• The face value is $100 million — On-line Deals Inc ODI business selling things company currently owned two founding — sells airline tickets well hotel rooms Sometimes will buy
Accounting & FinancePayroll AccountingCase Study
On-line Deals Inc. (ODI) is in the business of selling things on-line. The company is currently owned by two founding partners, Jay and Wen. Due to the rise in Internet commerce, Jay and Wen are thinking about taking the company public. Revenues have increased steadily over the past few years and demand for this type of service appears to be growing.
ODI sells airline tickets as well as hotel rooms. Sometimes it will buy a block of rooms or airline flights from a company and sell them on-line to interested individuals. Other times airline and hotel companies advise ODI when they have excess capacity and ODI passes this information on to its customers, hoping that they will buy. All transactions are booked as revenues when the customer pays for them. The amount of revenues is generally equal to the fair value of the flight or hotel room (which is equal to what the customer pays).
During the year, in response to increased competition from other on-line businesses, ODI has spent a significant amount of money on revamping its website. It unveiled the “new look” just before year end and customers appear to really like the new features built into the website. In this business, it is very important to have a fresh and current look to the website to keep customers coming back. ODI has a large staff of dedicated information technology and service staff who deal with this. Like Jay and Wen, the senior management team do not yet draw salaries from the company but are paid with stock options. It is very difficult to determine the value of these options as the company is not yet public.
In the past year, the company’s website and customer database were attacked by computer hackers. This was very embarrassing for ODI and many customers were very angry. Jay and Wen made a public announcement that they would spend whatever it took to increase security so it would never happen again. Several customers are suing the company in a class action lawsuit. The case goes to trial early next year. ODI’s lawyers are a bit worried since similar lawsuits for other companies have ended up with the company paying out a fairly large settlement. Part of the problem in this case was that ODI relies on an outside company (Store All Inc., or SAI) that stores all of its data. The breach occurred at SAI although Jay and Wen also know that part of the problem was their own computer system, on which they had spent significant funds to develop. ODI has since terminated its dealings with SAI and is in the process of building a new company-owned technology facility that will be up and running by next year. The new facility is state of the art and is very expensive. Jay and Wen have been heavily involved in the design of the new facility. They have been discussing with their lawyers their intention to sue SAI for the problems caused.
In order to finance the new facility, ODI issued financial instruments to a large institutional investor. The terms of the financial instruments are below:
• The face value is $100 million.
• They are repayable when revenues exceed two times the historic revenue levels.
• Each year, the financial instruments pay out a dividend of 3%.
• An annual audit must be performed.
Instructions
Adopt the role of the auditors and discuss the financial reporting issues.
SOLUTION
-Growing company thinking of going public
-GAAP is a constraint – due to FI agreement requiring audited financials – also thinking of going public so best to use GAAP and in particular IFRS
-May be a bias to make statements look better in order to increase initial share price – senior management is compensated with stock options and will stand to benefit greatly from higher share prices.
-As auditor would be cautious and conservative due to increased risk associated with potentially going public.
Analysis and recommendations
Issue: Revenues
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Gross
Net
-Must examine whether they are acting as a principal (e.g. selling things for a profit) or agent – providing a service of selling -In this case – where they are buying blocks of rooms or flights, they have the risks and rewards of ownership and stand to lose if they do not sell the whole block -They are acting as principals – selling assets that they have legal title to (blocks of rooms and flights) -Other
-Looks like they are providing a service of putting sellers and buyers together -The revenue is therefore a type of commission and should be shown on a net basis -Would have to analyze carefully but for many of the items where they are putting buyers and sellers together – there is no risk of loss to them. If the item is not sold then the loss rests with the airline or hotel company -Other
Recommendation:
Would have to analyze carefully as there are multiple types of transactions. Safer to show on a net basis until more info can be obtained regarding whether they take legal title of the rooms/flights and whether they are at risk of loss.
Issue: Website costs
Capitalize
Expense
-The website is a critical asset that will provide future benefit by providing the platform by which ODI interacts with its customers -Without this – no sales or future cash inflows can occur -The website is owned and controlled by the company -Other
-Seems like the website is pretty critical to the business and it is important to continuously invest in it – therefore it is an ordinary, ongoing cost of doing business -Even if this is seen as an asset – given the problems this year regarding the hacking incident, might want to write off or impair any costs capitalized and understand that costs being incurred going forward are only good until there is a breach. Computer hacking is a big risk in this business and as soon as new security features are in place, someone is trying to breach them. -Other
Recommendation: Treat as expenses.
Issue: Lawsuit
Recognize
Do not
-There is definitely an obligation or duty to deal with this problem -It was caused by a breach that Jay and Wen know about. Part of the breach was due to their own website and even for the SAI problem – Jay and Wen were the ones that contracted with SAI -Jay and Wen have publicly apologized and promised to make things right. This creates a constructive obligation. -The lawyers have noted that for similar companies and situations – there have been significant lawsuit losses so a loss is likely. -Other
-Very difficult to measure -Even though the lawyers feel that there are similar cases, each case is different -Plan to sue SAI and so the net losses may be insignificant -Other
Recommendation: Accrue a liability
Issue: FI
Debt
Equity
-An obligation to deliver cash exists because of the triggering event -This triggering event is outside the control of the company as it will depend on sales from customers -The company will obviously have a goal to grow as large as possible and would not limit growth just to preclude the triggering event happening -This is a more conservative view and given the significant growth and the continuing growth of this type of industry – growth is inevitable -Other
-Legally equity since pays dividends and has no due date -Looks like permanent financing since the triggering event is not likely to happen (is not genuine). Revenues are so huge currently because of the accounting policy to recognize on a gross basis. It makes more sense to recognize on a net basis and this will decrease revenues significantly and make the target more difficult to achieve (assuming the target is based on the historically recognized gross revenues) -The level of revenues might be seen to be within the control of the company – especially since it depends on an accounting policy choice and also on management decisions as to how much they would like to grow -Other
Recommendation: Debt – more conservative
Issue: Stock options
Recognize as salary expense
Do not recognize
-This represents a cost of doing business -Management is providing a service to the company which must be captured so that the business model is more transparent – otherwise profits are overstated -Other
-Difficult to measure since this is a private company and also since it is fairly new – there is not much history -Difficult to measure the value of the contribution and/or the value of the company -Other
Recommendation: Accrue
Issue: Self-constructed asset
Capitalize construction costs
Expense
-May capitalize costs such as salaries and other costs to build the facility – Jay and Wen spend a significant amount of time on the design – all adds future value and is directly related to the construction activity -Proper design is critical and Jay and Wen have significant insight into the key risks of the company including the risks associated with protecting customer information -Other
-Jay and Wen own and work for the company – their compensation is an ordinary cost of doing business -It is very difficult to separate the value that they add to the business every day from the value they are adding to this particular asset -Other