Chapter 1 -
Case 1 – Superlative Software
Corp. – You Are the CFO
Learning Objectives
• Review common accounting, auditing and regulatory issues related to revenue
recognition;
• Sensitize you to how your integrity can become an issue in financial management
decision making, particularly in the context of revenue recognition; and
• Understand proper internal and external reporting procedures when faced with accounting
irregularities.
Introduction
The following case study is designed to highlight the most common cause of accounting
irregularities, busted audits, restatements, and accounting enforcement actions: revenue
recognition. Time and again, financial managers are called upon to make business decisions
about how (or if) to record revenues from the sale of services or products. Many of these
decisions are made in reliance on the representations of officers or employees of the
organization, meaning that your integrity can oftentimes be riding on the integrity of others.
While maintaining proper internal controls and procedures are instrumental in addressing many
of these issues, personal integrity and the willingness to confront difficult choices are a necessary
part of effective financial management. A lack of integrity on your part or on the part of others
may condemn the organization to joining the ranks of corporate wrongdoers and may expose you
to regulatory, civil, or criminal sanctions. Therefore, when you encounter difficult revenue
recognition issues, take time to reflect on the regulatory, ethical, and business implications of
your decisions and ask yourself:
How will this determination look in hindsight, particularly to
someone outside of our company?
Focus Points
The Treadway Commission report that analyzed approximately 200 cases of fraudulent financial
statement reporting from 1987 through 1997 found that over
50% of these cases involved either
the premature recording of revenues or the recording of fictitious revenues. Moreover, the CEO
and CFO were implicated in the fraudulent reporting in 83% of the cases. Most of the cases
were brought against companies that lacked an audit committee or had an audit committee that
met only once each year.
According to the 2008 Securities Class Action Filings Study conducted by Cornerstone Research
and Stanford Law School, 94% of the federal securities class action lawsuits filed through
December 15, 2008, included accounting allegations. Improper revenue recognition was cited in
26% of those cases. If you eliminate the miscellaneous category, the only category of accounting
allegations that individually accounted for more class action filings in 2008 than revenue
recognition was overstatement of assets other than accounts receivable and inventory – which
accounted for 32% of the filings. From these statistics, you can conclude that while 20 years has
passed since the Treadway Commission began its study, revenue recognition continues to be a
significant issue that places companies in legal and regulatory jeopardy.
In October 2007, the Huron Consulting Group published a study of financial restatements that
occurred between August 2004 and December 2006. The study found that approximately 1,900
companies had restated their financial statements during this 28 month period. Of the companies
that reported restatements, approximately 20% took longer than four months to file their restated
financial statements, resulting in these companies being generally unable to timely file a
quarterly report on Form 10-Q or an annual report on Form 10-K. The Huron Consulting Group
study also found that revenue recognition was among the top five accounting issues cited by
companies that restated their financial statements in this period, and was the second most
common reason cited for a restatement when the restatement took more than four months to
complete.
In March 2008, Audit Analytics reported that restatements in calendar year 2007 declined for the
first time since 2001. In 2007, the number of restatements dropped by 31% from 2006’s 1,801
restatements, to 1,237 restatements. The report also noted, however, that companies that filed
“revenue recognition restatements” experienced persistent declines in their stock prices both in
the 50 days preceding the restatement announcement and for the 50 days following the
announcement.
In the Exposure Draft for SAS No. 99
Consideration of Fraud in a Financial Statement Audit,
the following statement appeared:
In a public entity, because of the ever-present interest of the investors in the viability,
financial condition, and operating results of the entity, there is always some incentive or
pressure to achieve a given level of financial performance. [Paragraph 54]
This statement highlights the fact that in a public entity, there may almost never be a time when
some pressure is not present to present more favorable financial results than might have been
achieved.
