Screen Microtech Inc.

SCREEN MICROTECH INC.

Overview

Screen Microtech Inc., a capacitive touch screen manufacturer, had seen significant growth over the past few years: it had moved its manufacturing plant, expanded operations, built a larger client base and seen an unprecedented increase in sales. Its CEO was preparing an initial public offering that could lead to a significant bonus and stock shares for himself and for the company's chief financial officer. This could be enough to induce them to secure improved financial results through any means necessary. Certainly, it could bias their approach to accounting policy choices.

In order to prepare a fair, unbiased assessment of SMI’s financial performance, I, a financial analyst, wrote this report to Chris Derby, CEO, Brain Henderson, CFO and other senior management to point out unreasonable recordings and make readjustment based on the given accounting transactions prior to its IPO.

Basic Financial performance requirements

Audited comparative financial statements covering the previous three completed financial years. 

As for SMI, if the company is going to file an IPO prospectus in early 2016, financial statement requirements would include audited and unbiased comparative statements of comprehensive income, statements of changes in equity and statements of cash flows for fiscal years ending 2015, 2014 and 2013. Hence, in my report, I will adjust financial performance for these 3 continuous years.

Issues and adjustments for accounting transactions

I would start with the accounting method SMI is using. It has mentioned in the case that SMI is using a conservative approach, and management agreed that consistent methods should continue to be used through 2014.

Accounting conservatism is a branch of accounting that requires a high degree of verification before making a legal claim to any profit as it requires recognition of all probable losses as they are discovered and most expenditures as they are incurred. Revenue will be deferred until it is verified as strict revenue-recognition criteria is one of the most common forms of accounting conservatism.

In other words, all the transactions should be recorded in accordance with the conservative approach. However, by assessing the given information, I found out some of the recordings were against some accounting rules.

1. Provision for Bad debt and returns for 2013 and 2014

For SMI, the case says that because of the strong relationship with Deltech which led to consistent on-time payments and minimal late payments, giving Henderson the confidence to not provision for bad debts when recognizing revenue. Similarly, because Deltech’s needs were consistent and predictable, Henderson saw no need to provision for returns.

In fact, an example of accounting conservatism—overestimating an allowance for doubtful accounts—can give a more accurate picture of recoverable receivables given a specific economic outlook. Also, based on the income statement provided, there were actual bad debt expenses occurred in both two years. Which means the assumption Henderson made was not solid. In order to make the financial statement unbiased and fair, it is obviously that SMI should provision for at least 0.2% bad debts for 2013 and 2014 respectively based on the bad debt expense-gross sales ratio. Since provision should better be overestimated by the actual number, I would say a 0.4% would be reasonable.

Chart 1: provision for bad debt:

Similarly, I also insist on provisioning for returns on sales. As it shows in the case that historically, 2% of Deltech products were returned, and the initial numbers on new sales projected an overall average of 5% returns. Therefore, as for 2013 and 2014 Deltech was the main client and there were few other new clients, I would prepare a 2% return provision for each year. 

Chart 2: provision for returns for 2013 and 2014：

When it comes to 2015, since numerous new clients brought much new business to SMI at once, they also dictated many of the terms, which referring to liberal return policies and payment schedules. Even though that Derby was able to persuade Henderson to optimistically provision 3% for returns on sales, I would say this may be underestimated. Instead, I would use 5%, based on the overall average return rate of initial numbers on new sales.

Chart 3: provision for returns for 2015：

2.   Deferred R&D costs

SMI started a $2 million R&D project to help diversify the company’s offering. But because the benefits of this research would not be realized until 2016, Derby and Henderson agreed to defer $1.25 million of the costs to the 2016 year.

Theoretically, deferring these costs would decrease the operating expenses and increase the net income in 2015, causing the financial performance look much attractive. While this kind of treatment violates the conservative method as well as the accounting rules. According to the Financial Accounting Standards Board, or FASB, generally accepted accounting principles, or GAAP, require that most research and development costs (except for software) be expensed in the current period.