Case 1:

Conservative Recognition or Cookie Jar Reserves

SUMMARY OF THE FACTS
Parties Involved: Aunt Amelia – Founder of O’Brian Software, Nick’s aunt and inexperienced in accounting. Nick O’Brian – Junior Internal Auditor, recently college graduate, nephew of the Lee Marchetti – Chief Financial Officer of O’Brian Software. After recently graduating college two months prior, Nick O’Brian is hired as a Junior Internal Auditor for his Aunt Amelia’s company, O’Brian Software. O’Brian Software has been in operations for five years and is a multi-million dollar publicly traded company that provides both software and consulting services to its clients. Although this is Nick’s first position at the company, he’s been involved since the very beginning of this family venture, since family members owned the majority of the stock. Realizing “her specialty is software, not accounting “, Aunt Amelia hires Lee Machete to be Chief Financial Officer (CFO) of O’Brian Software after the firm’s initial public offering (IPO) three years ago. Nick notices a significant amount of unearned revenue the balance sheet and wonders if O’Brian Software is being overly conservative in estimating the amount of deferred income. After having a difficult understanding the firm’s methodology for revenue recognition, Nick decides to talk to Marchetti. In the meeting with Marchetti, Nick states what worries him. “Overly conservative reporting could leave the impression we’re trying to create cookie jar reserves.” Machete assures Nick that based his judgment the firms accounting practices are sound, has proper documentation, and meets the Securities Exchange Commission (SEC) requirements. Nick later meets with his Aunt Amelia to convey his concern. Since Marchetti never mentioned these concerns to her, Aunt Amelia doesn’t understand the problem. She feels confident that as long as the firm isn’t underreporting expenses, or inflating our income by prematurely recognizing revenue they are doing the right thing. Nick expresses the serious ethical implications with being overly conservative reporting, “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.” Aunt Amelia grasps the serious nature of the issue but is unsure on what steps to take next. She asks Nick if she should bring the issue to the attention of the company’s audit committee.
IDENTIFIED ISSUE AND QUESTIONS

The major question in this case involves whether or not O’Brian Software is engaging in a form of the earnings management, known as income smoothing. Income smoothing is when accounting measures are used to lessen fluctuations in reported earnings over a period of time (Ronen & Yaari, 2008, p.317). At first, Nick feels that he may be overreacting, but later feels he has legitimate concerns. How should he go about resolving these concerns? This case also involves numerous issues faced by professional accounting professional, such as the application of ethical judgment, deploying professional skepticism, dealing with external and internal pressures, and the proper policies and procedures to be followed in addressing accounting concerns.
RELEVANT ACCOUNTING STANDARDS AND PRACTICES

Generally Accepted Accounting Principles – Revenue Recognition
U.S. GAAP provides detailed guidance about the separation and allocation of the multiple-deliverable arrangements. FASB ASC 605, “Revenue Recognition” was issued to provide additional guidance on revenue recognition criteria and to rein in some of the inappropriate practices that had been observed. FASB ASC 605 concedes that revenue may be recognized in some circumstances where delivery has not occurred, but sets out criteria that limit the ability to record such transaction as revenue. (FASB, 2011) “ASC 985-605-15-3(e) discusses an arrangement “to deliver software or a software system, either alone or together with other products or services,” in which “significant production, modification, or customization of software” is required. Such an arrangement should be accounted for under ASC 605-35 because the software cannot be accounted for separately from the production, modification, or customization services (Deloitte & Touche, 2007) Qualitative Characteristics of Accounting Information
The Financial Accounting Standard Board (FASB) outlines in “Concepts Statement No. 2: Qualitative Characteristics of Accounting Information Statement of Concepts maintains that information must be relevance, reliability, and consistent. “To be relevant, information must be timely and it must have predictive value or feedback value or both. To be reliable, information must have representational faithfulness and it must be verifiable and neutral. Comparability, which includes consistency, is a secondary quality that interacts with relevance and reliability to contribute to the usefulness of information.” (FASB, 2008) Companies commonly make estimate determinations using fair value, historical costs, current costs, or current market value. Resources and Guidance on Ethic Issues
The American Institute of Certified Public Accountants (AICPA), the Institute of Management Accountants (IMA) give professional codes of conduct, guidance to accounting practitioners, and highlight the nature of ethical dilemmas and challenges that occur in these professions. An accounting professional must stay true to his or her principles in the face of the adversity. (Christian & Gumbus, 2009) The resources and instructions of the AICPA and IMA are beneficial resources, provides clarity, and reaffirms that silence do not serve the public’s interest.
If an accounting professional is presented with an ethical issue involving pressures by senior management to disregard the generally ¬accepted accounting principles, the AICPA offers guidance on what to do, who to talk to, and where to look for resources. Generally, the AICPA advises that one should try to resolve ethical issue within the company, if possible. Sometimes the severity of the issue many require that accountants to enlist the aid of the outside resources, such as a mentor, an ethics hotline, or attorney. However, AICPA ET Section 102.1 supersedes these recommendations if the issues are related to a dispute or disagreement about the recording of a transaction or preparation of the financial statement. AICPA advises that members should always be knowledgeable of his or her obligations under interpretation 102-3 [ET section 102.04], which is stated below:
“.05–102-4—Subordination of judgment by a member. Rule 102 [ET section 102.01] prohibits a member from knowingly misrepresenting facts or subordinating his or her judgment when performing professional services. Under this rule, if a member and his or her supervisor have a disagreement or dispute relating to the preparation of financial statements or the recording of transactions, the member should take the following steps to ensure that the situation does not constitute a subordination of judgment” (AICPA, 2002)
OPINION

