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.

Question

What will be an ideal response?

Answer 1

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
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.