Whether the Use of Cookie Cutter Reserves Is Ethical and Within Accounting Standards

Summary

Nick O'Brian works for his aunt's software company in the accounting department. He had graduated college two months prior but has held other positions such as junior auditor in the past. Nick decides to take a look at the financial statements and crunch some numbers. In doing so he discovers some questionable practices regarding revenue recognition in which he brings to the attention of the CFO, Lee Marchetti. Lee Marchetti acknowledges that the rules for deferred revenue can be heavily dependent on the judgment at the company. He insists though that the deferrals and estimates are within SEC rules and are well documented. Nick proceeds up the chain of command and speaks with his aunt about this issue which ends on her asking him if she should run it by t he audit committee.

Issues and Questions

The primary issue raised by this case study is whether the use of cookie cutter reserves is ethical and within accounting standards. This is a result of a company using unrealistic assumption to estimate items such as sales returns and warranty costs in order to stash accruals in the reserves for down periods of business. In actuality this approach is very conservative and provides a large buffer for the company against the market. The question is whether this type of action is ethical and provides a clear financial view of the company. Ideally, the goal of financial statements is transparency so investors know when a company is doing well.

The second issue at hand for Nick is whether he should advise his aunt to see the auditing committees help in this matter. If the company were to in fact be taking on greater liabilities during good times with intent to write them down during bad times and "weather the storm" to meet estimates this is an account violation and not in accordance with GAAP.

There are other questions that need to be asked before deciding whether to proceed to the audit committee. First, Nick must do all of his research on this issue before going forward. It will take a deep understanding of the company's finances and business model to understand if cookie jar accounting is taking place. As stated earlier there needs to be proved clear intent to write down the liabilities. Therefore a thorough understanding of how the estimates are done for these liabilities will need to be realized before going to the audit committee.

Relevant Accounting Standards and Practices

According to FASB Statement of Financial Accounting Concepts No. 5, "revenue is recognized when a transaction occurs and 1) the revenue is realized or realizable and 2) the revenue is earned. Revenue from a transaction must meet both criteria in order to be recognized." This seems pretty straight-forward however it can get very hazy due to the flexibility of application