Case 1 Written Report: Stirling Homex (A)

By Kenneth Jules Garol, Arlene Jacobe, Carmina Petero & Regina Sison

I. Point of View
The Securities and Exchange Commission (SEC) evaluates the registration of Stirling
Homex (the Company)’s July 29, 1971 preferred stock offering by examining their audited
financial statements, specifically requesting clarification on the company’s revenue
recognition policy. The company produced thousands of modular units, and recognized
revenue without customers who were willing and able to pay for the produced units. In
addition, there are some issues dealing with the allocation of profit between divisions, and
the capitalization of expenses.

II. Statement of the Problem

Does the method used by Stirling Homex to recognize revenue adheres to generally
accepted accounting principles, specifically in relation to (a) Revenue recognition, (b) Profit
allocation, and (c) Capitalization of expenses?

III. Analysis
A. Recognition of Revenue
The company’s revenue is composed of 80% from the manufacturing division where
sales are recognized when units are manufactured and assigned to specific contracts and
20% from installation which is recorded on the percentage of completion method.
There was a noted 79% increase in revenues from the manufacturing division from
1970 to 1971. Under IAS 18, Revenue arising from the sale of goods should be recognized
when all of the following criteria have been satisfied: [IAS 18.14]
● The seller has transferred to the buyer the significant risks and rewards of
ownership.
● The seller retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold.
● The amount of revenue can be measured reliably
● It is probable that the economic benefits associated with the transaction will flow to
the seller, and
● the costs incurred or to be incurred in respect of the transaction can be measured
reliably
But the “Turnkey” program made the company retain title and risk of loss until
installation is complete and the new owner could claim possession of the project. The
company is still the owner of the modules at the time of their recognition of revenue.
The company’s unbilled receivables represented 70% of the total contract receivable
balance for 1971. (see Note 3 in Notes to Consolidated Financial Statements July 31, 1971)
Stirling Homex was not able to satisfy all criteria under IAS 18. Hence, the revenues
and receivables pertaining to the manufacturing division were overstated. Also, since the
revenue is from sale of goods, inventory balance is also understated.
All contracts entered into were substantially sales to local housing authorities and
sponsors who qualify for financial assistance under the US gov’t but there was no mention
of the contract of sale being countersigned by Housing and Urban Development thus there
was no legally binding commitment of federal funds. With this, the company did not
recognize allowance for doubtful accounts. Regardless of the company’s risk policies, the
risk of not being able to receive payment from customers is always present, which is why
there's an allowance for doubtful accounts. The company failed to mitigate this risk and
assumed that all customers will be able to pay.

B. Profit Allocation
The company’s profit margin was composed of sales of modular units produced and
revenues from installation work which people familiar with the company were said to be
allocated on an estimated break-even basis.
Upon examining the company’s income statement, there were no additional notes
or disclosures that pertain to the variable and fixed cost components of the said divisions.
The Stirling Homex Company’s method of allocating profit to installation of work is
favorable only to the company. The company’s method is not that reliable since as
mentioned, sales were recognized upon contract assignment and revenues from
installations recognized even if installations are not yet complete.

