Revenue Recognition Procedures And Informix's Reason example essay topic

... MEMORANDUM Date: February 22, 2005 To: Deborah Jones, Coordinator of WSU-Financial Accounting Research Program From: Alina Tous ain, Sruti Lik hite, Karthik Krishnamurthy Re: Group 2 - Case 2.1 "Software Revenue Recognition: Informix Corporation " Companies following GAAP can manage earnings by simply altering its accounting policy to select those accounting principles that benefit them the most. Entities have a host of reasons for selecting those principles that will paint the rosiest financial picture. Some would argue that the market demands it, as reflected by the stock price punishment for companies that differ by as little as one penny per share from prior estimates. External market pressures to "meet the numbers" conflicts with market pressure for transparency in financial reporting. Most fraudulent financial reporting schemes involve "earnings management" techniques, which inflate earnings, create an improved financial picture, or conversely, mask a deteriorating one.

Premature revenue recognition is one of the most common forms of fraudulent earnings management and the case of Informix Software Inc. unfortunately illustrates closely this practice. The analysis of this case will shed light on issues like: vs. Informix's revenue recognition policy prior to 1990 and its compliance with FASB Concept #5, FASB Statement #86, GAAP protocols. vs. Informix's reactions to AICPA SOP in changing the revenue recognition procedures and Informix's reason to prematurely and voluntarily implement the new policy The changes that took place at Informix and the financial results reported during 1990 Furthermore, we will also evaluate the software industry practices and the regulations in place at that time. We conclude with lessons learnt and recommendations towards identifying and discouraging non-GAAP revenue recognition practices. 1986-1990 Revenue Recognition Policy at Informix Corporation REVENUE RECOGNITION POLICY BEFORE THE PROPOSED AICPA SOP Prior to 1990 the software industry had the FASB Statement of Financial Accounting Concept No. 5 and the FASB Statement No. 86 to provide guidance in the revenue recognition concepts.

The Accounting Research Bulletin (ARB) No. 45 which discussed long-term construction type contract was also available but did not specify application for the software industry and so it was ignored. Before 1990 (refer exhibit 1) Informix recognized product revenue - general contracts for sale of software license - at the time of shipment and thus in accordance with FASB. The nonrefundable license fee contracts were recognized at contract signing thereby deviating from FASB's inference and thus violating GAAP's Conservatism Principal. The revenues recognized at the time of contract signing were neither realized nor earned, which led to an overestimate of Net Income in Informix's financial statements. The revenues from maintenance contracts were recognized over the term of the contract conforming to GAAP and finally the research and development costs were amortized on a straight-line basis over the life of the product, deviating from FASB statement no. 86 Due to the fact that majority of the revenues for Informix were from contract licensing, one can imply that GAAP's Matching Principle was violated due to the fact that the revenues were recognized much earlier than the effort in building the software or providing the service. Thus, the company failed to match the accomplishments with the expenses, which also resulted in the overstatement of accounts receivables.

Informix's financial statements indicated a significant increase in net income (22.8% on 40.1% increase in revenues) and accounts receivables (28.4%) in 1989 from 1988. Informix's Notes to Consolidated Financial Statements as of December 31, 1989 indicated existing high accounts receivable balance, pertaining to the remaining un billed balance of the already recognized revenue, probably the result of bad debt. Allocating for proper bad debt expense would have better aligned the accounts receivables thereby providing for a truer statement than provided. Also Informix's profit margin on sales year over the year declined from a high of 12.8% in 1986 to a low of 4.4% in 1989.

This indicates that revenues were being booked early and expenses and costs were catching up in later years especially with the application of research and development costs. INFORMIX CORPORATION AT CROSS ROADS In the early 1990's, due to the above mentioned irregularities in the application of the revenue recognition policies by the software industry, AICPA through its Statement of Position (SOP) decided to take a leadership role in providing guidance on financial reporting topics till the FASB set standards on the issues in question. AICPA clearly sought to provide guidance for the industry, which many perceived as questionably applying the revenue recognition principle. Also there was the need to eliminate a conflict of interest that existed between a manager's responsibility towards the company and the financial community and their personal interests of wealth maximization.

