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

A matter of intent:

The result of appropriate decision making or judgments

ORMotivated by a conscious effort to manipulate earnings for one’s advantage

EARNINGS MANAGEMENT or FRAUD

3

Perceived Need

Opportunity Rationalization

FRAUD

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

EARNINGS MANAGEMENT TECHNIQUES

5

Starts with “making the numbers”

Then “managing the numbers”

Ends with “making up the numbers”

The jail

Slippery Slope

6

Ethical errors end careers more quickly and more

definitively than any other mistake in judgment or

accounting”Solomon, 1994

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

RATIONALIZATIONS MANAGERS USE TO JUSTIFY SUSPECT BEHAVIOR

Is it Fraud or Unethical?Legal Test

Ethical

Unethical

IllegalLegalCorporate

Decisions

Financial Reporting Rules

Professional andFinancialDecisions

Quadrant IIEthical and Illegal

Quadrant IEthical and Legal

Quadrant IVUnethical and IllegalQuadrant III

Unethical and Legal

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

Common types of financial statement 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

Specific Revenue Recognition Issues that may Lead to Fraud

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

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”

Revenue Recognition Issues

13

Revenue Recognition

14

FASB Concept Statement #5Revenue is recognized when it is:

Revenue Recognition:Basic Concepts

Realized orRealizable

Earnedand

15

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

Revenue Recognition Issues

16

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?

SAB 101 – Basis for Revenue Recognition

17

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.

SAB 101

18

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

Delivery and Performance

19

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

Delivery and Performance

20

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

Multiple-Element (or Bundled) Arrangements

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

Issued in October 2009 - ASU 2009-13 Eliminates requirement to establish Fair value

of all componentsRequires 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 985-605) or apply to software transactions

“REVENUE ARRANGEMENTS WITH MULTIPLE DELIVERABLES”

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

What this means

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

ASU 2009-13, Multiple-Deliverable Revenue Arrangements – Basic Rule

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?

The Issues

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

New Rule Lessens Separation Requirements for Contract Components

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.

Separate if Stand-alone value

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.

Example: Separating elements: stand-alone value of

delivered item

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

Measurement – Selling Price

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

ALLOCATING CONSIDERATION

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

Hierarchy of Evidence for Determining each Unit’s Selling Price:

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

Level 1 - 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

Level 2 Third Party Evidence

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

New: Level 3 – 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.

Consider the Following Entity-specific Factors, in Developing Best Estimate of Selling Price

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, 2010. 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 605-25, 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.

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

ESTIMATING SELLING PRICES

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 605-25, 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 605-25, management must determine its best estimate of selling price for equipment C.

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. 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 605-25, 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.

Example 2 – Best estimate of selling price: equipment

ASC 605-25, Revenue Recognition: Multiple-Element Arrangements

ASC 605-28, Revenue Recognition: Milestone Method

ASC 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts

ASC 730-20, Research and Development: Research and Development Arrangements

ASC 985-605, Software: Revenue Recognition

SolvGen - 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

Deliverables

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.

Alternative 1

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.

Codification example 605-25-55-37

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.

Alternative 2

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

Accounting Alternatives

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.

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

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

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.

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

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

Alternative 1 Selected

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.

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.

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

IFRS