Case 7-2 Edvid - Teaching Notes Case 7-2 Edvid Teaching Notes This case provides an opportunity to discuss

with students the revenue recognition rules under GAAP. Ethical Issues Revenue recognition rules require that revenue should be matched with the costs. The company and its top management should anticipate that auditor will carry out their responsibilities in a reliable and dependable manner. Hutton and the accounting firm are obligated to honor the public trust and maintain their integrity. Differences of opinion with a client on an accounting matter should be resolved by reference to the proper accounting rules, and the firms position should be consistent with its public interest obligation. The investors, creditors and suppliers rely on the accuracy of the financial information. If the revenue is manipulated then these users will be making investment decisions based on incorrect information. The users of financial statements expect independent auditors to be honest and trustworthy so that the users do, in fact, receive reliable information. Questions 1. Explain why you think Hutton was concerned with Muttons delaying the recognition of 70 percent of the revenue? What do you think Hutton meant by his desire to exercise due care? Hutton was concerned with the delay in recognition of revenue as it is a manipulation of revenue. Anytime there is manipulation of revenue and expenses the auditor needs to exercise due care, research the proper treatment and make sure that GAAP is being followed. 2. Compute the following: a. The amount of profit on each contract to sell ten DVDs over a two-year period? $1,000 (10 x $50) = $500 profit over two year period. b. The percentage increase in revenue from 2004 to 2005 and 2005 to 2006. ($129 - $108)/$108 x 100 = 19.4% c. The percentage increase in net income from 2004 to 2005 and 2005 to 2006. ($156 - $129)/$156 x 100 = 20.9%

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Case 7-2 Edvid - Teaching Notes

3. Describe the rules for recognizing revenue in accounting? Do you think Edvid violated those rules? Why or why not? Revenue should be recognized when it is both earned and either realized or realizable (Concept Statement No. 5). As stated in Concept Statement No.5, revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. This may be delivering goods, performing services, providing information, or any other activity for which one entity would pay another entity. The acts the seller performs to fulfill the earned criteria are termed the earnings process. The four conditions for recognition are 1) persuasive evidence of an arrangement exists; 2) the arrangement fee is fixed or determinable; 3) delivery or performance has occurred; and 4) collectibility is reasonably assured. Edvid has an earnings process and delivery of product over a two-year period. The revenue should be spread equally (50/50) over the two-year period. Edvid has violated those rules by using a 30/70 spread over the two-year period. 4. Is there anything wrong with what Edvid is doing in recording contract revenue? Be sure to use specific ethical values, virtues and standards of behavior in supporting your answer. Edvid is not complying with GAAP by using a 30/70 spread over the two years instead of 50/50 spread. Edvids agreements are where the rentors periodically withdraw material from a continuously updated library. Edvids costs are predominately associated with fulfilling the rental agreement as assets are checked out, not with initial costs. The actions of Hutton and the firm will violate the integrity standard of the AICPA Code of Professional Conduct if the clients judgment is given priority over professional judgment. GAAP standards (Rule 203) also will be violated because the firm should not go along with a client when there is a material departure from GAAP. 5. Who are the stakeholders affected by Edvids action? How are they affected? The stakeholders are the public, creditors, suppliers, customers, employees, and regulators. These stakeholders rely on the accuracy of the financial information. If the revenue is manipulated then these users will be making investment decisions based on incorrect information. The users of financial statements expect independent auditors to be honest and trustworthy so that the users do, in fact, receive reliable information. 6. If you were in Charles Huttons position, what would you do? Why? Charles Huttons position should be to follow GAAP and not to subordinate his judgment.

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Case 7-2 Edvid - Teaching Notes

7. Hutton approaches Mutton with this information and states emphatically that the numbers must be changed for the past three years. Mutton refuses to do so and informs Hutton that the accounting is justified based on the long-term interests of Edvid. a. Do any accounting issues exist that Hutton might use to try and influence Muttons decision? Be specific. Hutton should use Accounting Concept Statement No. 5, SFAS No. 48 Revenue Recognition Where Right of Return Exists, and Emerging Issues Task Force 01-8 Determining Whether an Arrangement Contains a Lease. b. What ethical values might drive Hutton in formulating an argument to use in his discussions with Mutton? Hutton could use rights, justice, utilitarianism, and virtue theories in his discussion with Mutton. From a rights perspective, 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. From a justice perspective, stakeholder interests are not fairly represented because the perceived interests of the management are given priority over the interest of all other stakeholders. Rule-utilitarianism requires that the correct rule should be followed. 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. From virtue perspective, honesty, objectivity, trustworthiness, and integrity should be considered. Honesty requires that the statements should be truthful and recognize revenue using generally accepted accounting principles. 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 Hutton should have the moral courage to withstand Muttons pressure, and not to subordinate judgment. c. Are there any provisions of the AICPA Code of Professional Conduct that apply to the situation discussed by Hutton and Mutton? Be specific in answering this question. Rule 102 (Integrity and Objectivity), Rule 202 (Compliance with Standards), and Rule 203 (Accounting Principles) apply to the situation discussed by Hutton and Mutton.

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