AICPA's primary goal was to eliminate the artificial inflation or deflation of the stock price and increase the confidence in the information published through the financial statements. The basic idea that revenue was being recognized even when the actual product was not delivered probably moved AICPA to provide guidance that matched with the FASB's conceptual framework of SFA C No. 5. But the main reason to change the revenue recognition policy was to stop the industry from overstating the current period's revenues at the expense of future period's income. Even before the new AICPA SOP was implemented and adopted by the Software Industry at large, Informix surprised everybody with its announcement of implementing the new policy retroactively to January 1, 1990. Informix reported that year an operating loss of $18.7 million compared to 1989, after an increase of $10.9 million in the operating income between 1988 and 1989, this suggests that Informix hoped to disguise their reported results on the upcoming AICPA guidance rather than have auditors and investors examine their operating income in detail. (Needless to say that there were clues that dictated the need to cover the troubles that were already published in the consolidated financial statements IAM NOT SURE I UNDERSTAND THIS) (refer exhibit 2).

After the adjustments were made for year 1990, the following took place Short term ability to pay debt and the immediate liquidity decreased significantly vs. Unexplained decrease in accounts receivable turnover from 190 days to 140 days was reported The ratio of credit sales to cash sales decreased 26.78 times from 1989 to 1990, after a sudden increase from 3.79, to 25.73 times between 1988 and 1989 All the above were possible signs of accounts receivable manipulations. Other possible troubles that might have determined Informix's management to act fast on the regulation change could be: vs. Shipping unfinished or incomplete software packages to customers, or at a time prior to when the customers were ready to accept them, which could be explained by the increased portion of "not yet due accounts receivable" from $34 million to $44 million reported in the adjusted pro-forma report of 1989 vs. Engaging in "Soft Sales"vs. Recognizing the full amount of revenue on contracts prior to completion of servicing the client, for example the case of the licensing software contracts which were completed, tested and shipped after the revenue was recognized Thus, Informix had numerous incentives to proceed ahead with accepting the proposed AICPA changes, but only a thorough analysis of prior, current and adjusted financial statements, interviews with responsible parties of the company and an outside firm's relationship will give us a concrete answer to Informix's real reason. This should have been the job of the auditors, the SEC and the company management team. INFORMIX SOFTWARE INC.

DURING & AFTER 1990 After 1990 the software industry had the AICPA SOP 91 and the accounting Bulletin Research No. 45 to provide guidance in the revenue recognition concepts (refer exhibit 3). They included specifications with regard to revenues from sales of software contracts, sale of customized software products, training & consulting services, maintenance contracts, capitalization and amortization of R&D costs and even the treatment of revenues from sales of products with uncertainty in the collectibles rates and return rates. During 1990 Informix had aligned its revenue recognition procedures closely with the new regulations. But the revenues from its core activities - fees from software licenses and income from end-users, resellers and hardware manufacturers, were still problematic. The company continued to recognize unrealized revenues (those that could not be readily converted to cash) at the time the contract was signed, or when the contract became due within 12 months in spite of AICPA requirements to recognize it when earned or realized. Also this meant that on some occasions they were going to recognize all the revenue at the beginning of the 12 months, even though they had to recognize only a percentage based on the completion of the contract or software package.

In other cases, Informix Software was going to recognize revenue at the earliest on either prepayment of license fee or shipment of software per unit basis. If a contract requires the seller to provide "multiple deliverable's", the delivery is not deemed complete unless substantially all elements or deliverable's are delivered. The sales revenue should be recognized only if inconsequential elements remain to be delivered. Thus, Informix chose again to report some revenues in a way that would require further examination to determine their conformance to GAAP, which meant additional information hidden from investors. The financial results of the Informix's newly adopted revenue recognition policy can be assessed with the help of the profitability ratios and the difference between the unadjusted and adjusted results registered by the company starting 1986 through 1990 (refer exhibit 4). Also the consolidated statements of operations and cash flows inform us about the quality of earnings.

