“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, 2019, 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, 2018. Both
Young and Henley are CPAs.
Young has excluded the amount in contention from revenue and net income for 2018, but Henley wants
the amount to be included in the 2018 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, 2018, 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 2019. 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, 2018, when the software product was shipped FOB shipping point.
Background
Solutions Network, Inc., became a publicly owned company on March 15, 2014, 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
- The revenue and earnings streams during those years are as follows:
The Transaction
On December 28, 2018, 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
In her discussions with Henley, Young points out that the auditors will arrive on January 15, 2019;
therefore, the company should be certain of the appropriateness of its accounting before that time.
After all, says Young, “the auditors rely on us to record transactions properly as part of their audit
expectations.” At this point Henley reacts angrily and tells Young she can pack her bags and go if she
doesn’t support the company in its revenue recognition of the DSS transaction. Young is taken aback.
Henley seems unusually agitated. Perhaps he was under a lot more pressure to “meet the numbers”
than she anticipated. To defuse the matter, Young makes an excuse to end the meeting prematurely and
asks if they could meet on Monday morning, after the weekend. Henley agrees.
Over the weekend, Sarah Young calls her best friend, Shannon McCollough, for advice. Shannon is a
controller at another company and Sarah would often commensurate with Shannon over their mutual
experiences. Shannon suggests that Sarah should explain to Paul Henley exactly what her ethical
obligations are in the matter. Shannon thinks it might make a difference because Paul is a CPA as well.
After the discussion with Shannon, Sarah considers whether she is being too firm in her position. On the
one hand, she knows that regardless of the passage of title to DSS on December 31, 2018, 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 because DSS did not complete its portion of the agreement by that date. She has her
doubts whether the auditors would sanction the accounting treatment.
On the other hand, Sarah is also concerned about the fact that another transaction occurred during the
previous year that she questioned but, in the end, went along with Paul’s accounting for this
transaction. On December 28, 2017, Solutions Network sold a major system for $20 million to Laramie
Systems but executed a side agreement with Laramie on that date which gave Laramie the right to
return the product for any reason within 30 days. Even though Solutions Network recorded the revenue
in 2017 and Sarah felt uneasy about it, she did not object because Laramie did not return the product;
her acceptance was motivated by the delay in the external audit until after the 30-day period had
expired. Now, however, Sarah is concerned that a pattern may be developing.
Questions - What are the main arguments Sarah is trying to counter? That is, what are the reasons and
rationalizations she needs to address in deciding how to handle the meeting with Paul Henley? - What is at stake for the key parties in this case? What are Sarah’s ethical obligations to them?
- Should Sarah’s decision on revenue recognition in 2017 influence how she handles the DSS
transaction? Explain. - Should Sarah follow Shannon’s advice? What if she does and Paul Henley does not back off?
What additional levers can she use to strengthen her position? - What is the most powerful and persuasive response to the reasons and rationalizations Sarah
needs to address? To whom should the argument be made? When and in what context? - What should Sarah do next if all parties at Solutions Network support Paul Henley’s position and
flat out tell Sarah to be a team player?
