Case 7-2
Solutions Network, Inc.
“We can’t recognize revenue immediately, Paul, since we agreed to buy similar software from Data
Systems Solutions (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, 2014, 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, 2013. Both Young and
Henley are CPAs.
Sarah has excluded the amount in contention from revenue and net income for 2013. Henley wants the
amount to be included in the 2013 results. Henley told Sarah that the order came from the top to record the
revenue on December 28, 2013, the day the transaction with DSS was finalized. Sarah pointed out that
Solutions Network ordered essentially the same software from DSS to be shipped and delivered early in
2014. Therefore, according to Sarah, Solutions Network should delay revenue recognition on this “swap”
transaction until that time. Henley argued against Sarah’s position stating that title had passed from the
company to DSS on December 31, 2013, when the software product was shipped with FOB shipping point
terms.
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. One is DSS.
However, DSS operates in a larger market providing IT services management products that coordinate the
entire business infrastructure into a single system.
Solutions Networks grew very rapidly during the past five years. The revenue and earnings streams
during those years are as follows:
Year
Revenues
($ in millions)
Net Income
($ in millions)
2008 $148.0 $11.9
2009 175.8 13.2
2010 202.2 15.0
2011 229.8 16.1
2012 267.5 17.3
Young prepared the following estimates for 2013:
Year
Revenues
($ in millions)
Net Income ($
in millions)
2013 (projected) $287.5 $17.9
The Transaction
On December 28, 2013, 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 together 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 services management
products.
The $30 million of revenue would increase net income $1.9 million over the projected amount for 2013.
For Solutions Network, the revenue from the transaction was enough to enable the company to meet
targeted goals and the higher level of income would provide extra bonus money at year end for Sarah
Young, Paul Henley, and Ed Fralen, the CEO.
Accounting Considerations
In her discussions with Henley, Sarah points out that the auditors will arrive on February 1, 2014; therefore,
the company should be certain of the appropriateness of its accounting before that time. After all, says
Sarah, “the auditors rely on us to record transactions properly as part of their audit expectations.” At this
point Henley reacts angrily and tells Sarah she can pack her bags and go if she doesn’t support the company
in its revenue recognition of DSS transaction. To defuse the matter, Henley suggests that they meet in one
week on January 14 to “put this matter to bed.”
Normally, Sarah wouldn’t object to Paul’s proposed accounting for the transaction with DSS. However,
she knows that regardless of the passage of title to DSS on December 31, 2013, the transaction is linked to
Solutions Network’s agreement to take the DSS product 30 days later. While she doesn’t anticipate any
problems in that regard, Sarah is uncomfortable with the recording of revenue on December 31 since DSS
did not complete its portion of the agreement by that date. Sarah has her doubts whether the auditors would
sanction the accounting treatment.
Sarah is also concerned about the fact that another transaction occurred during the previous year that she
questioned but, in the end, Sarah went along with Paul’s accounting for this transaction. On December 28,
2012, Solutions Network sold a major system for $20 million to Laramie Systems but executed a side
agreement with Laramie on December 29, 2012, that gave the customer the right to return the product for
any reason after January 1, 2013, and for 27 additional days. Even though Solutions Network recorded the
revenue on December 29, 2012, and Sarah felt uneasy about it, she did not object because Laramie did not
return the product. Sarah never brought it up again. Now, she is concerned that a pattern may be
developing.
NOTES
Ethical Issues
Investors rely on the accuracy of the financial statement information. If revenue is deliberately overstated,
then these users will be making investment decisions based on incorrect information. The SEC expects a
public company to report truthful information in all of its filings with the Commission. The accounting
profession (FASB, AICPA, and IMA) expects that its technical and ethical rules will be followed by all
accountants — CPAs, and CMAs. The accounting profession is harmed when an accountant compromises
integrity by going along with a position that is not justified under the rules. Under AICPA Code, CPAs have
an obligation to have integrity, objectivity, and to follow GAAP. Under the IMA Code, CMAs have an
obligation to the general public, the members of their profession, the organization they serve, and
themselves, to have integrity, objectivity, and communicate information fairly and objectively. Below is a
brief discussion using the different ethical theories.
