1. “To see what is right and not to do it is want of courage
“To see what is right and not to do it is want of courage.” (Confucius)

2. EARNINGS MANAGEMENT or FRAUD
A matter of intent: The result of appropriate decision making or judgments OR Motivated by a conscious effort to manipulate earnings for one’s advantage

3. Perceived
Need
FRAUD
Opportunity
Rationalization

4. EARNINGS MANAGEMENT TECHNIQUES
Recording revenue too soon
Recording fictitious revenue
Including one time gains in revenue
Shifting expenses to a later period (capitalizing an expense)
Failing to recognize liabilities
“Cookie jar” reserves
Shifting revenue to a later period
Accelerating discretionary expenses

5. Slippery Slope Starts with “making the numbers”
Then “managing the numbers”
Ends with “making up the numbers”
The jail

6. Ethical errors end careers more quickly and more definitively than any other mistake in judgment or accounting”
Solomon, 1994

7. RATIONALIZATIONS MANAGERS USE TO JUSTIFY SUSPECT BEHAVIOR
The activity is within reasonable ethical and legal limits (not really illegal or unethical)
Loyalty to the company
No one will ever know
I’m helping the company

8. Is it Fraud or Unethical? Legal Test
Quadrant I
Ethical and Legal
Quadrant II
Ethical and Illegal
Ethical
Professional and
Financial
Decisions
Financial Reporting Rules
Corporate
Decisions
Legal
Illegal
Quadrant IV
Unethical and Illegal
Quadrant III
Unethical and Legal
Unethical

9. Common types of financial statement fraud
Revenue recognition
Fictitious sales
Premature revenue recognition
Channel stuffing
Contingencies (not yet met)
Inventory and Cost of Goods Sold
Reserves
Foreign Corrupt Practices Act violations
Deloitte Dbrief 2008

10. Specific Revenue Recognition Issues that may Lead to Fraud
Sales contingencies not disclosed to accounting or management
Sales booked before delivery completed
Significant rights of return existed
Revenue recognized before underlying services were performed
False sales agreements and documentation
“Bill and hold” sales not deferred
“Round trip” transactions
Refundable membership fees

11. Revenue Recognition Issues
Bill and hold transactions
Long associated with financial fraud
Difficult substance over form questions
Customer agrees to purchase goods, but the seller remains in possession until the customer requests shipment
Look at inventory to determine whether there are goods that were billed to customers but not shipped or physically separated

12. Revenue Recognition Issues
Barter transactions
Two companies swap the same commodity with each company recognizing revenue from the exchange even though little of economic substance has actually transpired
“Round trip” transactions
Similar to barter except that one company sells a product for cash to another company, which in turn sells an equivalent product back to the initial seller for a similar price, with each company recognizing revenue on its “sale”

13. Revenue Recognition

14. Revenue Recognition: Basic Concepts
FASB Concept Statement #5 Revenue is recognized when it is:
Realized or
Realizable
Earned
and

15. Revenue Recognition Issues
Sales contingencies not disclosed to accounting or management
Sales booked before delivery completed
Significant rights of return existed
Revenue recognized before underlying services were performed
False sales agreements and documentation
“Bill and hold” sales
Long term service transactions
Bundled transactions
Up-front payment with continuing involvement
Gross or net reporting

16. SAB 101 – Basis for Revenue Recognition
Persuasive evidence of an arrangement exists
Sales generally evidenced by a written contract and a purchase order
Delivery has occurred or services have been rendered
Title and risk of loss have passed
Customer acceptance criteria considered
Undelivered elements?
This is in essence “Revenue Recognition Accounting 101.”

17. SAB 101 Seller’s fee is fixed or determinable
Extended payment terms
Rights of return
Refund, cancellation or termination clause
Collectibility is reasonably assured
History of concessions?
Credit worthiness of customer
Liquidated Damages and other penalties/rebates
Revenue should not be recognized until it is “realized or realizable” and the revenue is earned.

18. Delivery and Performance
Customer has taken title and assumed the risks and rewards of ownership of the products specified in the sales agreement
Product has been delivered to the customer’s place of business or another site specified by the customer

19. Delivery and Performance
If delivery has not occurred, the following criteria must be met:
Risk of ownership passes to the buyer
Buyer has a fixed commitment to purchase
Fixed schedule for delivery
No further seller-specific performance obligations
Segregated goods
Product must be complete and ready for shipment

20. Multiple-Element (or Bundled) Arrangements
Characteristics of these arrangements are:
Involve the delivery or performance of multiple products and services
Delivery may take place over varied lengths of time
May result in a significant impact to the timing of revenue recognition
Some elements are obvious, such as software and hardware products and services.
However, some are not, such as unspecified software upgrades and enhancements (PCS) ~ dot releases, free products, product credits, and future discounts.
For Non-SOP 81-1 arrangements (customized arrangements), if you don’t have “fair value” for the individual elements, revenue recognition can be severely impacted.

