Question 3 solution

a. This case is designed to illustrate a situation in which a senior manager has a difference of
opinion with a partner (Maria) concerning a client’s revenue recognition accounting policy. Both
Frank and Maria believe they are right.

Here are the applicable steps from the nine-step approach to case analysis

Identify problems and issues

Frank, a senior audit manager, believes the revenue recognition method that Machine
International Corp. has used for a number of years is no longer appropriate because of a recent
ruling by the Ontario Securities Commission (OSC). Maria, the partner on the audit, reviews the
situation and concludes that because the method has been used for 10 years and Machine
International Corp. does not file with the OSC, the revenue recognition method is acceptable.

Maria states that she will take responsibility for the decision. Although Frank says the method is
inappropriate, you do not know whether it results in a material misstatement.

Generate alternatives

Frank’s alternatives are (1) speak to another partner, (2) agree with Maria and accept Machine
International Corp.’s accounting, or (3) resign from the audit and possibly the firm.

Select the decision criteria

Frank should consider his choice in the context of what a professional with integrity would do.
For example, when faced with a choice, most professionals would put their responsibility to the
profession and society ahead of personal advancement.

The chosen alternative must consider the needs and interests of all stakeholders and be ethically
sound (in compliance with the CGA-Canada Code of Ethical Principles and Rules of Conduct).

Analyze and evaluate the alternatives

In making his decision about how to deal with the issue, Frank should consider the stakeholders
and their various motivations:

Frank wants to be partner, but does that mean he should go along with whatever
the partner thinks is right? What about what is right for the client, the other
partners, and the firm?

Maria thinks the accounting method is appropriate and is certain the firm would lose
its client if the current accounting method were deemed inappropriate. She is
motivated to keep the client and thinks she can absolve Frank of any responsibility
for his conclusions by writing a letter.

Machine International Corp. is a large international company and hence would have
many diverse financial statement users. It is likely motivated to show healthy, stable
operating results by staying with the same accounting method it has used for the
past 10 years. A change in accounting policy would probably show poorer results
for the year of change. You don’t know if management or the board of directors is
aware that its method of revenue recognition is under question, or what effect a
change in policy will have on the financial statements.
 The other partners at Bright and Lorren may want to keep one of their “most
prestigious clients” at all costs, or may disagree with Maria’s position.

What does the CGA-Canada Code of Ethical Principles and Rules of Conduct say about the issue?
Rule R303 requires adherence to acknowledged principles and standards. Is the OSC ruling such
a standard? Read Rule R303 and reach your own conclusion. What do the principles say? Would
using the “bill and hold” method result in misleading information? If so, Frank shouldn’t be
associated with these statements even if his decision places him in a difficult situation with his
employer. This is true regardless of the fact that Maria has written a disclaimer of responsibility.

Frank should also determine the possible consequences of each alternative:

Speak to another partner and/or write a statement for the file summarizing his
conclusions. Inform other partners if Maria refuses to include the statement in the
working papers.

Frank will maintain his integrity, but he may lose any chance of advancement at
Bright and Lorren. Maria could be right, and Frank could endanger his career. If the
partner he talked to sided with Maria, Frank could lose his job. If the partner sided
with Frank, Maria’s future could be affected.

Agree with Maria and accept Machine International Corp.’s accounting.

The client will use a possibly inappropriate accounting method, and Bright and
Lorren could face potential liability. Investors in Machine International Corp. could
make bad investment decisions and lose money. Frank’s integrity would be
compromised. He could find himself in even more compromising situations in the
future if Maria perceives that he lacks the inner strength to do what he believes is
right in difficult situations.

Frank must also consider the possibility that Maria, with her greater experience, is
right. If she is right, he could be very embarrassed.

Resign from the audit and possibly the firm.

Frank will maintain his integrity but will be unemployed. The client will continue to
use a possibly inappropriate accounting method, and Bright and Lorren could face
potential liability. Maria could be right, in which case Frank’s action would be
wasted.

Make a recommendation or decision.

Consider all the possibilities and their implications and make a choice. It is important that your
choice be made thoughtfully, taking into account the analysis you have done.

Frank should, as a minimum, tell another partner. Before he does so, however, he should write a
memo to Maria summarizing the issues and explaining his point of view, recommendations, and
what he proposes to do so she can present her side of the issue. He should be respectf ul of the
position of all other partners in the firm. Most, if not all, of the other partners would probably
appreciate Frank’s willingness to express his opinion regarding the inappropriateness of the
revenue recognition method used by the client.

b.

Bright and Lorren

Certified General Accountants
INTER-OFFICE MEMO
Date: April 15,

20X1 From:

Frank Dorrance

To: Maria da

Silva

Subject: Machine International Corp.

Maria, further to our discussions, I would like to take this opportunity to set out the
issues and my recommendations regarding the “bill and hold” revenue recognition
method at Machine International Corp.

As you are aware, the public perception of the fairness of financial statements has
suffered over the past few years, especially in the wake of the U.S. financial scandals.
The implementation of the Sarbanes-Oxley Act of 2002 in the United States and the
corresponding CSA initiatives mean that we, as professional accountants, must not only
do the right thing, but must also be perceived to be doing the right thing.

The conceptual framework in place in both Canada and the United States sets up a
process for revenue recognition by focusing on four principles. Under these
principles, revenue can be realized only when there is persuasive evidence of an
arrangement, delivery has occurred or services have been rendered, the seller’s
price to the buyer is fixed or determinable, and collectability is reasonably assured.

I’ve done a fair bit of research and I am convinced that the “bill and hold” situation at
Machine International Corp. is exactly the sort of thing that the OSC has questioned,
so we need to be sensitive to the regulators’ ruling.

I realize that Machine International Corp. does not file with the OSC, so it could be
argued that the views of the regulators are not relevant. However, whatever we do must
consider the needs and interests of all stakeholders and be ethically sound (in
compliance with the CGA-Canada Code of Ethical Principles and Rules of Conduct ). I
am concerned that, if anything ever went wrong at Machine International Corp., we could
be criticized by one of the minority shareholders for failing to act appropriately.

In addition, there is the matter of association. We are associated with those financial
statements, and the CGA-Canada Code of Ethical Principles and Rules of Conduct
expressly forbids us to be associated with information that is possibly false and/or
misleading. I’m not saying that the statements are misleading; but if it turned out that
they were and we hadn’t done anything, we could face serious repercussions.

I feel strongly that this issue should be discussed with another partner. Therefore, I
respectfully request your approval to discuss this issue with Norm. He has a great
deal of experience in matters such as this, and I feel that he may be able to help us
resolve the issue. I want what’s best for the firm. I feel I have a duty to all
stakeholders —Bright and Lorren, Machines International Corp., and the public — to
make sure that we do the right thing. Please let me know your thoughts on this at
your earliest convenience.