Financial Statement Fraud : Strategies for Detection and Investigation

by Gerard M. Zack
Copyright © 2013 by Gerard M. Zack.

C HAPTER THREE

Fictitious and Inflated

Revenue

FICTITIOUS REVENUE SCHEMES

Fictitious revenue schemes artificially inflate a company’s profits by recording

phony revenues for goods or services that are never delivered. These schemes
are distinguished from timing difference schemes in that with fictitious rev-
enues, the revenue should not be recognized in any period. This is normally
accomplished in one of two manners:

1. Recording journal entries for sales without attributing the sales to specific
customers (e.g., “top‐side” entries)
2. Recording sales attributable to fictitious customers

A third technique, recording of phony sales to legitimate customers, can

be utilized but is less common.
The mechanics of fictitious revenue schemes will be illustrated through
descriptions of three cases:

1. Satyam Computer Services Ltd.

2. Symmetry Medical Sheffield
3. LocatePlus Holdings Corporation

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34 ◾ Revenue-Based Schemes

Satyam Computer Services Ltd.

One of largest reported fictitious revenue cases occurred with Satyam Com-
puter Services Ltd., which later became Mahindra Satyam Ltd. Satyam was
incorporated in India and was recognized as one of that country’s largest infor-
mation technology services companies. It employed more than 40,000 people
in offices throughout the world.
From at least 2003 through September 2008, false and inflated sales invoices
were created outside the normal accounting processes by which revenues were
recorded. This resulted in fraudulently reported revenues of more than $1 bil-
lion. During this period, more than 6,600 false sales invoices were generated
and recorded in Satyam’s invoice management system. Some of these invoices
were false sales to real customers, while others involved fictitious customers
altogether. This was accomplished by providing special log‐in access to certain
employees. This enabled these employees to enter the fraudulent sales invoices
without the knowledge of the heads of Satyam’s business units, who would have
otherwise recognized that the services reflected on the invoices had not been
provided to customers. The phony sales nonetheless rolled up to the company‐
wide financial statements and were reported as revenue, as data from the invoice
management system was exported into the corporate financial system.
As with so many financial reporting frauds, the scheme grew over time.
In a complaint filed by the SEC, the fictitious revenue reported by Satyam
was $46 million in fiscal year 2004 (which ended March 31, 2004), almost
$69 million in 2005, $149 million in 2006, $151 million in 2007, and more
than $430 million in 2008. Another $275 million in fraudulent revenue was
recorded in the first six months of the fiscal year 2009 (i.e., the period from
April 1 through September 30, 2008).
Satyam’s false revenue inflated the company’s profits, but also impacted
several other areas of its financial statements. When the chair of Satyam’s
board admitted the fraud in January 2009, he stated that cash was overstated
by approximately $1 billion, while other assets were overstated by lesser
amounts and certain liabilities were understated. Senior management tried
desperately to acquire real assets to fill in the gaps created by the fraud. But
the fraud continued to escalate. In connection with the growing nature of the
fraud, the chair stated that it “was like riding a tiger, not knowing how to get
off without being eaten.”
An investigation by India’s Central Bureau of Investigation concluded that
10 individuals involved defrauded the company (and its investors, of course) of
$2.5 billion.
 Fictitious and Inflated Revenue ◾ 35