Rights Theory: It is not right to mislead the investors by making it look as though the company is doing
better than it really is. Any attempt to intentionally misstate the financial statements violates the categorical
imperative. An ends justifies the mean approach often is used by egoistic managers but violates the
universal accounting value that financial statements must be accurate and reliable for users to make
informed decisions.
Justice Theory: Stakeholder interests are not fairly represented because the perceived interests of the
management are given priority over the interest of all other stakeholders. Procedural justice issues exist
here because of the way in which Henley is trying to get Sarah to accept the improper accounting.
Utilitarian Theory — Rule-utilitarianism: Rule Utilitarianism requires that the correct moral rule should be
followed. The correct moral rule in this instance is not to lie or deceive shareholders in the financial
statements. Act-utilitarianism requires that the act that creates the greatest good for the greatest number of
stakeholders should be selected. None of the stakeholders benefit from an action that misstates net income
other than Paul Henley and other executives who will receive greater bonuses if earnings targets are met or
exceeded.
Virtue Theory: Honesty requires that the statements should be truthful and recognize revenue using GAAP.
Objectivity requires that the company should approach its decision about the proper revenue recognition
procedure with fair-mindedness and without partially to one set of stakeholders. Trustworthiness means
that the accountants should not violate the investors’ faith that the statements are accurate and reliable.
Integrity requires that Sarah Young should have the moral courage to withstand Henley’s and Fralen’s
pressure, and not to subordinate judgment.
Questions
1. Describe the rules in accounting for revenue recognition in general and relate them to the two
transactions mentioned in the case. Be sure to include proper citations from the pronouncements
of the Financial Accounting Standards Board (FASB) and other relevant material. Do you believe
the transactions have been accounted for properly?
Revenue from the sale of goods should be recognized when it is both earned and realized or realizable. In
other words, the earnings process must be complete or virtually complete and the revenue measurable.
Important considerations in product sales are whether title and the significant risks and rewards of
ownership have passed to the customer. Free on board (FOB) terms, sales terms, and the entity’s business
The sale to DSS is not earned or realizable due to the agreement for Solution Networks to take the DSS
product thirty days later. The FOB shipping point is a valid argument only if all of Solution Networks
products are shipped FOB shipping point and the agreement with DSS noted the FOB shipping point terms.
2. Prepare the following schedules:
a. Percentage change in revenues from 2009 through the projected amounts in 2013.
Question 2 (a)
Year Revenues Net Income %Chg in Rev
2008 148 11.9
2009 175.8 13.2 18.78%
b. Percentage of net income to revenues from 2008 through the projected amounts in 2013.
Question 2 (b)(
Year Revenues Net Income %NI:Rev
2008 148 11.9 8.04%
2009 175.8 13.2 7.51%
2010 202.2 15.0 7.42%
c. Redo parts (a) and (b) assuming the DSS transaction is included in the projected results for
2013.
Question 2 ( c)
DSS transaction in
2013
Year Revenues Net Income %NI:Rev %Chg in Rev %Chg in NI
2008 148 11.9 8.04%
2009 175.8 13.2 7.51% 18.78% 10.92%
What questions might you raise from an ethical perspective with respect to these calculations and
the motivation for Paul Henley to include the DSS transaction in 2013?
What is the underlying motivation for Henley to record revenue in 2013? Is it to meet and
exceed market expectations? Since the firm became public in March 2013, has Henley
pushed to make numbers? Does he want the stock price to remain high? Does he have
3.Assume you are in Sarah Young’s position and have decided to try to change Paul Henley’s mind
with respect to the accounting for the December 28, 2013 transactions. What steps might you
take to counteract the position of Henley prior to the auditors’ arrival on February 1, and why?
Sarah should consider her position and options, but should not subordinate her judgment
to Henley. If Sarah gives in to the firm’s pressure to recognize revenue improperly, then
she is reasoning at Stage 3. Reasoning at stage 4 means Sarah is following the laws and
Sarah needs to identify enablers in this situation that can help counteract the pressure of
Henley. Sarah should explore going to the Audit Committee for help after exhausting all