21. The following products or services are considered “elements” for purposes of applying accounting guidance
Services (i.e. NNSS, Software Release Service, etc.)
Extended warranty (separately priced and optional)
Future upgrades/enhancements (specified and unspecified)
Hardware/software
“Significant Incremental Discounts” on optional products/services
Engineering and installation
Training credits
Certain product credits
Other non-cash incentives

22. “REVENUE ARRANGEMENTS WITH MULTIPLE DELIVERABLES”
Issued in October ASU
Eliminates requirement to establish Fair value of all components
Requires use of VSOE or third party evidence, if available
Otherwise, use management’s estimated selling price (ESP)
Allocate based on estimated selling prices of all deliverables
No change to the “standalone value” criteria
Does not change previous rules (SOP 97-2…ASC ) or apply to software transactions

23. What this means
Previously all items had to have stand alone fair market value to be separated…otherwise no revenue was recognized until the bundled transaction was complete
New rules permit more liberal revenue recognition

24. ASU 2009-13, Multiple-Deliverable Revenue Arrangements – Basic Rule
Modified criteria now used to separate elements in a multiple-element arrangement
• Replaces the term “fair value” with “selling price”
• Introduces the concept of “best estimate of selling price” for determining the selling price of a deliverable
• Establishes a hierarchy of evidence for determining best selling price of a deliverable
• Requires the use of the relative selling price method and prohibits the use of the residual method to allocate arrangement consideration among units of accounting
• Expands the disclosure requirements for all entities with multiple-element arrangements

25. The Issues
Can you separate the components of the contract…do they have stand-alone value?
If they are separated, how do you allocate revenue to the separate components?
When is the revenue recognized?

26. New Rule Lessens Separation Requirements for Contract Components
Eliminates previous criterion that required objective and reliable evidence of fair value for the undelivered item(s).
Under previous guidance, evidence of fair value included either of the following:
Vendor-specific objective evidence (VSOE), which includes the price charged when the same element is sold separately or, for an element not yet sold separately, the price established by management with the relevant authority
Third-party evidence (TPE), such as competitors’ sales prices for the same or largely interchangeable products or services to similar customers in stand- alone sales, if VSOE is not available

27. Separate if Stand-alone value
An item has stand-alone value if either of the following conditions is met:
It is sold separately by any vendor.
The customer could resell the item on a stand-alone basis.
Determining whether stand-alone value exists is relatively straightforward when the item being evaluated is sold separately by the entity.

28. Example: Separating elements: stand-alone value of delivered item
Company A is a manufacturer of office equipment. On February 15, 20X0, Company A enters into an arrangement with Company B for the delivery and installation of a state-of-the-art color copier/printer and ongoing maintenance for three years. The equipment is delivered and installed on February 28, 20X0. Currently no competitors offer comparable color copier/printers. However, there is an observable secondary market for these color copier/printers. Company A has a history of entering into maintenance agreements with secondary owners of its office equipment.
Even though there are currently no competitors, Company A concludes that the color copier/printer has stand-alone value because a secondary market exists. The fact that company A provides maintenance services to secondary owners of its equipment supports the position that the copier/printer has stand-alone value in this arrangement.

29. Measurement – Selling Price
The amended guidance replaces the term “fair value” with “selling price” to clarify that revenue is allocated based on entity-specific assumptions rather than on market participant assumptions

30. ALLOCATING CONSIDERATION
Arrangement consideration should be allocated at the inception of an arrangement using relative selling prices
Subsequent changes in selling prices do not change initial allocation
Exceptions and qualifications
Only allocate revenue that is fixed and determinable
Amount allocated to delivered items is limited to amount that is not contingent on delivery of any undelivered item or meeting specified performance criteria
Measurement of revenue per period must assume customer will not cancel arrangement
Revenue recognized cannot exceed non-cancelable amounts
Other GAAP requires deliverable to be recorded at Fair Value

31. Hierarchy of Evidence for Determining each Unit’s Selling Price:
1. VSOE
Vendor-specific objective evidence (VSOE), which includes the price charged when the same element is sold separately or, for an element not yet sold separately, the price established by management with the relevant authority
2. TPE in the absence of VSOE
Third-party evidence (TPE), such as competitors’ sales prices for the same or largely interchangeable products or services to similar customers in stand-alone sales, if VSOE is not available
3. Best estimate of selling price only in the absence of both VSOE and TPE
best estimate of selling price, management should consider market conditions in addition to entity-specific factors (This is the new addition)
Now required for delivered and undelivered elements
- Allocate arrangement consideration on pro rata basis
- Residual method no longer allowed

