Revenue Recognition

Summary:

Nick O’Brian, a recent college graduate, began working in the accounting department at his aunt’s software company, O’Brian Software. While going over the financial statements, Nick recognizes an issue in the company’s revenue recognition. The revenue seems to stable and he thinks it could have been smoothed on purpose. He addresses his concerns to the company’s CFO, Lee Marchetti. Having been in the industry for a long time, Marchetti explains that the financials have been reported in accordance to regulations and that there shouldn’t be any concerns. He also mentioned that the statements have passed audits with clean opinions. Nick, however, is still concerned about the books and approached his aunt, the company’s CEO, about it. Nick’s aunt admittedly does not have much expertise in accounting and asked Nick if they should present the findings to the audit committee.

Issues:

There are several issues that might cause significant problems for O’Brian Software. The biggest issue is that the company might be involved in setting aside revenue for rainy days, creating a cookie jar reserve. This kind of activity is prohibited as it creates a misleading picture about the company’s performance. It is material since investors will not be able to use it as an accurate source of information that could affect their decision. FASB Statement of Concepts No.2 states that “bias in estimating components of earnings, whether overly conservative or unconservative, usually influences the timing of earnings or losses rather than their aggregate amount. As a result, unjustified excesses in either direction may mislead one group of investors to the possible benefit or detriment of others (FASB, 2014).

Another issue that contributes to the complication of the situation is that Nick is unsure of this activity is going on since the financial have been audited with clean opinions. If the CFO is correct then restating the earnings would cause investors, present and future, to shy away from the company. However, if Nick is correct then it is of utmost importance that the issue is addressed since O’Brian Software is getting ready to release new software, Brainwave.

Software revenue recognition also presents an issue in this case since it is not well defined and many things are left up to the opinion and interpretation of the preparers. Since the statements received clean opinions, it essentially means that the financials were prepared in accordance to regulations without any materiality. In order to strengthen his case, Nick has to understand O’Brian’s revenue recognition principles. If Nick comes to a conclusion without the facts and understanding of how the company reports its revenue then he could be making a big deal out of nothing. Doing so could hurt the company’s reputation and potentially, its performance.

Lastly,