In 1996, Nicklaus decided to expand his business operations by spinning off a subsidiary from GBI via an initial public offering (IPO). Nicklaus named the new public company Golden Bear Golf, Inc. (Golden Bear). One of Golden Bears principal lines of business would be the construction of golf courses. GBI would remain a privately owned company that would continue to manage Nicklauss other business ventures.Because Nicklaus planned to retain more than 50 percent of Golden Bears commonstock, he and his subordinates would be able to completely control the new companys operations. Nicklaus chose his trusted associate Richard Bellinger to serve as Golden Bears CEO. Bellinger then appointed John Boyd and Christopher Curbello as the two top executives of Paragon International, Golden Bears wholly owned subsidiary that would be responsible for the companys golf course construction business. Boyd became Paragons president and principal operating officer, while Curbello assumed the titleof Paragons vice president of operations. On August 1, 1996, Golden Bear went public. The companys stock traded on the NASDAQ exchange under the ticker symbol JACK. Triple Bogey for Golden Bear Shortly after Golden Bears successful IPO, Paragon Internationals management team was in undated with requests to build Jack Nicklausdesigned golf courses. In a few months, the company had entered into contracts to build more than one dozen golf courses. Wall Street analysts, portfolio managers, and individual investors expected these contracts to translate into sizable profits for Golden Bear. Unfortunately, those profits never materialized. Less than one year after Golden Bears IPO, Boyd and Curbello realized that they had been much too optimistic in forecasting the gross profit margins Paragon would earn on its construction projects. Instead of earning substantial profits on those projects, Paragon would incur large losses on many of them. To avoid the embarrassment of publicly revealing that they had committed Paragon to a string of unprofitable construction projects, the two executives instructed Paragons accounting staff to embellish the subsidiarys reported operating results. A key factor that may have contributed to Boyd and Curbellos decision to conceal Paragons financial problems was the incentive compensation package each had received when they signed on with the company. The two executives could earn sizable bonuses if Paragon met certain operating benchmarks. In addition, Boyd had been granted a large number of Golden Bear stock options. Because Paragons construction projects required considerably more than one yearto complete, the company used percentage-of-completion accounting to recognize the revenues associated with those projects. Initially, Paragon applied the widely used cost-to-cost percentage-of-completion method that requires a company to determine the percentage of a projects total estimated construction costs incurred in a given accounting period. Then, the same percentage of the total revenue (and gross profit) to be earned on the project is booked that period. During the second quarter of fiscal 1997, Boyd and Curbello determined that Paragon would have a large operating loss if the cost-to-cost method was used to recognize revenue on the golf course construction projects. At that point, the two executives instructed Paragons controller to switch to what they referred to as the earned value percentage-of-completion accounting method. In developing its percentage-of-completion estimates under the earned value method, Paragon relied not on objective criteria, such as costs incurred, but instead relied on managements subjective estimates as to its [a projects] progress. Throughout the remainder of fiscal 1997 and into fiscal 1998, Paragons management routinely overstated the percentage-of-completion estimates for the companys golf course construction projects each quarter. To further enhance Paragons operating results, the companys accounting staff inflated the contractual revenue amounts for most of the companys construction projects. These increased revenue amounts were allegedly attributable to change orders that amended the original construction contracts between Paragon and the companys clients. A final window-dressing scheme used by Paragon was recording revenue for potential construction projects.In some cases, Paragon recognized revenue in connection with potential projects that Paragon had identified while looking for new work, even though Paragon had no agreements in connection with these projects. In other cases, Paragon recognized revenue in connection with projects where the projects owners were either entertaining bids from Paragon and other contractors or were negotiating with Paragon regarding a project yet to be awarded. During the spring of 1998, John Boyd and several of his top subordinates, including Christopher Curbello, attempted to purchase Paragon International from Golden Bear. When that effort failed, Boyd and Curbello resigned their positions with Paragon. After their departure, Paragons new management team quickly discovered that the subsidiarys operating results had been grossly misrepresented. A subsequent investigation carried out jointly by Arthur Andersen & Co. (Paragons audit firm), Pricewaterhouse Coopers, and Golden Bears external legal firm resulted in Golden Bear issuing restated financial statements in October 1998 for fi scal 1997 and for the first quarter of fi scal 1998. For fiscal 1997, Golden Bear had initially reported a $2.9 million net loss and golf course construction revenues of $39.7 million; the restated amounts included a $24.7 million net