Symmetry Medical Sheffield

In January 2012, four former executives and accountants of the British com-
pany Symmetry Medical Sheffield LTD, formerly known as Thornton Precision
Components (TPC), were charged for their roles in a massive fictitious revenue
scheme that took place between 2004 and 2007. TPC accounted for a signifi-
cant portion of the consolidated revenues of its parent company, U.S.‐based
Symmetry Medical, Inc., a manufacturer of prosthetics, medical implants and
instruments, and other specialized products for the aerospace industry. Sym-
metry Medical acquired TPC in 2003 and had its IPO in December 2004.
A timing scheme to recognize revenue early had already been in place at
TPC as early as 1999. However, things got really interesting in 2004, when
the strategy shifted from premature revenue recognition to fictitious revenues.
Beginning in 2004, one of TPC’s executives would assess how much TPC fell
short of its sales targets on a monthly and quarterly basis. When shortfalls
existed, a top‐side journal entry would be made debiting accounts receivable
and crediting sales. These were internally referred to as “provisional” sales. In
an attempt to conceal the fictitious revenue, this individual then sent a record
of the provisional sales to another person, who calculated and recorded the
fictitious cost of goods sold associated with the fictitious sales. This helped TPC’s
gross margin remain comparable, at least temporarily.
The top‐side sales entries made TPC’s accounts receivable subsidiary ledger
out of balance with the general ledger (which had the higher figure for receiv-
ables). To hide this from all parties not involved in the scheme (including the
external and internal auditors), a fictitious sub‐ledger was created in the form of
an Excel spreadsheet. This spreadsheet only reflected total accounts receivable
and aging by customer and not the details by sale and invoice number normally
included in a sub‐ledger. The spreadsheet was created from a downloaded copy
of a summary version of the real sub‐ledger which was exported into Excel, and
the fictitious receivables were then added to the schedule so that it agreed to
the general ledger balance.
These fictitious sales had a material impact on the financial statements
of TPC. At the close of fiscal year 2005, £4,122,000 (38 percent) of the
total reported accounts receivable of £10,717,000 was fictitious. For 2006,
£6,031,000 (48 percent) of the reported £12,440,000 was fictitious.
Although the perpetrators of this fraud recorded cost of goods sold to
align with the fictitious sales, the scheme also involved a separate effort
to inflate inventory balances and, therefore, understate cost of goods sold.
This was accomplished using a similar approach to the fictitious accounts
36 ◾ Revenue-Based Schemes

receivable—top‐side journal entries supported by a falsified inventory sub‐

ledger containing inserted lines of fictitious work‐in‐process inventory,
all prepared after the physical count. At the end of fiscal year 2005, only
£3,531,000 (36 percent) of TPC’s reported inventory of £9,753,000 actually
existed. Cost of goods sold for 2005 was understated (and, therefore, gross
profit was overstated) by £2,505,000 as a result of the inventory inflation
scheme. At the end of 2006, just £3,692,000 (33 percent) of the reported
inventory balance of £10,973,000 was real, and cost of goods sold was
understated by £1,058,000.
The incentive behind the TPC schemes was nothing new—pure greed. The
perpetrators received bonuses based on the purported performance of TPC, and
they profited handsomely from their sale of parent company Symmetry stock.

LocatePlus Holdings Corporation

In 2010, the SEC charged LocatePlus Holdings Corporation, a seller of personal
information used for investigative searches, with inflating its revenue during
2005 and 2006 through the creation of a fictitious customer known as Omni
Data Services, Inc. (“Omni Data”). In order to make the transactions appear
legitimate, Omni Data paid LocatePlus for the sales. However, these payments
were actually funded with cash routed through entities under the control
of LocatePlus executives. This practice is sometimes known as a “round-trip
transaction.”
For example, in one transaction, LocatePlus made a $650,000 payment
to an entity, which then transferred $600,000 to Omni Data, and Omni Data
then paid the $600,000 back to LocatePlus as purported payment for services.
In another transaction, at least $250,000 of the proceeds of unregistered stock
sales were transferred to Omni Data, which then transferred those funds to
LocatePlus, again as payment for purported services. The improper Omni
Data payments were fraudulently included as revenue in LocatePlus’s finan-
cial statements.
In total, approximately $2 million was funneled to OmniData in support
of phony sales transactions. The effects on LocatePlus’s financial statements
were material. Phony sales to Omni Data represented 31 percent of LocatePlus’s
2005 reported revenue and 22 percent of 2006 reported revenue.
In addition to its charges that LocatePlus fraudulently reported revenue
from this fictitious customer, the SEC also charged LocatePlus with failing to
disclose the fictitious customer as a related party! Now that’s just pouring salt
in the wound.