AICPA Case Development Program Case No. 95-07: Cal Temp Services, Inc. ♦ 1 Copyright 2002 by the American Institute of Certified Public Accountants (AICPA). Cases developed and distributed under the AICPA Professor/Practitioner Case Development Program are intended for use in higher education for instructional purposes only, and are not for application in practice. Permission is granted to photocopy any case(s) for classroom teaching purposes only. All other rights are reserved. The AICPA neither approves nor endorses this case or any solution provided herein or subsequently developed. CAL TEMP SERVICES, INC. REVENUE RECOGNITION AND ACCOUNTS RECEIVABLE COLLATERAL REPORTING (Year 2002 Update) Thomas R. Weirich, Arthur Andersen & Co. Alumni Professor Central Michigan University, Mt. Pleasant, Michigan Rodney L. Crawford, Partner Puja Bhargava, Intern Arthur Andersen LLP, Detroit, Michigan COMPANY BACKGROUND AND HISTORICAL FACTS Cal Temp Services, Inc. (“CTS”) was founded by Jack C. Williamson in 1991 to provide engineering services, temporary personnel and personnel training services for the defense contracting industry. Due to the technology-intensive nature of the defense contracting industry, there exists a constant need for well-trained technical personnel. CTS attempted to fill certain aspects of these needs by offering temporary personnel and training services ranging from general employee training to computer systems design and implementation. Jack Williamson started the Company in 1991 after he was laid off from his job with a major defense contractor as a result of a 1990 reorganization. As with similar entities in the start-up phase, CTS was minimally capitalized, as it was originally funded with only Jack’s small savings. However, with Jack’s technical expertise, CTS was profitable from its formation and grew rapidly, as reported in its audited financial statements, with revenues reaching $5.4 million in 1997. As CTS expanded in the 1990’s it became necessary to obtain additional financing to fuel the growth of the business. The Company established a line of credit with a local bank with collateral for the loan consisting of a first security interest in CTS’s accounts receivable. The bankers were comfortable in lending against the accounts receivable since CTS’s customers were mostly large well-established companies and the credit risk on those accounts receivable was expected to be minimal. The maximum amount available on the line of credit was $600,000. At the request of the bank, Williamson made the commitment to have audited financial statements for CTS. He did not resist this request, as he believed that an audit by an independent CPA added creditability to CTS and its financial statements. Therefore, CTS’s financial statements were audited annually for the years ended December 31, 1993 through 2000 by theAICPA Case Development Program Case No. 95-07: Cal Temp Services, Inc. ♦ 2 accounting firm of Miller & Starr, CPAs (“M&S”). Each year M&S, following their audit, provided CTS with a signed audit report that stated that in their opinion CTS’s financial statements were prepared in accordance with generally accepted accounting principles (“GAAP”). These audits were usually completed within four months of the CTS fiscal year-end (December 31). 1998 While CTS had made some efforts to diversify into other product lines prior to 1998, its primary business remained temporary personnel and personnel training services for the defense contracting industry. This market became extremely competitive in the late 1990’s due to defense industry downsizing, which resulted in CTS’s profit margins and market share coming under pressure. Certain of CTS’s customer contracts were expiring in 1998 and Williamson felt the Company needed to focus on selling larger engineering projects and other value-added services in order to continue its growth. In order to provide additional financing for the larger project work, Williamson in early 1998 contacted Second Union Bank (“Second Union”), to establish a new banking relationship with a larger bank. Jack concluded that a new banking relationship would help in the expansion plans for CTS. The introduction to the bankers was assisted by Dennis Starr of M&S, who had a good working relationship with Second Union. In May 1998, Second Union agreed to establish an asset-based line of credit for CTS for the greater of $1,000,000 or 75% of the eligible accounts receivable. To complete the agreement, CTS had to provide a first security interest in all of their business assets as collateral for loans under the line-of-credit. However, only receivables less than 90 days old would be considered by Second Union in determining the maximum advances under the line of credit. Second Union, like the prior bank, believed that if the CTS business ever failed, the only assets which would likely have remaining value would be the receivables. The Bank’s security interest in other assets such as inventory, prepaids, and equipment would have little realizable value in the event of a liquidation of assets. Second Union therefore agreed to advance the greater of 75% of eligible accounts receivable or $1.0 million as a loan to CTS. The loan agreement specifically required that CTS furnish Second Union audited financial statements prepared in accordance with generally accepted accounting principles. In addition, the agreement stipulated that CTS provide a collateral report consisting of an aged listing of accounts receivable within 20 days after the close of each month. These reports were also to be accompanied by a certification from an officer of CTS that the reports were complete and accurate. 1999 In 1999, Second Union became aware that CTS’s financial condition had taken a turn for the worse. Upon receipt of the 1998 audited financial statements, the bank learned that revenues for 1998 had declined by approximately 7%, while gross profit margins declined and administrative expenses increased. The combination of these factors resulted in a pre-tax loss of $(279,931). This was particularly distressing to the Bank because the interim financial statements they had been shown had not reflected a problem of this magnitude. Following receipt of the audited financial statements in Apri1 1999, Ron Gray, Second Union’s loan officer, informed Jack Williamson that in view of the CTS’s