As issued, SAS No. 99 highlighted several incentives and sources of pressure that may increase
the risk of fraudulent financial reporting, including
• The company’s financial stability or profitability is threatened by economic, industry, or
entity operating conditions;
• Excessive pressure on management to meet third party expectations, such as those of
analysts, creditors, rating agencies, or potential acquisition targets;
• Management or the board members’ net worth is threatened by the company’s financial
performance; and
• Incentive sales or profitability goals create undue pressure on management or operating
personnel.
Avoid this Pitfall. If other members of your management team evidence tendencies to
internalize these types of pressures, your integrity (not to mention your professional career) may
ride on your ability to withstand such pressures. In talking with the other members of
management, remind them that once the company takes the first step down that “slippery slope,”
it becomes increasingly likely that more steps will have to be taken, thus leading to a “snowball”
effect. If you sense that this is where pressures from third parties are likely to take the company,
you need to carefully consider whether you want to be associated with the company under these
circumstances. It is interesting to note that many cases of fraudulent financial reporting begin as
“minor” adjustments that multiply over time and ultimately result in a restatement that finds the
company and its officers the subject of regulatory action. Conversely, a management team that
deals with these or other pressures in an honest and forthright manner will command the respect
of outsiders and is a desirable place for you to be.
Regulatory Issues
FASB Statements of Financial Accounting Concepts (SFACs), SEC Staff Accounting Bulletins
(SABs) and a wealth of Statements of Financial Accounting Standards (SFASs),1 Accounting
Principles Board Opinions (APBs),1 Accounting Research Bulletins (ARBs),1 AICPA Statement
of Positions (SOPs),1 Financial Reporting Releases (FRRs),1 and Emerging Issues Task Force
(EITF)1 issuances give general and specific industry guidance for revenue recognition. (See the
discussion in the introduction of SAB Nos. 101 and 104 for a non-exclusive listing of revenue
recognition releases, including their industry topics.) Unfortunately, revenue recognition or,
more to the point, improper recording and/or recognition of revenues, are also prevalent topics in
the SEC’s Accounting and Auditing Enforcement Releases (AAERs) involving public
companies, their financial executives, and their auditors.
The issue of
round tripping of revenues received much attention after Enron, other energy
trading companies, and a host of telecommunications carriers were accused of engaging in this
practice. Round tripping involves the recording of revenues from simultaneous or nearly
simultaneous trades of financial instruments, capacity, or commodities by two companies. In
most instances, round trip trades should have been characterized as exchanges rather than sales.
Avoid this Pitfall. When dealing with a customer of your company that also happens to be a
supplier of products or services to your company, be especially cautious about booking revenues,
particularly if the timing or dollar amount of purchases and sales between the companies happen
to coincide. Remember that these types of relationships will draw a high degree of regulatory
and audit scrutiny, so your files should have backup that will help in delineating why the
transactions were proper, necessary and in the ordinary course.
Revenue recognition is without doubt
the critical accounting policy to be discussed in
Management’s Discussion and Analysis (MD&A). Furthermore, the discussion of any critical
accounting estimates that underlie revenue recognition is vitally important to regulators and
investors seeking to understand the impact of estimates on a company’s financial performance.
Remember, however, as the Commission stated in its release on
Current Accounting and
Disclosure Issues in August 2001, “The disclosure should be concise and to the point; more
disclosure is not necessarily better.” In other words, quality, not quantity.
The following four criteria must be met under SAB No. 101 and SAB No. 104 to recognize
revenue: (1) persuasive evidence of an arrangement exists, (2) the product has been shipped and
the customer takes ownership and assumes the risk of loss, (3) the selling price is fixed or
determinable, and (4) collection of the resulting receivable is reasonably assured. These criteria
are consistent with those set forth in FASB
Accounting Standards Codification (ASC) 985-605
(SOP No. 97-2), which specifically addresses revenue recognition in the context of software
sales. FASB ASC 985-605 (SOP No. 97-2) goes on to state that if software upgrades,
1 Guidance has been organized under the FASB Accounting Standards Codification™, which is expected to become
authoritative in July 2009 (at the time this manual went to press). See the Latest Developments Chapter for
additional information.
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