9.

3 Case Instructional Notes Longeta Corporation:

Facts

• The student completing the case is assuming the role of a hypothetical new staff auditor
on the Longeta Corporation financial statement audit. T

• The staff auditor is responsible for auditing revenues at Longeta. Longeta Corporation is
a California-based developer and marketer of software used to manage data storage
functions for complex computer networks.

• Longeta sells products to intermediaries who in turn sell the products to government
purchasers and other organizations.

• The audit relates to Longeta s fiscal year ended September 30, 2006. Most of the audit
work related to revenue accounting is complete.

• There is one particular transaction that the staff auditor is evaluating. It relates to a
proposed transaction with a third-party intermediary. The third-party intermediary
involved in this transaction is Magicon, who will resell the software to the U.S. Air
Force. The size of the transaction is $7 million, which is material to Longeta. The
transaction relates to the sale of both software and related support services.

• Magicon placed an order letter just before September 30, 2006. In negotiating the order
letter, Magicon requested the right to cancel its obligation to pay Longeta if final terms
could not be arranged.

• Longeta s Vice President of Sales issued a separate letter to Magicon noting that the terms
and conditions of the transaction have not been finalized. In fact, the letter acknowledges
that the terms and conditions must be mutually agreed upon within 30 days (which is
after the fiscal year end).

• The letter also gives Magicon full rights to return with no commitment to pay in the event
the terms and conditions cannot be satisfactorily determined. Based on the order letter
and separate side letter from the Vice President of Sales, Longeta recorded the $7 million
transaction for the year ended September 30, 2006, with $5.8 million treated as revenue
and the remaining $1.2 million treated as deferred revenue.

1. Research required accounting treatment criteria related to revenue recognition to make sure you have
a clear understanding of the explicit criteria that must be satisfied before revenue can be recognized. The
Securities and Exchange Commission s (SEC) Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements, provides a good summary of the key required elements. Read the SEC s guidance
and document the four criteria the SEC believes must be satisfied for revenue recognition.

The determination of whether a company is reporting transactions within the confines of GAAP
(aggressively reporting versus fraudulently reporting) requires professional judgment. In order to record
revenue transactions, the SEC s SAB No. 101 notes that GAAP requires the following conditions to be

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 satisfied: 1. Evidence of an arrangement exists. 2. The earnings process is complete or nearly complete.
Thus, the company has performed the service or provided the product and an exchange has taken place. In
exchange for the company s provision of services or shipment of products, the customer generally
provides cash or a promise to pay cash in the future (i.e., a receivable). 3. The seller s price to the buyer is
fixed or determinable. 4. Collection is reasonably assured. Thus, for sales on account, collection is
considered reasonable as of the date of sale.

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.

Longeta s recording of $5.8 million in revenue for the year ended September 30, 2006 related to the
portion of the contract tied to the actual shipment of software product. Given the shipment of the software
product to Magicon prior to year end, Longeta decided to treat the revenue associated with the sale of
software as a current sale on the income statement. In contrast, Longeta recorded the remaining $1.2
million as deferred revenue given that Longeta was obligated to provide support services related to the
software during future periods. Because delivery of support services had not occurred as of year end,
Longeta recorded the portion of the contract related to support services as deferred revenues. For the
portion of services to be provided over the next 12 months, Longeta would present the deferred revenue
as a current liability on the balance sheet. To the extent there was a commitment to provide services after
12 months, Longeta would record deferred revenues as a long-term liability on the balance sheet. 3
Beasley / Buckless / Glover / Prawitt

3. Assess the content of the separate letter issued by Longeta s vice of president 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, 2009. The separate letter issued by the vice
president of sales clearly demonstrates that the terms of the transaction had not been agreed to by either
party. In fact, the letter acknowledges that both Longeta and Magicon needed to reach agreement as to the
terms of the transaction. Thus, as of the fiscal year end, no formal arrangement for the transaction existed.
This directly violates one of the four criteria for revenue recognition: Evidence of an arrangement must
exist (see the solution to question 1 above). Additionally, the lack of agreed upon terms also suggests that
there was no fixed or determinable price associated with the transaction, another criteria necessary for
revenue recognition. Thus, the acknowledgement of the lack of a final contract provides direct evidence
that two of the four revenue recognition criteria were not satisfied. Furthermore, the separate letter gives
Magicon full rights of return of the merchandise, in the event terms cannot be agreed upon. As a result, no
formal exchange has taken place. That is, while Longeta has shipped product, it has received no formal
commitment in exchange for that product. Thus, the transaction resembles a shipment of goods on
consignment rather than the shipment of goods for sale.

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.

The separate letter issued by Longeta s vice president of sales is an example of a side letter agreement.
Several instances of fraud and revenue restatements have been triggered due to the issuance of side

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 agreements, which in essence unravel the terms of the transaction such that revenue should not be
recorded. The fact that the separate letter (or side agreement) wasn t attached to the order agreement does
not impact the accounting treatment. Because the vice president of sales issued the separate letter, the
letter directly impacts factors that affect the viability of recording this transaction as revenue. Thus, the
separate issuance of the letter that was not attached to the order letter has just as much impact on the
GAAP treatment as if the letter had been attached to the order letter. In fact, even verbal arrangements
similar to the ones documented in the separate letter should be considered when evaluating the correct
treatment of revenue transactions. Interestingly, the vice president of sale s letter actually acknowledges
the GAAP treatment, suggesting his or her awareness of the requirements of GAAP. Apparently, the vice
president believes that issuing a modification of transaction terms in a document not attached to the actual
order letter would actually make a difference in the proper accounting treatment. However, the substance
of the transaction revealed that no formal arrangement existed. GAAP intends to capture the substance, as
opposed to the form, of transactions. Thus, the format of the modification of sales terms does not alter the
nature of the accounting treatment.

