2.99 See Answer

Question: You couldn’t be more excited about

You couldn’t be more excited about being on your first financial statement audit as you launch into your new professional accounting career. Having recently graduated with a Master of Accountancy degree, you are thrilled to be employing all the skills acquired in your rigorous accounting program.
The client engagement you’re now working on is Longeta Corporation, which is a California-based developer and marketer of software used to manage data storage functions for complex computer networks. Longeta particularly markets its products to other companies who serve as intermediaries for government purchasers.These intermediaries purchase Longeta’s products and then “resell” them to government purchasers and other organizations. The company’s stock is quoted on the NASDAQ National Market System.
The audit manager in charge of the engagement assigned you responsibility for auditing revenues for Longeta. You are excited to be in charge of this highly significant account and are enjoying the work you’ve done so far in the audit of some of the significant revenue transactions recorded during the year. The financial statements under audit are for the fiscal period ended September 30, 2019.
You have gathered quite a bit of information about several of the revenue transactions for the year. One of the transactions particularly caught your attention given its size. So, you’re in the process of assessing the evidence obtained to determine if the revenues from this transaction are fairly stated.You obtained this information from reviewing documentation related to the transaction and from inquiries you made of the vice president of sales and the controller.You made the following notes about what you’ve learned and are now preparing for a meeting with the audit manager to discuss issues related to the transaction. Here’s what you’ve noted so far:
 During July 2019, Longeta’s vice president of sales sent a proposal to Magicon Inc, to sell $7 million worth of Longeta software and services to the U.S. Air Force. Longeta approached Magicon because Magicon has a relationship with the U.S. Air Force while Longeta does not. Magicon is a necessary intermediary under the government’s procurement regulations.
 Under terms of the proposal, Magicon would place a $7 million order for Longeta software and services by September 30, 2019, which is the last day of Longeta’s fiscal year. In exchange, Magicon would receive a sizeable commission and become an exclusive reseller of Longeta products for the Air Force.
 Longeta normally must enter into “reseller agreements” with intermediaries such as Magicon in order to complete transactions. However, given the short timetable, Magicon was unable to obtain necessary corporate approvals from its legal department to sign a reseller agreement with Longeta before year end on September 30.
 As a substitute for the reseller agreement, Magicon’s buyers agreed to place its order through an “order letter” that would later be followed by a purchase order and the reseller agreement.
 Before the order letter was submitted, Magicon’s legal department requested that Longeta grant Magicon the right to cancel its obligation to pay Longeta the $7 million if Longeta and Magicon were unable to negotiate a mutually acceptable reseller agreement within 30 days.
 In late September, Longeta’s vice president of sales emailed and faxed a letter on Longeta letterhead to Magicon legal specialists. Here is an excerpt from the letter:
“Per our discussion, the following is a clarification of the intent of the order letter dated September 30, 2019 between Longeta Corporation and Magicon Inc.The order letter meets GAAP requirement for revenue recognition.The order letter allows Longeta to recognize revenue for our year ended September 30, 2019…The order letter gives us 30 days to reach mutually agreeable terms and conditions. In the unlikely event that we do not reach “mutually agreeable terms and conditions,” Magicon will have the right to terminate the order letter and all obligations.This contingency may not be expressly stated in the order letter. However, you have my assurance that in the event that we cannot reach terms we will not hold you to the commitment to pay referenced in the order letter.”
 On September 30, 2019, the Magicon legal department approved the deal and Magicon’s purchasers signed and transmitted an order letter from Magicon to Longeta to buy $7 million worth of software and support services. The separate letter from the vice president of sales to Magicon, however, was not attached to the order letter and it was not referenced in the order letter.
 The order letter was submitted to Longeta’s finance department.At that point, Longeta’s made an accounting entry to record $5.8 million as current revenue for the product Longeta had shipped. The remaining $1.2 million was to be separately invoiced for updates and technical support services and was therefore recorded as deferred revenue.
You want to be thoroughly prepared for the meeting with the audit manager. Perform the following procedures to be certain you have all necessary information about the transaction’s treatment.
[1] The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) recently completed a joint project to develop a common revenue standard for U.S. GAAP and IFRS to improve revenue recognition practices and to remove inconsistencies and weaknesses in revenue requirements. The updated guidance is contained in the Accounting Standards Codification as Topic 606, "Revenue from Contracts with Customers." Review that guidance to summarize the core principle for recognizing revenue and briefly describe the five steps needed to achieve the core principle. Also, describe how the core principle was not achieved in this situation.
[2] In your own words, explain the company’s reasoning for recording $5.8 million as current revenue while recording the remaining $1.2 million as deferred revenue. Also, document where on the financial statements the deferred revenue account would be presented.
[3] Assess the content of the separate letter issued by Longeta’s vice president of sales to Magicon. Document your conclusion about how the content of the letter affects or does not affect revenue recognition for Longeta for the year ended September 30, 2019.
[4] Given that the letter from the vice president of sales was not attached to or documented in the order letter submitted by Magicon to Longeta, document your conclusion as to the impact, if any, the vice president’s letter has on the accounting treatment for the transaction since it was not part of the order letter.
[5] Research PCAOB Auditing Standards on the PCAOB's website (www.pcaobus.org) to summarize the guidance for auditors in regards to their assessment of the risk of material misstatement related to revenue recognition. What do those standards require of auditors in regards to their assessment of risk related to revenue recognition?
[6] Auditing standards describe three conditions that are usually found to be present when fraud exists. What are those three conditions and what red flags, if any, might be present at Longeta?
[7] The separate letter from the vice president of sales was emailed and faxed to Magicon representatives. What would be the impact if Longeta’s vice president had only provided that information orally to Magicon representatives and not forwarded the information in written form?
[8] As of September 30, 2019, Magicon had only submitted the order letter. Document your conclusion about the impact on the accounting for the transaction if Longeta and Magicon (a) sign the reseller agreement within 30 days or (b) do not sign the reseller agreement within 30 days.
[9] Document your final conclusion about the accounting treatment of this transaction between Longeta and Magicon. Be sure to provide a basis for your conclusion.
It is recommended that you read the Professional Judgment Introduction found at the beginning of the book prior to responding to the following question.
[10] One of the environmental factors affecting judgment is the "rush to solve" judgment trap. Briefly describe the trap and how it applies to the situation affecting the recording of the sales transaction.


See Answer