"We can't recognize revenue immediately, Paul, since we agreed to buy similar software from DSS," Sarah Young stated.

"That's ridiculous," Paul Henley replied. "Get your head out of the sand, Sarah, before it's too late."

Sarah Young is the controller for Solutions Network, Inc., a publicly owned company headquartered in Sunnyvale, California. Solutions Network has an audit committee with three members of the board of directors that are independent of management. Sarah is meeting with Paul Henley, the CFO of the company on January 7, 2019, to discuss the accounting for a software systems transaction with Data Systems Solutions (DSS) prior to the company's audit for the year ended December 31, 2018. Both Young and Henley are CPAs.

Young has excluded the amount in contention from revenue and net income for 2018, but Henley wants the amount to be included in the 2018 results. Without it, Solutions Network would not meet earnings expectations. Henley tells Young that the order came from the top to record the revenue on December 28, 2018, the day the transaction with DSS was finalized. Young points out that Solutions Network ordered essentially the same software from DSS to be shipped and delivered early in 2019. Therefore, according to Young, Solutions Network should delay revenue recognition on this "swap" transaction until that time. Henley argues against Sarah's position, stating that title had passed from the company to DSS on December 31, 2018, when the software product was shipped FOB shipping point.

Background

Solutions Network, Inc., became a publicly owned company on March 15, 2014, following a successful initial public offering (IPO). Solutions Network built up a loyal clientele in the three years prior to the IPO by establishing close working relationships with technology leaders, including IBM, Apple, and Dell Computer. The company designs and engineers systems software to function seamlessly with minimal user interface. There are several companies that provide similar products and consulting services, and DSS is one. However, DSS operates in a larger market providing IT services management products that coordinate the entire business infrastructure into a single system.

Solutions Network grew very rapidly during the past five years, although sales slowed down a bit in 2018. The revenue and earnings streams during those years are as follows:

YearRevenues (millions)

Net Income (millions)

2013$148.0

$11.9

2014175.8

13.2

2015202.2

15.0

2016229.8

16.1

2017267.5

17.3

Young prepared the following estimates for 2018:

YearRevenues (millions)

Net Income (millions)

2018 (Projected)$262.5

$16.8

The Transaction

On December 28, 2018, Solutions Network offered to sell its Internet infrastructure software to DSS for its internal use. In return, DSS agreed to ship similar software 30 days later to Solutions Network for that company's internal use. The companies had conducted several transactions with each other during the previous five years, and while DSS initially balked at the transaction because it provided no value added to the company, it did not want to upset one of the fastest-growing software companies in the industry. Moreover, Solutions Network might be able to help identify future customers for DSS's IT service management products.

The $15 million of revenue would increase net income by $1.0 million. For Solutions Network, the revenue from the transaction would be enough to enable the company to meet targeted goals, and the higher level of income would provide extra bonus money at year-end for Young, Henley, and Ed Fralen, the CEO.

Accounting Considerations

In her discussions with Henley, Young points out that the auditors will arrive on January 15, 2019; therefore, the company should be certain of the appropriateness of its accounting before that time. After all, says Young, "the auditors rely on us to record transactions properly as part of their audit expectations." At this point Henley reacts angrily and tells Young she can pack her bags and go if she doesn't support the company in its revenue recognition of the DSS transaction. Young is taken aback. Henley seems unusually agitated. Perhaps he was under a lot more pressure to "meet the numbers" than she anticipated. To defuse the matter, Young makes an excuse to end the meeting prematurely and asks if they could meet on Monday morning, after the weekend. Henley agrees.

Over the weekend, Sarah Young calls her best friend, Shannon McCollough, for advice. Shannon is a controller at another company and Sarah would often commensurate with Shannon over their mutual experiences. Shannon suggests that Sarah should explain to Paul Henley exactly what her ethical obligations are in the matter. Shannon thinks it might make a difference because Paul is a CPA as well.

After the discussion with Shannon, Sarah considers whether she is being too firm in her position. On the one hand, she knows that regardless of the passage of title to DSS on December 31, 2018, the transaction is linked to Solutions Network's agreement to take the DSS product 30 days later. While she doesn't anticipate any problems in that regard, Sarah is uncomfortable with the recording of revenue on December 31 because DSS did not complete its portion of the agreement by that date. She has her doubts whether the auditors would sanction the accounting treatment.

On the other hand, Sarah is also concerned about the fact that another transaction occurred during the previous year that she questioned but, in the end, went along with Paul's accounting for this transaction. On December 28, 2017, Solutions Network sold a major system for $20 million to Laramie Systems but executed a side agreement with Laramie on that date which gave Laramie the right to return the product for any reason within 30 days. Even though Solutions Network recorded the revenue in 2017 and Sarah felt uneasy about it, she did not object because Laramie did not return the product; her acceptance was motivated by the delay in the external audit until after the 30-day period had expired. Now, however, Sarah is concerned that a pattern may be developing.

1. Solutions Network is attempting to manage earnings. Which features of earnings management is being employed by Solutions?

a. Alter numbers not yet in the financial records by using discretionary accruals.

b. Create or structure transactions for the purpose of altering the numbers.

c. Alter numbers already in the financial records by using discretionary accruals.

d. Alter numbers not yet in the financial records by using discretionary accruals and create or structure transactions for the purpose of altering the numbers.

e. Create or structure transactions for the purpose of altering the numbers andalter numbers already in the financial records by using discretionary accruals.

2. The approach Solutions is taking is most closely aligned with

a Operating expense management

b Operating earnings management

c Accounting expense management

d Accounting earnings management

3 Suppose Sarah meets with Paul on Monday and no resolution is obtained; Paul does not back off. To whom should Sarah turn next?

a Board of Directors

b Audit Committee

c External auditors

d SEC as a whistleblower

4 Sarah and Paul are industry CPAs rather than public CPAs. R. Z. Elias conducted a study of corporate ethical values and earnings management ethics. He found that CPAs in industry in an organization are:

a Significantly more likely than those in public accounting to perceive high ethical values.

b Significantly less likely than those in public accounting to perceive high ethical values.

c More reluctant to report to the SEC than CPAs in public accounting.

d No statistical significant difference exists between industry and public accounting CPAs.