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From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary Conservative Recognition Or Cookie Jar Reserves?
Nick O'Brian begins work at his family's 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.
Figuratively speaking, O'Brian Software's books smelled a little funny. Nick O'Brian, 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 he'd been analyzing wouldn't 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 company's 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, O'Brian Software's 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 O'Brian's finances.
In addition, from what Nick had learned in his position as junior internal auditor at O'Brian, the company's 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 O'Brian 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 O'Brian had been little more than a dream of Aunt Amelia's. She'd started out in her spare bedroom, providing software consulting services to local businesses. Next, she'd expanded into the development and sale of custom software systems. Then, with family members recruited as her sales force, she'd 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, she'd 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, O'Brian Software earned millions in revenues from Aunt Amelia's 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--O'Brian would surge ahead in another growth spurt. Wall Street buzz had the company poised on the forefront of the technology sector. Yes, Nick thought, O'Brian Software had definitely expanded beyond Aunt Amelia's 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, he'd 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.
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 O'Brian's 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 you've 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 O'Brian, and we could be here for days discussing it."
"I'll 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. O'Brian 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. "O'Brian Software has a significant amount of unearned revenue sitting on the balance sheet. It seems to me we've been overly conservative in estimating the amount of income we've 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. You're saying you think we haven't been reporting enough?"
"I'm just trying to follow the methodology we're using," Nick replied. He could tell he'd 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 you've been running companies since before I was born, and I know how much she relies on you. But I'm worried. Overly conservative reporting could leave the impression we're 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."
Lee's smile vanished. "You're 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. "There's no clear line spelling out exactly what's right and what's wrong. But don't you agree that since O'Brian 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 O'Brian will never cast doubt on the integrity of this company's financial statements. Our deferrals and estimates are well documented, and in accordance with SEC rules." Lee stood up. "Now, if you'll 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, she'd been an expert at doing two things at once. He'd always thought her drive was the main reason O'Brian 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, I'm your woman. But financial statements--if you have questions on those, you'll need to talk to Lee Marchetti."
"I did," Nick replied. "I'm surprised he didn't mention it to you. In fact, my talk with him is one reason I'm 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 he'd had with Lee.
When he was finished, she was frowning. "I'm not sure I understand why you're concerned, Nick. As I've said many times, I don't know much about accounting. But I know enough to grasp one thing--we're not underreporting expenses, or inflating our income by prematurely recognizing revenue. In fact, it sounds like O'Brian 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 O'Brian went public?"
She made a sound halfway between a snort and a chuckle. "Please, Nick, I'm sure you know the answer."
He smiled at her, rose, and set the statements down on her desk. "Well, take a look now." He shuffled the pages, pointed out numbers. "Our growth and revenue are fairly smooth, and always upward. It's kind of unusual in a new company, especially a new technology company, wouldn't you say?"
"I certainly know the software business has ups and downs," Aunt Amelia said. "All businesses do. But I still don't quite see the problem. After all, we're meeting our earnings projections, aren't we? We're keeping our analysts happy, aren't we?"
"Consistently," Nick agreed. "But I'm not sure we're doing it based on economic performance. In effect, what's happening is we're understating profits when times are good, and building artificial reserves we can use in lean times."
"You're saying we're playing games with the numbers. That is a serious charge, Nick." Aunt Amelia looked up and studied him. "I have complete confidence in Lee. But if we're doing something improper, I want to get to the bottom of it. Is this a problem I should take to the auditing committee?"
Nick had been sure of himself until she asked. Now he hesitated. He was convinced O'Brian Software's financial statements were not presenting an accurate picture to investors. But, as Lee Marchetti had pointed out, accounting revenue recognition rules were subject to judgment. And, in applying that judgment, management could make decisions easily proven wrong by subsequent events. Of course, clarity of hindsight didn't necessarily mean the decisions were improper.
What if he was wrong? If O'Brian disclosed a change in accounting for revenue recognition at this critical stage, the launch of BrainWave could be seriously compromised, causing big problems for O'Brian's future.
Nick stared at his aunt, pondering his answer. Was he making a big deal out of a legitimate practice? Or should he stick to his belief that O'Brian Software was smoothing income?