Conservatism vs. Earnings Management
“Relative to other companies, technology firms' earnings are characterized by higher levels of both conditional and unconditional conservatism.” (Chandra, 2011) Based on the facts of the case I believe the O’Brian Software be engaging in earnings management. “Earnings management occurs when companies artificially inflate (or deflate) their revenues or profits, or earnings per share figures. This is accomplished in two broad ways: (1) by using aggressive accounting techniques such as capitalizing costs that should have been expensed …. and (2) by establishing/ altering the elements of an estimate to achieve a desired goal….” (Mintz, 2011, p. 335) A major red flag is that, O’Brian Software’s growth and revenue has been fairly smooth and always trending upward. As Nick commented, “It’s kind of unusual in a new company, especially a new technology” I believe that Conservatism is generally a good, but being overly conservative in accounting is generally bad.” Ethical Judgment &Professional Skepticism
Because there is no generally accepted definition of earnings management in accounting, Nick must deploy an ethical reasoning view point. This can be difficult in a family oriented environment, such as O’Brian Software. I feel that it important that Nick uses professional skepticism and fulfills his role in protecting the public’s interest by making sure the firm’s methodology for recognizing revenue reflect virtues such as honesty ( full disclosure) and dependability (reliable numbers). To start, Nick should ask himself the following questions: Is the firm’s current revenue recognition policy motivated by self- interest of management or the interests of shareholders and other stakeholders? Bearing in mind, that Nick’s family is the major stockholders. (Mintz, 2011) I agree with Michael A. Santoro’s recommendation that Nick should the conduct tests and determine if amounts in the deferred accounts apply to any expired contracts and are materially overstated. (Carpenter, 2003) Dealing With Ethical Issues in Accounting Field
I think it is inappropriate for Nick’s Aunt Amelia to turn to him for the direction and decision making. It was implied in the case that Aunt Amelia hasn’t reviewed financial the company went public three years ago. This is another red flag. There also seem to be a lack of communication within the organization, because Marchetti failed to inform Amelia of Nick’s concerns or the contents of their meeting. Since that just starting his accounting career, I would suggest that Nick seek support from others in the field or professionals organizations. It would also be wise to document his concerns, meetings, evidence, and observations. As evident in the fraud scandals, such as WorldCom and Enron, there are serious dangers and long-lasting damages to the economy (domestic and global) due to actions of management resulting in misrepresentation in financial statements. This practice of intentional non-transparency is direct opposition to the values and codes of the conduct for the American Institute of Certified Public Accountants and Institute of Management Accountants (IMA). The IMA’s statement of ethical professional practice dictates that “members of IMA shall behave ethically. IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility.” (Christian & Gumbus, 2009) AICPA’s ET Section 53 Article 2 states that their member role to protect the public’s interest, ET Section 54 Article focuses on integrity and ET Section 55 Article 4 give instructions on objectivity and independence. (Christian & Gumbus, 2009)
REFERENCES

Carpenter, L. (2003). Conservative recognition or cookie jar reserves? Ethics and Fraud in Business: Cases and Commentary.

Chandra, U. (2011). Income Conservatism in the U.S. Technology Sector. Accounting Horizons, 25(2), 285-314. doi:10.2308/acch-10022

Christian, V., & Gumbus, A. (2009). Shades of gray: applying professional codes of ethics to workplace dilemmas. Organization Management Journal, 6(3), 178-199. doi:10.1057/omj.2009.22

Diamond, M. A., Stice, E. K., & Stice, J. D. (2000). Financial Accounting. [Cincinnati, OH]: Southwestern College Pub.

Deloitte & Touche. (2007). Software Revenue Recognition: A Roadmap to Applying AICPA Statement of Position 97-2. Retrieved September 20, 2013, from http://www.deloitte.com/dtt/cda/doc/content/us_assur_Roadmap_SOP97-2.pdf

FASB. (2008). Statement of Financial Accounting Concepts No. 2. Retrieved September 20, 2013, from Financial Accounting Standard Board: http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175820900526&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

FASB. (2009, December). Update No. 2009-17—Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. Retrieved September 20, 2013, from Financial Accounting Standards Board: http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175820006385&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

FASB. (2011, November 14). Revenue Recognition (Topic 605). September 20, 2013, from Finanical Accounting Standards Board: http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175823564392&blobheader=application/pdf

Mintz, S., & Morris, R. (201). Ethical obligations and decision making in accounting. (2nd ed ed.). New York: McGraw-Hill/Irwin.