Earnings Management And Accurate Reporting

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Earnings Management And Accurate Reporting

Case 7-2 Solutions Network, Inc. (a GVV case)

“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, 2016, 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, 2015. Both Young and Henley are CPAs.

Young has excluded the amount in contention from revenue and net income for 2015, but Henley wants the amount to be included in the 2015 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, 2015, 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 2016. 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, 2015, when the software product was shipped FOB shipping point.

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Background

Solutions Network, Inc., became a publicly owned company on March 15, 2011, 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 2015. The revenue and earnings streams during those years are as follows:

Year

Revenues (millions)

Net Income (millions)

2010

$148.0

$11.9

2011

175.8

13.2

2012

202.2

15.0

2013

229.8

16.1

2014

267.5

17.3

Young prepared the following estimates for 2015:

Year

Revenues (millions)

Net Income (millions)

2015 (projected)

$262.5

$16.8

The Transaction

On December 28, 2015, 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

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