Background We\'ve seen huge growth in the computer industry in a very short time

Question

Background
We've seen huge growth in the computer industry in a very short time. There is a high demand for new software from all types of users. But new software must be thoroughly tested and "debugged" before it can be implemented or sold to customers. Even seemingly small software problems can mean the loss of millions of dollars in sales, or the bankruptcy of an entire company.

Software testing has become a multi-billion dollar business, as software companies buy specialized programs to test their products. There are a couple of main suppliers that account for over 85% of total testing software sales. The remaining market share is divided among 20 or more smaller companies. Still, that can mean millions of dollars in sales for a small growing company. The environment is very competitive, since there are relatively few companies vying for a limited, but lucrative market share.

SoftTest, Inc. makes a product set called "BugZapper" designed to find software flaws. Last year the company had sales of around $3 million, and this year their sales are about $4.5 million. The company President, Fred Miller calls the CFO into his office and discusses some recent developments. A Department of Defense contractor has expressed interest in a large purchase of BugZapper. The purchase would nearly double the company's sales revenue, and greatly increase their profit margins. But there are some problems with the sale; the Buyer for the DoD contractor has expressed some concerns.

SoftTest, Inc. is privately held by a small number of stockholders who would like to take the company public within the next 3 years. The Buyer has indicated that the decision makers are leaning towards another slightly larger company's product. He indicates that the competitor posted slightly over $5 million in sales the previous year, and suggests that improvements in SoftTest's annual report could even the playing field. He also mentions that his team prefers BugZapper over the competitor's software, and would like this purchase to be approved.

The company President has a PhD in mathematics but he has never taken a course in accounting and is not familiar with GAAP. However, he suggests a couple of things that could be done to improve the financial statements and wants the CFO to make the changes. The combined changes would make the company's revenue slightly over $5 million, and put them in a better position to secure the new contract. The President does not feel that making the changes should be a problem.

A) A large percent of annual revenues come from software maintenance contracts. The contract revenue is posted to the Unearned Maintenance Revenue account at the inception of a maintenance contract. Every month a portion of Unearned Maintenance Revenue is recognized as Maintenance Revenue Earned. The CFO believes that the straight-line method could be replaced with an accelerated method where more maintenance is recognized in the early months of a maintenance contract. He contends that most of the maintenance work is done in the first 3 months of a new contract, and very little maintenance work is done in the remaining months. He suggest they change their methods and recognize an additional $300,000 in Maintenance Revenue Earned for last year.

B) New customers are given a trial period to see how new software will work for them, and to give their programmers a chance to test drive the product. The trial period is referred to as an "Evaluation" but sales are not booked until an actual sales order is placed. The company has some $500,000 in evaluation software in place, and the President feels confident that over half of the evaluations will turn into sales the first quarter of the coming year. He suggests that the CFO book $250,000 in sales against Accounts Receivable in anticipation of future sales.

The CFO feels that the proposed changes are at least somewhat questionable. That afternoon he receives a call from the Chairman of the Board of Directors, Stan Miller, Fred's brother. He feels that the changes should be made because the company is privately held and not a public company yet. There is no audit requirement for annual reports so they have no one looking over their shoulder telling them what to do. The new contract would be significant and would put the company within reach of it's goal to go public within 3 years. And after all, an audit is done to protect the stockholders. Since Stan is a stockholder he is not concerned about this and feels that improving the financial statements would benefit him. He also suggests that, if the sale goes through, he'll make sure the CFO gets a substantial bonus now and stock options when the company goes public.

QUESTIONS FOR YOU TO ANSWER

1. Based on your study of accounting so far, identify at least one significant accounting principle that must be considered for each of the suggested changes above.

A) Does the President have a justifiable position regarding recognition of Maintenance Revenue? Is the proposed method an acceptable application of GAAP? Will the proposed method strengthen or weaken proper revenue recognition within the company?

B) When does an Evaluation become a Sale? Is it OK to book Sales based on past experience, rather than wait for actual Sales Orders?

2. Is this a case of applying accounting principles, ethics in business, or both? Would the proposed changes effect the financial statements enough to be a problem? Would they be considered Material changes? And does that effect the magnitude of any ethical dilemmas?

3. There are 4 major players in this case - CFO, President, Board Chairman and Buyer.
a) Does the CFO of a small private company have an obilgation to the Public or the Buyer? Or does his/her loyalties lie with the Company that he/she works for? For this question assume the CFO is NOT a CPA or CMA.

b) If the CFO holds a CPA and/or CMA certificate? Will that change his/her ethical responsibilities? How so?

c) Asses and comment on the actions and attitudes of the President and Chairman. Remember that they are not accountants, don't understand GAAP and may believe that their requests are reasonable and "make sense."

d) What about the Buyer? Was he just making comments and passing along information? Maybe this is a case of "here's what you need to do to satisfy the people above me."

4) Can you think of any other accounting or ethical issues we might be missing or should consider here?

HINTS:
The two proposed adjustments are important accounting issues that have proved to be a problem in recent years for software companies. Some companies are not US based, and they follow the accounting principles of their respecitve countries. This adds additional problems for investors and decision-makers as they try to compare different company's ability to meet their obligations.

Do the names Enron, WorldCom and Tyco ring any bells?

Explanation / Answer

1.

Based on the study, the accounting principles that can be considered for the changes would be:

For the change as given in A, matching principle should be considered which means that revenue is to be matched to the respective expense. This principle requires the usage of accrual basis of accounting by the companies.

For the change given in B, revenue recognition principle should be considered according to which revenue is to be recognized when the service is performed or the products are sold irrespective of when the cash is received.

A. Yes, the president has a justifiable position regarding recognition of Maintenance Revenue.

This is acceptable according to GAAP as long as the revenue is matched with the expenses. The proposed method shall strengthen the revenue recognition in the company as the revenue shall be recognized not on a standards straight line basis but on the basis of how it is earned.

B. An evaluation becomes a sale when a sales order is placed.

It is not OK to books sales based on past experience even before the sales orders are placed. It is better to wait for the sales order to be placed.

2.

This is a case of both application of accounting principles as well as ethics in business.

The proposed change would definitely effect the financial statements as the sales are proposed to be recorded before the orders are placed without any evidence of them turning into sales. The revenue might not have much impact as the total annual revenue shall remain more or less the same even if it is allocated differently to different months in the year.

The change amounts to a material change as this change the financial statements and have an impact on the stockholders and other investors.

This ultimately does affect the magnitude of the ethical dilemma. It is clearly given that the Chairman is trying to take advantage of the company being a privately held one and as there is no one to watch out. Booking sales without them actually taking effect leads to window dressing which is an ethical issue.

3.

a. Generally in the case of a small privately held company the CFO has his major responsibility toward the company. However this does not give him rights to cheat the public by showing false information.

b. If the CFO holds a CPA /CMA he is a certified member of the board and any unethical act of his shall have a major impact on the public. He has his responsibilities towards the public and is required to make sure that the information provided is accurate and true.

c. The president has a generous and positive attitude with his main intention being the growth of the company. The suggestions made by him were reasonable and he wished to show the company in a better position.

However the chairman

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