32. Level 1 - VSOE
VSOE = Price charged when same element is sold separately
Minimal authoritative implementation guidance
Bell-curve approach – Generally used in practice
Example - 80% of separate sales within +/- 15% range

33. Level 2 Third Party Evidence
Third-party evidence (TPE), such as competitors’ sales prices for the same or largely interchangeable products or services to similar customers in stand-alone sales, if VSOE is not available

34. New: Level 3 – Best Estimate of Selling Price
Consider market conditions…include:
Overall economic conditions
• Customer demand for the deliverable(s)
• Impact of competition for the deliverable(s)
• Profit margins realized by entities in the industry

35. Consider the Following Entity-specific Factors, in Developing Best Estimate of Selling Price
Pricing practices for the deliverables, including discounts (i.e. volume discounts)
Costs incurred by the entity to provide the deliverables
Profit objectives for the deliverables
In a services arrangement, it may be practicable for a customer to perform certain services themselves
potential costs savings by the customer would be considered in determining its gross profit margins.

36. Entity A, with a December 31, 2009 year-end, sells equipment Y and Z, both with stand-alone value, to Entity B. Total arrangement consideration is $150,000. There are no return rights for Y and no refund rights if Z is not delivered. Equipment Y is delivered on December 15, 2009 and Z is delivered on April 15, Entity A has determined its best estimate of selling price for Y and Z is $100,000 and $50,000, respectively. Entity A has historically and continues to establish TPE of $110,000 for equipment Y.
Under previous guidance in ASC , since Entity A lacks objective and reliable evidence of fair value for the undelivered element (Z), the arrangement is a single unit of accounting. Revenue of $150,000 is
deferred until Z is delivered in April 2010, assuming all other revenue recognition criteria are met.
Under the amended guidance, the hierarchy requires that VSOE and then TPE, be considered first. Since TPE exists for equipment Y, that amount will be used for allocation. The discount is allocated ratably between equipment Y and Z under the relative selling price method. As such, $103,125 [($110,000/$160,000) x $150,000] is recognized when Y is delivered in December 2009, and $46,875 [($50,000/$160,000) x $150,000] is recognized when Z is delivered in April 2010, assuming all other revenue recognition criteria are met.

37. ESTIMATING SELLING PRICES
ESP is not the same as fair value
Level of support for estimated selling prices
Consider available evidence
Develop a methodology and consistently apply
Monitor for changes – Changes could occur mid-period or even daily!
No requirement for ability to reasonably estimate
Estimated selling prices can vary by customer class or geography
Ok to consider cost plus a standard profit margin as support
Some estimates likely to be quite subjective in nature

38. Example 1 – When to use a best estimate of selling price
On January 1, 20X0, Entity E, an equipment manufacturer, enters into a multiple-element arrangement to manufacture and deliver equipment A, B, and C on July 1, 20X0, October 1, 20X0, and January 1, 20X1, respectively, for total consideration of $760,000. All of the deliverables meet the separation criteria in ASC , and as a result, Entity E would account for each element in this arrangement as a separate unit of accounting. Entity E has VSOE for equipment A and TPE for equipment B, but does not have VSOE or TPE for equipment C.
Because Entity E does not have VSOE or TPE for an element that meets the other separation criteria in ASC , management must determine its best estimate of selling price for equipment C.

39. Example 2 – Best estimate of selling price: equipment
On January 1, 20X0, Entity E, an equipment manufacturer, enters into a multiple-element arrangement to manufacture and deliver equipment A, B, and C on July 1, 20X0, October 1, 20X0, and January 1, 20X1, respectively, for total consideration of $760,000. Stated contract prices are $185,000 for equipment A, $265,000 for equipment B, and $310,000 for equipment C. The deliverables all meet the separation criteria in ASC , and as such, Entity E would account for each element in this arrangement as a separate unit of accounting. Because Entity E does not have VSOE or TPE for any of these products, it must estimate the selling price for each deliverable.
Entity E considered the following factors in determining its best estimate of selling price for equipment A, B, and C.

40. SolvGen - Deliverables
ASC , Revenue Recognition: Multiple- Element Arrangements
ASC , Revenue Recognition: Milestone Method
ASC , Revenue Recognition: Construction-Type and Production-Type Contracts
ASC , Research and Development: Research and Development Arrangements
ASC , Software: Revenue Recognition

41. Deliverables
Alternative 1 — The arrangement consists of one deliverable: the sale of future proprietary instrument systems under the license and distribution agreement.
evaluated as a single arrangement because the two agreements were entered into by the same parties at the same time and in contemplation of each other.
Does not represent a borrowing

42. Alternative 1
Proponents of Alternative 1 believe that without the license and distribution agreement, the research and development agreement is of no value to Careway. Under the terms of the research and development agreement, Careway is not entitled to any of the intellectual rights of the research and development activities or findings (even in the event of default) and therefore cannot use or sell those findings. Accordingly, the only way in which Careway derives any benefit from the contractual arrangements with SolvGen is through Careway’s future distribution of the proprietary instrument systems to third- party customers.

