Please read the attached case abstract and prepare your write up that (1) summarizes the factual situation, (2) identifies the issues/questions in the case, (3) discusses the relevant accounting standards and practices (FASB, others), and (4) provides your opinion as to the reserves. There is no minimum number of pages for this assignment. However I am looking for a detailed analysis and discussion that adequately answers the above questions. 5 pages paper
Conservative Recognition or Cookie Jar Reserves?
by
Lorri Carpenter, CPA/PFS
Aunt Amelia has no accounting expertise and is interested in meeting projections and keeping the Wall Street analysts happy. Was her nephew Nick making too big a deal out of legitimate business practice?
Abstract
Nick OBrian begins work at his familys software company and quickly finds evidence of revenue recognition questions. Should he ignore them or should he recommend that the audit committee be notified? If he chooses the latter, an important upcoming product launch could be ruined.
Background
Figuratively speaking, OBrian Softwares books smelled a little funny. Nick OBrian, newest member of the accounting department, pushed the stack of financial statements away and ran a hand through his already rumpled hair. He had a feeling the numbers hed been analyzing wouldnt pass what his professors had called the sniff test. Nick rubbed his eyes and wondered if he was overreacting. After all, his Aunt Amelia, the companys founder, was the most honest person he knew–though she would be the first to admit she was no accounting expert.
Nick believed the person his aunt relied on–Lee Marchetti, OBrian Softwares chief financial officer, a man with years of experience in finance and accounting–was equally honest. Judging from the documentation Nick had found in the accounting files, Lee certainly kept a tight watch over every aspect of OBrians finances.
In addition, from what Nick had learned in his position as junior internal auditor at OBrian, the companys accounting controls were effective. Though family members still owned the majority of the stock, decisions regarding material aspects of the financial statements were discussed with the audit committee of the board of directors. The board itself was made up of five very respected members of the business community.
And, to top off the case for overreaction on his part, the financials had received a clean opinion from the outside auditors for each of the three years the company had been listed on the stock exchange.
But he still thought those numbers had an odor and might well be misleading investors. Nick was determined OBrian Software would never find itself in the same situation as so many companies these days. He was too proud of what his aunt had created to allow a Securities and Exchange Commission investigation to happen.
He leaned back in his chair and remembered when OBrian had been little more than a dream of Aunt Amelias. Shed started out in her spare bedroom, providing software consulting services to local businesses. Next, shed expanded into the development and sale of custom software systems. Then, with family members recruited as her sales force, shed begun selling the licenses to her software. At that point she realized the company was headed for an eventual initial public offering. With typical foresight, shed decided experienced management was needed. Lee Marchetti had come on board as CFO.
Now, five years since its inception, and three years after going public, OBrian Software earned millions in revenues from Aunt Amelias initial product licenses, along with fees for maintenance, support and technical training, and consulting and development services. With the next step–the release of BrainWave, an innovative, multi-dimensional software system compatible with industry standard platforms–OBrian would surge ahead in another growth spurt. Wall Street buzz had the company poised on the forefront of the technology sector. Yes, Nick thought, OBrian Software had definitely expanded beyond Aunt Amelias wildest expectations. Yet in many ways the company was as family oriented as it had been when it started. Nick was living proof.
Though his aunt had officially hired him only after his college graduation two months earlier, hed been part of the company since the day she founded it. He knew Aunt Amelia expected him to work his way up the management ladder. It was a challenge he was looking forward to.
Asking Questions
But right now there was a question he needed answered. And since Aunt Amelia was less than enthusiastic about accounting, the person to ask was OBrians CFO, Lee Marchetti. Nick grabbed the stack of papers, and headed out the door of his cubicle.
Always glad to answer questions, Nick. Lee Marchetti shuffled the papers on top of his walnut desk off to one side. But I have to say youve picked a difficult topic to start with. Software revenue recognition is complex. Throw in the mix of application development and consulting services we have at OBrian, and we could be here for days discussing it.
Ill try not to take up that much of your time, Nick said, with a grin. He leaned forward, his hands on his knees. I think I understand the general idea of multiple element transactions. Basically, revenue is broken down between product and services. OBrian recognizes revenue on the software if the sale is distinct from the service portion. Right so far?
Lee nodded. Right. When we enter contracts involving a combination of software and consulting services, we end up with revenue deferral. And of course, as you know, we defer revenue for other reasons, as well. We have reserves for product returns and warranties, among others.
Which leads to my question, Nick said. OBrian Software has a significant amount of unearned revenue sitting on the balance sheet. It seems to me weve been overly conservative in estimating the amount of income weve been deferring.
Lee blinked, than chuckled. Conservatism in financial reporting is generally considered a good thing, Nick. In fact, most folks are concerned about just the opposite effect–they worry companies report too much income. Youre saying you think we havent been reporting enough?
Im just trying to follow the methodology were using, Nick replied. He could tell hed surprised Lee with his question, so he went on. You have a lot more experience than I do, Lee, I know that. Heck, Aunt Amelia told me youve been running companies since before I was born, and I know how much she relies on you. But Im worried. Overly conservative reporting could leave the impression were trying to create cookie jar reserves. With all the corporate accounting problems in the news lately, the last thing we need is to face rumors of suspect accounting. Especially with BrainWave almost ready for release.
Lees smile vanished. Youre exactly right–we definitely do not need any hint of problems. Now or at any time. He eyed Nick, his face grim. Despite what most people believe, accounting is not an exact science. A lot of judgment is involved.
I understand, Nick said. Theres no clear line spelling out exactly whats right and whats wrong. But dont you agree that since OBrian is affected by the cyclical buying patterns in our industry it might seem we have incentive to smooth our earnings?
I can assure you the accounting practices here at OBrian will never cast doubt on the integrity of this companys financial statements. Our deferrals and estimates are well documented, and in accordance with SEC rules. Lee stood up. Now, if youll excuse me, I have a meeting with our bankers.
Meeting with Aunt Amelia
Nick, you know my specialty is software, not accounting. Though Aunt Amelia was facing him, Nick could see her fingers were still dancing across her keyboard. For as long as he could remember, shed been an expert at doing two things at once. Hed always thought her drive was the main reason OBrian Software was a success. She tipped her head toward the papers he held and added, If you want to discuss a problem with your PC software, Im your woman. But financial statements–if you have questions on those, youll need to talk to Lee Marchetti.
I did, Nick replied. Im surprised he didnt mention it to you. In fact, my talk with him is one reason Im here.
His aunt was startled enough to stop her keystroking. You sound serious.
I am, Nick said. Confident he had her full attention, he settled into the chair opposite her desk and repeated the discussion hed had with Lee.
When he was finished, she was frowning. Im not sure I understand why youre concerned, Nick. As Ive said many times, I dont know much about accounting. But I know enough to grasp one thing–were not underreporting expenses, or inflating our income by prematurely recognizing revenue. In fact, it sounds like OBrian Software is doing precisely the opposite of what most companies get in trouble for.
My point exactly. Nick tapped the statements with his forefinger. These reports are supposed to provide useful information, Aunt Amelia. Being too conservative is simply the opposite side of being too aggressive–neither position gives an accurate picture. In fact, they may even give investors an unrealistic view of our actual financial situation. He paused. Have you looked at the financial statements since OBrian went public?