New England Biz Law Update
The settlement by the U.S. Securities and Exchange Commission with the former CFO and CEO of WageWorks, as described in Accounting and Auditing Enforcement Release No. 4202, illustrates the financial reporting risks created by senior management who are too stubborn to acknowledge opposing viewpoints.
Headquartered in California, WageWorks administers Flexible Spending Accounts for clients. Per the SEC, the former officers made false and misleading statements that resulted in WageWorks improperly recognizing revenue of $3.6 million in 2016 related to a contract with a large public-sector client.
What went wrong?
For starters, the former officers felt they were right and their client was wrong about payment obligations under a contract for services.
In fact, as described below, the former officers failed to even acknowledge the client’s refusal to pay when allowing the company to report revenues earned for the amount in dispute.
Making the situation worse, in an effort to avoid disclosing the disagreement with the client, the former officers also misrepresented information to the company’s accounting staff and auditors.
The contract
WageWorks entered into the contract with the client to provide FSA benefits servicing on March 1, 2016. Between March 1 and Sept. 1, 2016, WageWorks was responsible for development and transition services so that the platform would be ready to process the client’s employee claims by Sept. 1. The client had a contract with a different service provider through Sept. 1, 2016.
WageWorks would be paid for its services based on a fee on a per-account, per-month basis, meaning fees earned would equal the number of participant accounts multiplied by a fixed price. The start date for such payments is where the former officers and the client interpreted the contract differently: March 1 or Sept. 1, respectively.
On March 17, 2016, a WageWorks employee emailed the client regarding billing for the development and transition period. On March 29, a client employee responded that it was not obligated to pay for any services during the period prior to Sept. 1, 2016. The former officers were aware of the email exchange.
Later, on June 10, during a telephone call between WageWorks project implementation employees and client employees, a client employee similarly stated that the client was not obligated to pay for services during the development and transition period. Again, the former officers were aware of the exchange.
Statements, omissions and misrepresentations
Despite the former officers’ knowledge that the client had no intention of paying fees during the development and transition period, WageWorks began to recognize revenue under the contract during the second quarter of 2016.
The accounting staff even prepared a memo that was reviewed by the former CFO, which stated that the client agreed to pay fees starting on March 1, 2016, and that WageWorks was able to bill for fees during the development and transition phase. Similarly, WageWorks recognized revenue for the development and transition phase in Q3 2016.
Despite recognizing revenue for the development and transition services period in Q2 and Q3 2016, WageWorks sent its first invoice to the client on Feb. 15, 2017 — an invoice for the period of March 1 through Dec. 31, 2016. The client rejected the invoice consistent with its earlier statements that it was under no obligation to pay for services prior to Sept. 1, 2016.
Importantly, Generally Accepted Accounting Principles required that revenue should only have been recognized when a) collectability is reasonably assured; b) services have been performed; c) persuasive evidence of an arrangement exists; and d) there is a fixed or determinable fee. Needless to say, collectability was not reasonably assured when the client repeatedly stated it would not pay.
Per the SEC, the former officers made numerous false statements and/or omissions of material facts to the WageWorks internal accounting staff and auditors, including for example:
- in Q3 2016, stating the client “had agreed to pay”;
- in Q1 2017, stating that WageWorks “was talking” to the client about payment and “was working on collection”;
- in Q2 2017, stating the client rejected WageWorks invoice “because it had been submitted in the wrong format” and that WageWorks expected to be paid after it resubmitted its invoice.”
Even after submitting a “certified claim” to the client during Q3 2017, as a precursor to litigation, the former officers advised the company’s auditors that WageWorks “would be paid by the end of the year” and that it “was going through a process to collect” the amounts owed.
Even if that was arguably true and based on their contract interpretation, the omission of material facts in their disclosures to the auditors raises serious questions about the former officers’ integrity.
It was not until Jan. 10, 2018, that the former officers advised the company’s accounting staff and auditors that the client denied that it owed any payment for services provided during the development and transition period.
That disclosure led to WageWorks reversing the revenue previously recognized for the development and transition period and restating its financial results for Q2 and Q3 2016.
Avoiding similar financial reporting problems
The facts described in the WageWorks enforcement action raise questions and matters for legal counsel to discuss with their clients to avoid similar problems.
- Can we recognize revenue without sending an invoice to the client?
Revenue should be recorded upon the completion of the earnings process, which during this time period requires the factors described above, including that collectability must be reasonably assured, services have been performed or a product delivered, persuasive evidence of an arrangement exists, and there is a fixed or determinable fee.
After meeting those standards, the client owes monies for the services or products delivered, which is represented on the company’s books and records as an account receivable in an amount equal to the revenue recorded. Consistent with owing monies, the client would record an account payable and an expense or asset for the delivery of services or a product.
The essential link in accounting between vendors, such as WageWorks, with their clients and customers is the invoice generated by the vendor and sent to the client or customer.
The lack of a timely delivered invoice by the vendor is troubling as the accounting appears one sided, and it indicates a problem regarding revenue recognition as collectability is not likely to be reasonably assured if the party obligated to pay does not have a payable recorded on its books and records.
Rules can have exceptions, but for a company such as WageWorks, revenue should not be recorded in the ordinary course without invoicing for the services or products delivered.
Rules can have exceptions, but for a company such as WageWorks, revenue should not be recorded in the ordinary course without invoicing for the services or products delivered.
The WageWorks release does not provide any information regarding whether the former officers suppressed the invoice or how the revenue was reported without an invoice being sent to the client. Needless to say, the lack of a timely invoice sent to the client should have raised concerns.
- Does our accounting staff communicate directly with project management?
Individuals overseeing the actual delivery of services or products to clients and customers generally know the most about the facts required to assess whether the earnings process is complete.
For the project described above, the WageWorks team responsible for the development and transition services knew the client explicitly stated that it was not obligated to pay for services until Sept. 1, 2016.
Per the release, project management shared this information with the former officers, but it is not clear whether the same individuals had any communication with the accounting staff or auditors.
To ensure the full and fair flow of necessary information from the project team to the financial reporting team, companies should implement processes to create and/or improve the sharing of periodic information. Checklists at the start of a contract describing its terms and regular updates shared directly with the accounting staff will provide favorable documentation for financial reporting estimates, judgments and assumptions.
Importantly, this type of process should eliminate the biases displayed by the former officers in controlling the flow of information in an unbalanced manner.
Other questions and issues for discussion based on the WageWorks matter include whether an ethics hotline exists; if revenue recognition training is provided for project personnel; and whether indicia of tone at the top suggests overzealous senior management.
Most important, a full and fair vetting of all facts, in an unfiltered manner, is essential to fairly stated financial results, and strong internal controls represent the best tool to eliminate senior management biases or stubbornness that dismiss unfavorable facts it refuses to accept.
Joseph J. Floyd, a CPA and attorney, is president of Floyd Advisory, a consulting firm in Boston and New York City that provides financial and accounting expertise in the areas of business strategy, valuation, SEC reporting and transaction analysis.
