Now lets take a look at the second transaction, which involved the recognition of $250,000 of revenue on a system not shipped as of December 31, 20X1, under a bill and hold arrangement with Alation Electronics. Alation paid $175,000 to Caltron on December 15, 20X1, and requested Caltron to hold the system for shipment until the first quarter of 20X2. Once Alation notified Caltron where to ship the system, it would pay the $75,000 balance due in 20X2.
This particular sale to Alation Electronics falls under a bill and hold agreement.
For revenue recognition to be acceptable under a bill and hold agreement, the following criteria must be met: The risks of ownership must have passed to the buyer. The customer must have a fixed commitment to purchase the goods, preferably reflected in written documentation. The buyer, not the seller, must request that the transaction be on a bill and hold basis. The buyer must have a substantial business purpose for ordering goods on a bill and hold basis. There must be fixed schedule for delivery of the goods. The date for delivery must be reasonable and must be consistent with the buyer’s business purposes. The seller must not have retained any specific performance obligations such that the earnings process is not complete. The ordered goods must have been segregated from the seller’s inventory and not be subject to being used to fill other orders; and the equipment must be complete and ready for shipment.
All of these conditions appear to have been met by Alation Electronics, and they paid 70% of the purchase price under the agreement. There are no other expectations on Caltron’s performance other than that of shipping the items held. Alation has indicated that it will pay the remaining $75,000 upon notification of shipment date, and there is no mention of a right to return the goods. In this case it could safely be assumed that ownership has already been transferred to Alation, and that the transaction is sufficiently complete on December 15, 20X1 to recognize revenue at that date. An exchange has occurred between the two parties: the items are ready for shipment at Alation’s request. The $250,000 revenue can be recognized since it is realizable and earned, and no return is expected. Looking at the other side of this transaction is that Caltron’s normal policy doesn’t account for bill and hold arrangements, as they normally would recognize revenue when the shipment is made. An exception could be allowed in this case as the buyer has made a purchase commitment and paid for most of the supply, as they are unable to accept delivery at this point in time. After reviewing this transaction we feel the way it has been recorded is fine and should be completed.
The third transaction also involved a bill and hold arrangement with BTO Computer Leasing, a lessor of computer equipment. On November 1, 20X1, BTO ordered five systems from Caltron and paid $190,000 down, on the condition that Caltron would hold the systems at its warehouse and assist BTO in finding lessees for the systems. Caltron recognized $950,000 of revenue in 20X1 on the BTO transaction. As of December 31, 20X1, Caltron identified an end user to lease one of the systems from BTO. The lease terms were still being negotiated between BTO and the end user.
Under the sale agreement, Caltron is expected to assist BTO in finding end-users for these systems. There is uncertainty that these end-users will actually be found and uncertainty as to the total number of systems that will finally be purchased by BTO. BTO’s down payment of $190,000 does not appear to be binding since the purchase is conditional on it finding users for the systems. The collection of the remaining $760,000 is not assured, nor has Caltron completed its part of the earning process. Although a lessee has been identified before the end of 20X1, the lease has not yet been signed; the end user could change his mind about leasing the system.
Although Caltron holds the systems at its warehouse under a bill and hold arrangement, this transaction still has the properties of a sale on consignment. The fact that the items are not shipped reduces doubt about who holds the risks of ownership.
Accordingly, it is inappropriate for Caltron to recognize revenue in this transaction. The initial investment and future payments from the buyer hinge on the successful lease of the products and Caltron has substantial involvement in the identification of potential lessees.
The revenue for each system in this case should be recognized at the time in which BTO notifies Caltron of its acceptance of the computer and the system is shipped. Before that, ownership rights belong to Caltron and the computers should be part of its inventory. As of December 31, 20X1, no sale has taken place and the payment should be recorded as unearned revenue.
The last transaction involved the fourth quarter 20X1 recognition of $220,000 of revenue and a related $110,000 allowance for sales returns for a system shipped to Harvey Industries on a trial basis for four months. The system was shipped to Harvey on November 27, 20X1, and Harvey paid 50 percent of the purchase price at that time. If Harvey accepts the system, the balance would be due March 27, 20X2. If Harvey returns the system, its down payment of $110,000 less any shipping costs would be returned. Caltron had previously entered into two similar transactions with Harvey. On one occasion Harvey purchased the system, and the other time Harvey returned the system. Based on these previous results, Caltron recorded the $110,000 allowance for sales returns.