5. 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?

Separate commitments provided by company representatives to customers outside the normal course of
business directly impact the accounting treatment, regardless of the nature of that communication. Thus,
both written and oral modifications to the transaction directly affect the correct accounting treatment. The
main criteria associated with GAAP accounting is based on the 4 Case 9.3 Longeta Corporation: Auditing
Revenue Contracts substance over form perspective. The substance of the transaction drives the
accounting treatment rather than the form in which the terms and conditions are described and
documented. Thus, if oral or written communications by sales staff change the substance of the
transaction, then the accounting treatment should consider those changes, regardless of the format in
which they are made.

6. As of September 30, 2006, 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.

As noted in the case, negotiations surrounding the order letter issued by Magicon noted that Magicon had
the right to cancel the contract if it was unable to satisfactorily negotiate an acceptable reseller agreement.
Thus, until a reseller agreement was obtained by Magicon, Longeta had no right to record the revenue
from the transaction with Magicon. If the reseller agreement was finalized within 30 days, then Longeta
could record the revenues related to this transaction at that time, which would be in October 2006. Thus,
in no event should Longeta have recorded the transaction as of September 30, 2006. Because Longeta
should not record the transaction until terms are finalized, Longeta would be prohibited from recording
revenue related to this transaction until a reseller agreement is signed.

7. Document your final conclusion about the accounting treatment of this transaction between Longeta
and Magicon. Be sure to provide a basis for your conclusion.

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 Longeta s recording of this sales transaction violated GAAP related to revenue recognition. First, neither
Longeta nor Magicon had reached agreement on the terms and conditions of the sale. Thus, no evidence
of an arrangement for the transaction exists. Second, the separate agreement gives Magicon full right of
return. Thus, no exchange of assets has taken place, given that Magicon has no commitment to provide
Longeta anything. Third, the separate agreement notes that if no terms can be finalized, Magicon has no
obligation to pay Longeta. Thus, no collection would be expected in that event. As a result, both the
recording of the $5.8 million in revenue and the $1.2 million in deferred revenue are not in accordance
with GAAP. 5 Beasley / Buckless / Glover / Prawitt Excerpts from the SEC s Litigation Release Against
Legato System Executives: U.S. SECURITIES AND EXCHANGE COMMISSION Litigation Release
No. 17524 / May 21, 2002 Accounting and Auditing Enforcement Release No. 1561 / May 21, 2002
SECURITIES AND EXCHANGE COMMISSION v. DAVID MALMSTEDT AND MARK
HUETTEMAN, No. C022427 JW PVT COMMISSION FILES FRAUD CHARGES AGAINST TWO
FORMER SALES EXECUTIVES OF LEGATO SYSTEMS, INC. The Commission announced that it
has filed an action in the United States District Court for the Northern District of California against
former sales executives of Legato Systems, Inc., a Mountain View, Calif. developer of data storage
software. In its Complaint, the Commission alleges fraud violations by former Legato executive vice
president of worldwide sales David Malmstedt, 46, of Manhattan Beach, Calif., and former vice president
of North American sales Mark Huetteman, 39, of Hinsdale, Illinois. The complaint alleges that from May
1999 through December 2000, Malmstedt and Huetteman caused Legato fraudulently to record millions
of dollars in revenue on orders that were contingent on resellers' ability to sell the product to an end
customer, or on customers' rights of exchange, return or cancellation. As a result of the fraud, Legato
overstated its revenue over three fiscal quarters in amounts ranging from 6% to 20% per quarter. In one
instance, Malmstedt and Huetteman caused Legato to recognize revenue on a $7 million purchase order
that was contingent on further successful negotiations between the parties. Pursuant to this arrangement,
if the negotiations broke down, the customer had the right to cancel the purchase order. The cancellation
right was set forth in a separate side letter, drafted by Huetteman, which stated in part: "This contingency
may not be expressly stated in the order letter, because of the impact on revenue recognition. However,
you have my assurance that in the event that we can not [sic] reach terms we will not hold you to the
commitment to pay referenced in the order letter." The complaint charges Malmstedt and Huetteman with
violating the antifraud, corporate reporting and books and records provisions of the federal securities
laws, and seeks injunctions, disgorgement of losses avoided on sales of Legato stock by Malmstedt and
Huetteman during the course of the fraud, and monetary penalties. In particular, the Commission asserts
claims against defendants for violations of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(5) of the
Securities Exchange Act of 1934 ("Exchange Act") and Rules 10b 5, 12b 20, 13a 13 and 13b2 1
thereunder. 6 Case 9.3 Longeta Corporation: Auditing Revenue Contracts
http://www.sec.gov/litigation/litreleases/lr17524.htm 7

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