Significant Accounting and Audit Issues - Case Study Example

Executive Summary This is a memo on the significant accounting and audit issues for It’s Close Enough Inc. (ICE or the Company). One significant accounting issue is to capitalize or expense the costs of ICE related to the development of software for its internal use, which may result to the overstatement of ICE’s net income. To address this issue, we have to take into consideration the relevant provisions of AICPA’s Statement of Position (SOP) 98-1 on which costs to expense and which costs to capitalize. Another issue is the basis for recording the gain during an exchange of nonmonetary assets. Certain provisions of Statement of Financial Accounting Standards (SFAS) No. 153, Exchanges of Nonmonetary Assets, are applicable for this concern and should be carefully considered. The third issue is the inventory reserve previously set up by ICE but subsequently reversed and the propriety of such reversal. This is a possible fraud indicator and calls for careful review of the relevant documents and contracts. The fourth issue is whether to recognize the decline in the value of ICE’s investment as other-than-temporary. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, deals with the write down of other-than-temporary decline in the value of the equity securities and how it should be recognized in the income statement. The last issue is about the changes in ICE’s terms of sale, which is another possible fraud indicator, and the implications of such changes. Critical here is the careful analysis of the terms of sale and the actual contract between ICE and its customers. Summary of Significant Accounting and Audit Issues Software Development Costs For this transaction, we, as auditors, should be concerned about the risk that the income statement of the Company is misstated and that there is an error in management’s judgment in identifying which costs should be expensed when incurred. However, there is also a possibility that the Company may intentionally misstate its income statement by reclassifying the costs from the preliminary stage to the development stage, thus qualifying them for capitalization. In Mr. Hunts’ audit memo, he cited that the Company complied with the provisions of SOP 98-1 related to the accounting for costs of computer software developed for internal use. However, there are two things that he should have also considered and included in his memo. First, the project is to “upgrade the back-office systems” of ICE. According to paragraph 24 of SOP 98-1, upgrades to the computer software used by a company should “result in additional functionality” of the software before its costs would be capitalized. Secondly, SOP 98-1 also sets out the criteria for determining whether a software project is in the preliminary stage or in the application development stage and which costs, regardless of the stage, should be capitalized or expensed when incurred. The cut-off point between the two stages is, therefore, very important and should be considered in coming up with the final resolution of this issue. Exchange of Inventory for Barter Credits The issues here are: whether or not there the Company should record a gain on the transaction and if there is a need to write down the $10 million book value of the inventory. Since there was no gain recognized in the first place, the first issue did not result to overstatement of the net income of the Company. However, if there is an error in the $14 million value of the service credits to be received and the actual value is lower than the book value of the inventory to be exchanged, then the cost of the inventory should be written down to its realizable value. This may be an error in judgment, but it is a concern for the users of the financial statements because the value of the inventory (and total assets) is not properly stated. Another issue (which was not indicated in Mr. Hunts’ memo) is the proper basis for calculating the gain or loss from the transaction (i.e., fair value of the assets to be given or fair value of assets to be received). Paragraph 20 of SFAS No. 153 states that an exchange should be recorded at the fair value of the assets given up if the exchange lacks commercial substance. Paragraph 21 gives the definition of commercial substance. In this case, Mr. Hunts should have assessed whether there is commercial substance in the exchange and whether the Company is correct in using the value of the service credits in measuring the value and the gain from the exchange. Inventory Reserve Adjustment The issue here is whether or not the value of the inventories (and the assets) of the Company are properly stated. The risk is that management may have intentionally reversed the inventory reserve to present a more attractive picture to the users of its financial statements. On our point of view as auditors, this is actually a fraud indicator. However, in this section of his memo, Mr. Hunts failed to indicate it as such. Specifically, the Company may have justified the reversal of the reserve by making it appear that the inventories were actually sold and that they were sold above their realizable value. Mr. Hunts should have checked for signs of bill-and-hold transactions for those inventories that were supposedly sold during the year. Such checking should have covered verification of date of actual shipment or delivery of the goods. An analysis of the terms of the sale should also be done to ensure that ICE is not merely “channel stuffing” its distribution channels (SEC SAB No. 101, Question No. 9) in order to unload the inventories. Investment Portfolio In the memo, Mr. Hunts stated that there was already a temporary decline recorded in the previous year. The decline continued in the current year, which raises the question whether the decline is still temporary or not. This concern was not included in the memo. According to Paragraph 16 of SFAS No. 115, the write down of other-than-temporary decline in the value of the equity securities should be recognized in the income statement. In the Company’s case, failure to consider the decline as other-than-temporary will mean the decline is not recognized in the income statement and will, thus, overstate ICE’s net income. It may also mislead users into assuming that the impairment is just temporary and the investment cost will still be fully recovered in the future. Modifications to Terms of Sale The risk for this case is a possible misstatement of the Company’s liabilities, sales return and, consequently, net income. This is an area that calls for management estimates and judgment and an unintentional error in either one of them may cause the balances to be grossly misstated. These were considered by Mr. Hunts as evidenced by his memo and in his audit procedures. However, this may also be a possible fraud indicator, something which was not mentioned in his memo. As shown in the Sunbeam case of the Securities and Exchange Commission, the Company’s offer of discounts and attractive mark-ups may cause its customers to accept the Company’s goods, thereby generating sales that have, in principle, no economic substance. Such modifications may unduly increase sales to show more attractive revenue balances. Conclusion In summary, the issues stated in this memo should be revisited by us at the soonest possible time to ensure that the transactions entered into by the Company are properly accounted for in accordance with the relevant accounting standards. Also, some of the transactions mentioned in this memo may actually be fraud indicators that we should revisit to ensure that management is not intentionally misstating the Company’s financial statements. With the plan to go public next year, there is incentive to overstate earnings and assets and understate liabilities, thus, we, as auditors, should be extra vigilant in order to ensure that ICE’s accounts are not grossly misstated. References Accounting Standards Executive Committee. “Statement of Position 98-1: Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”. March 4, 1998. February 11, 2009. . Financial Accounting Standards Board. “Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities”. As amended in 2008. February 11, 2009. . Financial Accounting Standards Board. “Statement of Financial Accounting Standards No. 153: Exchanges of Nonmonetary Assets”. As amended in 2008. February 12, 2009. . U. S. Securities and Exchange Commission. “SEC Staff Accounting Bulletin (SAB): No. 101 – Revenue Recognition in Financial Statements”. December 3, 1999. February 12, 2009. . U. S. Securities and Exchange Commission. “In the Matter of Sunbeam Corporation. An Order Instituting Public Administrative Proceedings, Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making findings, and Imposing a Cease-and-Desist Order”. February 14, 2009. . Read More