The most dramatic differences between the results reported by Informix and the results it should have reported, are obvious in the last 2 years (1989 & 1988) before the change was implemented. The Net Revenues were overestimated by $13.5 million on average and the Net Income (Loss) was over $10.5 million on average, which determined an overestimate of Net Income per Share of 90 cents, while the Total Assets were overvalued $24.5 million on average., Lessons Learnt Because the software industry was relatively new prior to 1990 and specific accounting rules from any GAAP recognized literature was not forthcoming, specifically regarding revenue recognition, Informix cannot be unilaterally blamed for its practices and results. The company was adhering to the general aggressive practices prevalent in the software industry and was "customizing" the regulation that existed to its needs. If SEC did not bother for 5 years to implement new rules and the auditors were negligent in evaluating the impact of the aggressive application of revenue recognition protocols by Informix, it was clear that the managers would be concerned only with making the numbers look good. The conflict of interest that existed took its toll on the company's true bottom line until the circumstances permitted the company to find an alternate excuse for its irregularities. Thus, Informix can be fully blamed for its unethical conduct, which classically resulted in sufferance, by its shareholders, when the reality was unveiled.

The net income generated by each dollar sale was 36 cents lower, earnings per share were down $4.13 and the percentage of assets provided by creditors were up 17%. Even though the management tried quickly to remedy the situation, they still have not complied in entirety to GAAP protocols. This situation should not be overlooked due to its negative impact (distrust) in the integrity of the company's financial reports and the danger of creating an economy with form but without content (no real growth). Of course the blame can be shifted between parties, but it is more important that the lessons be learnt by all of us and the auditors, specifically when reviewing for and investigating allegations of improper revenue recognition: vs. Focus upon terms governing (i) payment and shipment, (ii) delivery and acceptance, ( ) risk of loss, (iv) terms requiring future performance on the part of the seller before payment, (v) payment of up-front fees, and (vi) other contingencies vs. Consider timing - particularly as it relates to the company's quarter and year-end period sv Inquiry of management and other relevant personnel as to the existence factors causing the auditor to believe the scheme exists Confirmation with customers about the existence of accounts receivable and the amount of consigned good sv Possible public records / background research / site visits conducted on customers / third parties to verify existence of the entity being billed; vs. Analyzing journal entry activity and supporting documentation in certain accounts, focusing on round dollar entries at the end of period sv Calculate changes in the liquidity, activity, profitability and coverage ratios The auditors should take all of the above recommendations seriously, as it is their job to protect the interests of all investors from fraudulent activities of any publicly traded company. In April of 1997, nearly 10 years after the near-death episode of the late 1980's, the price of Informix stock plunged.

Disappointing profits were blamed on marketing overemphasis of the Informix-Universal Server and neglect of the core relational database business. Informix Software Inc. Phase Two After about a decade, the CFO announced again that the sales-recognition policies were being upgraded to conform to national accounting standards and one of the consequences of this change would be that earnings for several previous quarters needed to be restated. NASDAQ and the Investment community were not amused. Internal critics, who had long argued that Informix ought to use its products to keep its own books, felt vindicated but economically insecure.

These problems were similar to the ones that Informix and other database vendors had faced in the early 1990's but this was the second episode for Informix. At this point, about a quarter of their workforce, suspecting that their stock options might not regain a positive value for a few years, sought new lives elsewhere or exploited their Informix expertise working for resellers and other partners of Informix. May of 1999 brought a resolution that settled claims arising from the 1996-97 sales-recognition debacle of $142 million. Of this total, Informix paid $3.2 million in its own cash and another $91 million in stock, with third parties providing the rest. Though large by the standards of Silicon Valley class-action lawsuits, the settlement left Informix with a good cash position and with only single-digit dilution of the stock value. It also removed the uncertainty that some investors associated with pending litigation.