43. Alternative 1 proponents contend that the arrangement is, in substance, one agreement to license and distribute the instrument systems and that the milestone payments are merely up- front payments for the right to license and distribute instrument systems in the future. Consequently, proponents of Alternative 1 believe the milestone payments are analogous to advance payments or up-front fees and do not reflect payments for “deliverables,” as nothing is delivered to Careway in exchange for those payments.

44. Codification example

45. Alternative 2
The arrangement consists of two deliverables: (1) research and development and
(2) the sale of future proprietary instrument systems under the license and distribution agreement
rejected because SolvGen retains the right to all the research and development findings in all instances, nothing delivered to Careway is associated with the research and development activities, and the research and development agreement is of no value to Careway without the license and distribution agreement on a standalone basis. Therefore, in this case the research and development activities do not represent a deliverable.

46. Accounting Alternatives
1 — The milestone payments should be recognized as revenue beginning with the commercial launch (i.e., March 31, 2006) of the instrument system over the remaining term of the license and distribution agreement on a pro rata basis as products are distributed under the license and distribution agreement.
the milestone payments received to date by SolvGen are analogous to upfront payments and should be deferred and amortized as revenue beginning with the date of the commercial launch of the product

47. Proponents of Alternative 1 believe that recognizing revenue related to nonrefundable milestone payments before the commercial launch date of the product amounts to recognizing revenue before a deliverable being provided to the customer, Careway. Before the commercial launch date, there is no product that Careway can buy from SolvGen and sell to a third party, and therefore Careway has received no benefit under the agreements with SolvGen. Therefore, the commercial launch date is the point in time that Careway can begin to recognize any benefits under the agreements by purchasing the instrument systems from SolvGen and selling those instrument systems to third parties.

48. Alternative 2 — The milestone payments should be recognized as revenue on a straight-line basis beginning with the date such payment is made over the remaining term of the license and distribution agreement

49. Alternative 2 proponents also believe that the amortization of the up-front fees should begin once each milestone payment has been received. Proponents of Alternative 2 contend that this approach is consistent with the SEC guidance stated above and results in recognizing the milestone payments in a systematic, rational manner over the remaining term of the license and distribution agreement. Proponents of Alternative 2 also note that the milestone payments are nonrefundable and that services (i.e., research and development activities) have already been provided. Therefore, proponents of Alternative 2 do not believe it is necessary to wait until the commercial launch date of the instrument system to begin recognizing revenue for payments received

50. Alternative 3 — The milestone payments should be recognized as revenue when received.
Alternative 3 proponents note that the development of the proprietary instrument systems began before SolvGen and Careway entered into their contractual arrangements and believe the substance of the milestone payments is to compensate SolvGen for its past research and development activities.

51. Alternative 4 — The milestone payments should be recognized as revenue on a straight-line basis beginning with the commercial launch (i.e., March 31, 2006) of the instrument system over the remaining term of the license and distribution agreement.
Same as 1 only straight-line

52. Alternative 1 Selected
if the Company can demonstrate the ability to reliably estimate sales of the proprietary instrument systems over the five-year license and distribution agreement period.
2 was rejected because while proponents of Alternative 2 considered the milestone payments to be analogous to up-front payments, they ignored the conclusion in the first question that there is only one deliverable in the arrangement

53. 3 was rejected because at the time the payments were made, there was no exchange of significant value between the two parties
SolvGen has a continuing obligation to manufacture and supply instrument systems to Careway. In signing the agreements and in making the milestone payments, the customer, Careway, is purchasing rights to sell the instrument systems. SolvGen, in signing the agreement and receiving the milestone payments, is obligated to supply future instrument systems to Careway. Therefore, SolvGen has an integrated package of performance obligations that are not discrete earning events and that ultimately relate to Careway’s ability to sell future products and SolvGen’s continuing obligation to provide those products.

54. mixed views regarding Alternative 4
mixed views regarding Alternative 4. Some may reject Alternative 4 because while the commercial launch date is the appropriate date at which to begin amortizing the payments, the payments are, in substance, an advance payment for the distribution of future instrument systems and therefore those payments are earned as the instrument systems are delivered — not on a straight-line basis. However, others believe that Alternative 4 may be acceptable under existing GAAP. That is, some believe that a multiple attribution revenue recognition model, whereby the milestone payments are recognized on a straight line basis and instrument sales are recognized as instrument systems are sold, is also acceptable.

55. IFRS
Although significant judgment must be applied, it is unlikely that the case solution under Discussion 1 would change under IFRSs. The research and development agreement and the license and distribution agreement should be evaluated as a single arrangement because the two agreements were entered into by the same parties at the same time and in contemplation of each other