This transaction, although similar to the first one, presents a slight twist. In this case, the buyer pays 50% of the purchase price at the time of shipment. This could be interpreted as an indication of a more substantive commitment than in transaction one. However, the arrangement provides for a no-obligation four month trial after which the amount paid would be refunded if the customer returns the computer. Therefore, the payment does not establish revenue realization. Another difference in this transaction is the existence of historical data on previous sales to Harvey, with a 50% record of returns. In this case, Caltron recorded an allowance for return of $110,000 (50% of the total revenues recognized). Recording an allowance reducing revenues to their realizable amount could be an appropriate way of recording this transaction.
Within Generally Accepted Accounting Principles (GAAP), there are multiple ways to recognize revenue. Depending upon which method is chosen, the financial statements may look drastically different even though economic reality is the same. It is very important to choose the appropriate revenue recognition method for a company. Irrespective of the method chosen, it is very critical not to report the revenues prematurely. This is what the Chief Accountant of SEC Lynn Turner mentioned in her remarks in 2001.
"The COSO Report notes that over half the frauds in the study involved over-stating revenues by recording revenues prematurely or fictitiously. These results are consistent with a study published in the August 2000 report of the Panel on Audit Effectiveness (also known as the "O'Malley Report") entitled, Analysis of SEC Accounting and Auditing Enforcement Releases, which found that approximately 70% of the cases in the study involved overstatement of revenues - again, either premature revenue recognition or fictitious revenue." (Turner, 2001)
Standard Setting Process
The sources of accounting information are as follows; generally accepted accounting principles, also known as GAAP, is the financial accounting treatment of rules. Other sources of accounting principles are the Financial Standards Board (FASB), The American Institute of Certified Public Accountants (AICPA) and the Securities and Exchange Commission (SEC) usually set accounting standards. The rules and the judgments regarding correct treatment of accounting information can be found in GAAP.
The Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the preparation of financial reports, and they are officially recognized as authoritative by the Securities and Exchange Commission and the American Institute of Certified Public Accountants. Such standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information (FASB, 2008).
The Sarbanes Oxley act of 2002 sets down accounting standards. It regulates the US federal securities law, corporate disclosure and securities trading, corporate governance, executive fiduciary responsibility, including loans to officers and directors, management oversight, director due diligence and executive compensation, and the duties of external auditors and attorneys. The SEC promulgates many of the regulations required to implement the act. As far as the source of information is concerned, all periodic reports filed with the SEC must be certified by the CEO and the CFO thus clarifying that the report, “Fairly presents, in all material respects, the financial condition and results of operations of the issuer.” (http://www.gtlaw.com) False information can mean fines up to $5million and jail up to 20 years. The CEO and CFO will have to provide much greater certification for annual and quarterly reports and mention any changes in the internal control system. No loans to directors or executive officers are permitted, and insider trading must be informed, whistle blowing protected, securities fraud liabilities not chargeable to bankruptcy and criminal penalties for violations.
PCAOB sets a standard for internal control attestation: It pointed out the deficiencies in the accounting standards. Second, PCAOB pointed out the benefits of enhanced internal controls. Third, it lays down standards for disclosure controls and procedures. Fourth, it lays down the supporting managerial documentation required. Fifth, lays down standards for service organization. Sixth insists on a top down approach and lays down the path for auditor walk through. Those are all the different organizations involved in the thorough accounting standards process, and are why we are questioning some of the ways you are recognizing revenue.
Practicality of One Set of Standards
For over 20 years there has been some disgruntled rumbling in the trenches of the accounting profession. As the Financial Accounting Standards Board (FASB) issues ever-more complex standards, financial executives of nonpublic companies have been groaning under the weight of the accounting requirements that often just don't seem to apply for them. Because of the different goals of the different types of organizations, having one set of accounting standards for all types of organizations will be very difficult. Over recent years, there has been significant growth in the government and not-for-profit sector. Consequently any comprehensive accounting program should include a study of government and not-for-profit accounting.