IBM's acquisition of the brand in 2001 caused a seismic shift in the technical support, marketing and future of the Informix products. However with IBM's excellent track record, there is now a bright and assured future for Informix. EXHIBIT 1 Revenue Recognition Before Proposed AICPA SOP Rule to follow: FASB Concept # 5 & FASB Statement #86 General Contracts for Sale of Software License Nonrefundable License Fee Contracts Service Revenue R&D Costs At the Time of Delivery / Shipment when the Revenue is realized and earned Implied:" At the Time of Delivery / Shipment when the Revenue is realized and earned' At the time Service is rendered, when the Revenue is earned & realized Capitalized & Amortized when the technological feasibility of a product is established Revenue Recognition at Informix Before Proposed AICPA SOP General Contracts for Sale of Software License Nonrefundable License Fee Contracts Maintenance Service R&D Costs At the Time of Shipment At Contract Signing or when the Contract Amount Becomes Due within 12 months Over the Term of the Contract Capitalized & Amortized on a straight line basis over the life of the product EXHIBIT 2 Comparative Financial Ratios at Informix Software End of Year 1990 End of Year 1989 Changes 1989 to 1990 Liquidity Current Ratio 1.67 2.94 1.27 Times Decrease Quick Ratio 1.46 2.68 1.22 Times Decrease Activity Receivable Turnover 2.60 1.92 A. R Turnover Equivalent Days 140.35 190.05 83.04 Days Decrease Receivable Allowance 0.03 0.02 1% Increase Ratio of Credit Sales To Cash Sale -1.05 25.73 26.78 Times Decreased Profitability / Coverage Profit Margin on Sales -0.32 0.04 36 Cents Decrease Rate of Return on Assets -0.37 0.05 42 Cents Decrease Earnings per Share -3.65 0.48 4.13 Dollars Decrease Debt to Total Assets 0.65 0.48 17% Increase EXHIBIT 3 Revenue Recognition After Proposed AICPA SOP Rules to follow: AICPA SOP 91 & Research Bulletin #45 General Contracts for Sale of Software License Customized Software Products / Long -Term Construction Type Contracts Training, & Consulting / Other Services Prices Separately Maintenance Contract / Post Contract Customer Support After Delivery, Contracts with significant uncertainty regarding customer Acceptance After delivery, Contracts with significant Uncertainty of Collectibles R & D Costs Revenues from Resellers, Hardware Manufacturers and End-users Upon Delivery of the Finished Software; Using the Percentage-of-Completion method or as production takes place As service is performed or rat ably over the period during which service is performed Ratable over the Term of the Contract Recognized only after the uncertainty was removed Recognized using the Installment method or Cost-Recovery method Capitalized & Amortized when the technological feasibility of a product is established NOT SPECIFIED Revenue Recognition at Informix After the Proposed AICPA SOP General Contracts for Sale of Software License Customized Software Products / Long -Term Construction Type Contracts Training, & Consulting / Other Services Prices Separately Maintenance Contract / Post contract Customer Support After Delivery, Contracts with significant uncertainty regarding customer Acceptance After delivery, Contracts with significant Uncertainty of Collectibles R & D Costs Revenues from Resellers, Hardware Manufacturers and End-users At the Time of Shipment At Contract Signing, if a master or first copy of the license is delivered and the buyer and seller meet certain criteria; or when the Contract Amount Becomes Due within 12 months At the time service is performed Over the Term of the Contract NOT SPECIFIED NOT SPECIFIED NOT SPECIFIED At the Earliest of either Prepayment of License Fee or Shipment of Software per-unit basis.