C. Capitalization of Expenses
The capitalization of costs are required under Generally Accepted Accounting
Principles (GAAP) when a future benefit for the expenditure exists. Costs will be recognized
as an asset in the balance sheet when the company will benefit from the costs more than
one year or it will be directly recognized in the Income Statement during the applicable
accounting period.
In Note 7 of the company’s July 31, 1971 Financial Statement, Training and
professional development is capitalized as Deferred charges to be amortized for a period of
3 years. This may not be appropriate since the future economic benefit from training and
developing the company’s personnel are not reasonably certain. People differ in learning
curves and enhancing their productivity may not guarantee future benefits for the company
due to uncontrollable events such as the employee’s right to resign, leave, or retire in the
given 3-year period. Assets therefore are overstated by $491,641 and $148,636, expenses
are understated by the same amount which would lead to Net income overstatement of
also that amount in July 31, 1971 and July 30, 1970 respectively.
The company also recognized Research and development (R&D) costs as Deferred
Charges in the Balance sheet for a 5-year period. GAAP generally classifies R&D as expenses
in the year incurred unless they meet the recognition criteria of Intangible Assets under IAS
38. It was not explicitly stated in the case facts and in the Notes to FS if the criteria was met
by the company. This resulted also to an overstatement in Assets of $671,897 and $84,496,
and expenses are understated by the same amount which would also lead to Net income
overstatement of that amount in July 31, 1971 and July 30, 1970 respectively.
IAS 38 requires an entity to recognize an intangible asset, whether purchased or self-
created (at cost) if, and only if:
● [IAS 38.21] It is probable that the future economic benefits that are attributable to
the asset will flow to the entity; and the cost of the asset can be measured reliably.
This requirement applies whether an intangible asset is acquired externally or
generated internally. IAS 38 includes additional recognition criteria for internally
generated intangible assets. The probability of future economic benefits must be
based on reasonable and supportable assumptions about conditions that will exist
over the life of the asset.
 ● [IAS 38.22] The probability recognition criterion is always considered to be satisfied
for intangible assets that are acquired separately or in a business combination. [IAS
38.33]
If recognition criteria are not met. If an intangible item does not meet both the definition of
and the criteria for recognition as an intangible asset, IAS 38 requires the expenditure on
this item to be recognized as an expense when it is incurred. [IAS 38.68]

IV. Decision/Recommendation

Our analysis revealed the following:

● The incorrect timing of revenue recognition led to overstatement of company
profits. The AFS should be reissued so the end-users of the report could have a
better grasp of the company’s financial condition to make better decisions.
● In relation to the allocation of profit, the company may need to disclose and provide
a breakdown of their variable and fixed costs per division. The classification will aid
users of financial statements on how the company’s profit margin was allocated with
references to the behavior of costs.
● The company and the company’s auditor are negligent with the AFS. The company
should hire a new auditor that could better recognize accounting errors.
● It is also noteworthy that based on Note 1, the company did not include on its
consolidated financial statements the financial subsidiary U.S. Shelter Corporation.
● In addition to providing a more detailed analysis on what happens to the company’s
cash to demonstrate their ability to operate in the short and long term, we could
also recommend Stirling to reconcile the company’s reported net income to cash
flows from operations so they can then understand why cash flows from operations
differed from the reported net income of a company.

Stirling Homex July 31, 1971 financial statements misrepresented their actual
financial results and would deceive the users of their financial statements.. There was an
overstatement of the company’s revenues which resulted in higher net income. The
company had inconsistencies in their accounting policies with regards to revenue
recognition and capitalization of expenses which did not adhere to the Generally Accepted
Accounting Principles. Since the auditor of the Company expressed an unqualified opinion
on the complete set of Stirling Homex July 31, 1971 financial statements, the SEC should
sanction and fine PEAT, MARWICK, MITCHELL & CO.
The SEC should implement and set forth necessary guidelines to prevent similar
occurrences in the future. Auditors should also be wary in the case of revenue recognition
since this is always a significant risk and should exercise a high degree of professional
skepticism to protect the stakeholders, the users of financial statements and the public’s
interest.

Your grade is 88 broken down as follows:

Content – 53
Tools – 22
Presentation - 13
APPENDICES:

Calculating for Composition of the Company’s Revenue per division

Calculating for Sales Increase (1970 versus 1971)

(Based on Revenues from Manufacturing Division)

Figures based on the Financial Statements of Stirling Home Corporation and Consolidated Subsidiaries and $16,492,770
(1970) / Consolidated Statement of Income Year ended July 31, 1971 with comparative figures for 1970): $29,482,271
(1971)

Calculating for Percentage of Unbilled Contract Receivables

Figures based on Stirling Home Corporation Notes to Consolidated Financial Statements July 31, 1971 (Note 3 Receivables):
$24,633,799 (Unbilled Contract Receivables) and $35,016,425 (Total Contract Receivables)

REFERENCES:
https://www.iasplus.com/en/standards/ias/ias18
https://www.iasplus.com/en/standards/ias/ias38
https://www.investopedia.com/terms/a/allowancefordoubtfulaccounts.asp