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Revenue Recognition and Corporate Counsel

The reported corporate accounting frauds in recent years evidence an epidemic of infectious financial fraud involving an overwhelming number of companies. The scandals are systemic and generally involve a type of accounting fraud that has been termed improper revenue recognition. The fact that corporate officers are using these deceptive devices to create false numbers does not permit corporate lawyers to label these frauds as accounting problems. Rather, the abatement of these sham transactions and resultant disclosure failures is also corporate counsel’s responsibility. With the passing of the Sarbanes-Oxley Act, Congress has ordered lawyers to tell corporate directors about evidence of corporate fraud, authorized federal regulation of corporate counsel, and imposed a new federal duty to report evidence of fraud and breaches of fiduciary duty to their corporate clients’ highest authorities. This recently imposed duty, enacted in an environment where most of the fraud has involved deceptive revenue recognition, requires all corporate counsel to have at least the competence of sophomore accounting majors. Corporate counsel can no longer feign ignorance of financial fraud or simply abdicate their responsibilities to the accounting profession.In this article, the author addresses the question of how lawyers must reposition themselves in their role as corporate advisers. It begins by focusing on lawyers’ duty of competence and the intensifying demands that they develop basic accounting skills in order to competently perform their roles as corporate advisers. After the discussion of corporate counsel’s enhanced duty of competence, the author analyzes the materiality doctrine and describes the necessarily subordinate revenue recognition principles generally applied in connection with preparation of financial disclosures. He then describes the more commonly employed abusive revenue recognition practices that have caused the vast majority of revenue restatements in recent years. Because improper revenue recognition has been at the core of many of the current financial scandals and continues to be a major corporate liability risk, the essential competence required of corporate lawyers must include the ability to recognize the most common deceptive revenue recognition devices and the red flags that indicate the possibility of their occurrence. The author concludes that this enhancement of lawyers’ competence will not only serve the interests of their corporate clients, but will also preserve what remains of the traditional role of the legal profession in establishing its owns principles and standards of professional conduct.