Revenue Recognition - IBM
Once there were giants … the Standard Oil Trust, the mighty Railroads who owned the West,
U.S Steel, "what's good for the country" General Motors and "Ma Bell". ITT in its heydays had
its own state Department and then of course there was mighty "Big Blue", IBM. Time, the
Sherman Anti-trust law, foreign competition and management failure have treated them harshly.
Until the mid-nineteen eighties IBM was the dominating force in the computer industry. It was
feared that eventually IBM would be the only computer company in the world. The Justice
Department conducted an almost decade long investigation to determine if IBM should be
broken up under the Sherman Antitrust laws. However, unnoticed by the Department of Justice
or IBM, competition arose from an unexpected quarter, the garages of Silicon Valley. There
computer "nerds" were developing small desktop computers that eventually would challenge the
hegemony of "Big Blue". While IBM did not completely ignore what was happening in its
backyard, neither did it take the PC revolution seriously. IBM, where everyone wore a white
shirt and dark tie, would not be intimidated by ex- Hippies in T-shirts. IBM bet that mainframe
computers would continue to rule the business world. By the mid-nineteen eighties it became
obvious that IBM was losing the bet and belatedly it too entered the PC field. Until then IBM
had been a cash generating machine, its main problem seemed to be how to minimize its reported
earnings. In 1984 the company boasted a 26.5% return on equity, but by 1989 the return on
equity had plunged to 9.8% and in the early 1990's it had disappeared in losses. The price of
IBM stock hit a high of $175 per share in 1987, by 1993 it had dropped to $52. Something
had to change.
Computer Sales
Traditionally, IBM's computer business consisted of the manufacture and sale or lease of
main-frame computers. The computers were installed and "operationalized" and maintained by
IBM employees. IBM is known for "standing behind its product", but overall, mainframe
customers had few alternatives, due to IBM' domination of the field.
When IBM belatedly entered the PC market, it faced a very different environment. Not only
was there significantly more competition, but also rapid technological change. IBM instituted a
number of policies to make sales or leases of its computers more attractive: Stretched out
payment plans, a "try and buy" policy with no initial payment, free upgrades and a "price
protection plan" under which, if prices fell, the customer would only have to pay the new, lower
price.
Shipping and Delivery
IBM uses a delivery system that is somewhat similar to the Airlines "Spoke and Hub" system.
Upon completion computers are shipped to central distribution warehouses and from there they
are delivered to customers. It used to take up to 45 days until computers would reach the
ultimate customer, but this has been cut to 30 days.
One Stop shopping
For internal and external reporting purposes the company separately accounts for and discloses
revenues and costs for hardware products, software products and services. Historically,
customers had purchased each of these categories separately. Today the technology industry
has become “Network Centric”. Customers demand more than delivery and installation of
products. The demand for products has been changed into a demand for “Solutions”. To
remain competitive, IBM began offering “Business Solutions” in addition to individually selling
products, as had traditionally been the case. Company sales consultants were instructed to
aggressively market the “Total Business Solution” and provide customers with a combined price
quote that includes hardware, software and networking products and services. Sales consultants
receive a small base salary, however, the majority of their income consists of commissions based
on revenue recognized.
Revenue Recognition
Revenue is recognized when the product is shipped. While IBM makes provisions for returns
and adjustments, nevertheless, it was criticized by a number of accountants and even one of its
own auditors for using "aggressive revenue recognition" methods. Thornton O'glove, a San
Francisco based auditing expert, charged that in 1984 these and other aggressive accounting
methods were responsible for 26% of IBM's profit increase or 45 cents a share. According to
him, in 1985 earnings fell 10 cents a share, but without the accounting changes the decline would
have been 86 cents a share. IBM disputed these charges and claims that it makes appropriate
provisions.
Required:
1. Find IBM's annual report and form 10k (use Edgar) on the Internet and carefully study the
revenue recognition and related footnotes.
2. Search the authoritative literature and identify the accounting principles, concepts and
standards that are related to IBM's revenue recognition methods.
3. Based on the information you found in (1) and (2) do you agree or disagree with IBM'
revenue recognition methods?
4. Describe alternatives to IBM's approach.
5. Below is an example of a combined product-services offering.
A. Hardware and software average gross margins ranged from 30-50%. Service margins
ranged from 10-25%. Should these “Combined Offerings” be accounted for as one contract
using an average contract margin? Or, should an allocation to each component
(hardware/software/services) of the contract be made based on the margins realized when
each is sold separately?
B. When should revenue be recognized? Upon completion of all related services? Or at
intervals - for example, at the time of shipment for the hardware component, upon
installation for software and as performed for services?
TYPICAL CONTRACT. Following are the major terms of a typical contract:
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IBM agrees to provide X Company 1,000 PC’s
Each PC will be preloaded with “vendor” software
The 1,000 PC’s will be integrated into a Local Access Network (LAN)
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The LAN will provide access to the X Company’s mainframe
The billing software will be customized to interface with marketing
The fee for the project is $1,000,000
The project is to be completed in 12 months.
Costs for this contract are expected as follows:
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$350,000
$100,000
$200,000
$ 50,000
Cost of PC’s, based on 40% margin (list price)
Cost of the software, based on 40% margin (list price)
Cost of labor related to integration of network
Cost of labor to customize the billing software.
QUESTIONS:
1. How would you allocate the $1,000,000 of contract revenue?
2. What revenue recognition method would you use?
3. What other accounting and business issues arise?