loss for fi scal 1997 and golf course construction revenues of only $21.8 million. For the first quarter of fiscal 1998, Golden Bear had reported an $800,000 net loss and golf course construction revenues of$16.0 million. Those amounts were restated to a $7.2 million net loss and golf course construction revenues of $8.3 million. A significant unbilled revenue balance requires adequate testing to determine the reason that the company is not billing for the work it reports as complete and whether unbilled amounts are properly recognized as revenue. Instead, the SEC charged that Sullivan relied excessively on oral representations from Paragon management to confirm the unbilled revenues and corresponding receivables. In at least one case, the SEC reported that members of the Golden Bear audit team asked the owner of a Paragon project under construction to comment on the reasonableness of the $2 million unbilled receivable that Paragon had recorded for that projectat the end of 1997. The owner contested that amount, alleging that Paragon had overestimated the projects stage of completion. Despite this signifi cant evidence that a third party with knowledge of the projects status disputed Paragons estimated percentage-of-completion under the contract, the audit team did not properly investigate this project or otherwise expand Andersens scope of testing of Paragons unbilled revenue balances. According to the SEC, Sullivan did not believe the unbilled revenue posed major audit issues but instead was a business issue that Paragonhad to resolve with its clients. A second tactic Paragon used to infl ate its reported profi ts was to overstate the total revenues to be earned on individual construction projects. During the 1997 audit,Andersen personnel selected 13 of Paragons construction projects to corroborate the total revenue figures the company was using in applying the earned value percentage of-completion accounting method to its unfinished projects. For 11 of the 13 projects selected, the Andersen auditors discovered that the total revenue being used in the percentage-of-completion computations by Paragon exceeded the revenue figure documented in the construction contract. Paragons management attributed these differences to unsigned change orders that had been processed for the given projects but could not produce any documents supporting these oral representations. Sullivan accepted the clients representations that the given revenue amounts were valid. In each instance, Sullivan failed to properly follow up on a single undocumented amount; instead, Sullivan relied solely on Paragon managements oral representations that the estimated revenue amounts accurately reflected the economic status of the jobs. Another scam used by Paragon to inflate its revenues and profits was to record revenue for non existent projects. In the enforcement release that focused on Sullivans role in the Paragon scandal, SEC officials pointed out that the publication AICPA Audit and Accounting GuideConstruction Contracts is clearly relevant to the audits of construction companies such as Paragon. This publication recommends that auditors visit construction sites and discuss the given projects with project managers, architects, and other appropriate personnel. The purpose of these procedures is toassess the representations of management (for example, representations about the stage of completion and estimated costs to complete). Despite this guidance, the Andersen auditors did not visit any project sites during the 1997 audit. Such visits may have resulted in Andersen discovering that some of Paragons projects were purely imaginary. In addition, Andersen would likely have determined that Paragon was overstating the stages of completion of most of its existing projects. Likewise, the SEC contended that Sullivan should have required Golden Bear to disclose material related-party transactions involving Paragon and Jack Nicklaus, Golden Bears majority stockholder. Finally, the SEC noted that Sullivan failed to heed his own concerns while planning the 1997 Golden Bear audit. During the initial planning phase of that audit, Sullivan had identified several factors that prompted him to designate the 1997 Golden Bear audit a high-risk engagement. These factors included the subjective nature of the earned value method, Paragons large unbilled revenues, the aggressive revenue recognition practices advocated by Golden Bear management, and severe weaknesses in Paragons cost accounting system. Because of these factors, the SEC maintained that Sullivan and his subordinates should have been particularly cautious during the1997 Golden Bear audit and employed a rigorous and thorough set of substantive audit procedures. In August 1998, angry Golden Bear stockholders filed a class-action lawsuit against the company, its major officers, and its principal owner, Jack Nicklaus. That same month, the NASDAQ delisted the companys common stock, which was trading for less than $1 per share, considerably below its all-time high of $20. Richard Bellinger resigned as Golden Bears CEO two months later to pursue other interests. In December 1999, Golden Bear announced that it had reached an agreement to settle the classaction lawsuit. That settlement required the company to pay its stockholders $3.5 million in total and to purchase their shares at a price of $0.75.

Question

1. Was the change that Paragon made in applying the percentage-of-completion accounting method a change in accounting principle or a change inaccounting estimate? Briefly describe the accounting and financial reporting treatment that must be applied to each type of change.