer accounts. That account will them write off due to the customers are unable to contact them.

However, this kind of fraud might be detected by management by setting up a strong internal control.

Fraud over financial reporting, on the other hand, are very difficult to detect and auditor might need to pay very great attention since the detection risk is high considering the fraud might be committed by management or even at the board level.

Therefore, there is a significant risk of material misstatements for the revenues related to fraud.

Control Risk:

The risk of material misstatement of the revenue due to control might occur but depending on the control of each entity that the auditor is auditing.

Auditors normally need to obtain an understanding of the internal control that the entity set to see if there is any loophole that could lead to risks of material misstatements on the revenues.

Auditors need to assess the implementation of control and whether the key control that helps to present error or fraud is effectively and efficiently implemented by the company.

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If the control is effectively and efficiently implemented, then the risk of material misstatements might be low. And if the control is not strong and the implementation is not effective and efficient, then the risk of material misstatement is high and the auditor should prepare the procedures to address those risks.