Governments, not-for-profits, and private companies differ significantly from public companies in ways which have profound implications for financial reporting. To begin with, the primary goal of governments and not-for-profits is to provide some service to constituents and not to earn a profit. Governments and not-for-profits are governed mainly by their budgets and not by the marketplace. At the outset of our discussion then we should consider some of the more important characteristics of government, not-for-profit, and for-profit organizations.
When looking at government agencies their ultimate objective is to meet a political or social need, and their goals are not to provide the highest net income possible. They commonly render services with no expectation of revenue and are primarily supported by taxes while they are not subject to taxes themselves. Not-for-Profit Organizations have a goal to meet whatever the need is of their organization and they also are not looking to make a specific profit for shareholders. They are supported by donations and grants from the government, while all their major decisions are made by consensus vote of an executive board of directors.
According to Bill Balhoff, CPA it’s time to finally start realizing that we do need to separate companies fro ma private vs. public stance. "Over the years, I've defended the concept of a single set of accounting rules for all companies, public and private," Balhoff says. "But over the past year, decisions at FASB, the creation of the Public Company Accounting Oversight Board (PCAOB) and the drift of the International Accounting Standards Board (IASB) have led me to the conclusion that GAAP for public companies is less than ideal for private companies, sometimes even less than tolerable."
Keeping the small company in mind when writing standards or converging with international standards is made more difficult by FASB's difficulty in finding accountants from small companies or auditors from small firms to serve on its board or work on staff. For the past several years, there have been none. Everyone at FASB headquarters in Norwalk, Conn., comes from a public company or Big Four audit firm. AICPA Chairman and President Barry Melancon says the institute has issued a call for a nationwide discussion on the feasibility and advisability of differential accounting. Actually, AICPA is already working on a similar concept that relates to auditing standards. The Auditing Standards Board (ASB), which set audit standards for all companies until the creation of the PCAOB, has decided to shift its mission. Now that PCAOB is setting the standards for audits of public companies, the ASB intends to set standards that apply to private companies. "We need to have this debate, and we need to not be fearful about the outcome," Melancon says. "We have to be open enough to say, 'No, we're not going to do it,' or 'Yes, we are going to do it.' There are pros and cons to the question."
The cons are plenty, and raise plenty of questions: Who would set the new standards, and how long would it take? Would division be drawn along the public-private line or by company size? Can transactions really be accurately recorded by two means of measurement? How would this affect the U.S. acceptance of international standards? What happens to the comparability of private and public companies and between U.S. and offshore companies? What happens to the books when a private company goes public? Will investors and other users of information respect one kind of accounting more than the other? Are there really two correct ways to account for transactions?
Any such change would affect every part of the accounting profession. Many auditors would have to learn two different sets of accounting standards, or possibly two specialties would develop. Changing jobs or moving up the audit firm ladder would get tricky. This isn’t stating that their should necessarily be two sets of accounting standards, but in fact that it doesn’t seem that one set should be set for all the different types of companies out there. As I stated earlier many different companies are concerned with different things, and that should be taken into consideration. Of course all public companies who are looking to post the highest net revenues possible should all be under the same set of standards, but others such as smaller private firms or government agencies need to be given the proper addendums in order to conduct their business as well.
When it comes to Caltron and the standards they follow, it’s very important to make sure they stay within GAAP and the standards enforced by FASB. The quality of earnings refers to how closely reported earnings correlate to cash flows. Low-quality earnings can mean that the bottom line is padded through the use of liberal accounting policies. When concerns exist over the quality of reported earnings, questions arise about a company’s ability to sustain future earnings and the resultant effect on its stock price, as well as how reliable the financial data is.
In conclusion, it is difficult to say whether Caltron was attempting to manipulate earnings except to say that its liberal revenue recognition policies positively impacted earnings, a much desired result in view of the imminent secondary public stock offering. I recommend that you take this memo and consider having your financial reporting team adjust the transactions to properly state earnings, as you don’t want to mislead your potential shareholders in the market and inflate earnings before income is earned.
References
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