Revenue recognition – accounting issues

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Revenue Recognition Concerns Expressed in Recent SEC Pronouncement 12/14/99
On September 28, 1998, in response to growing concerns about companies managing earnings in order to
achieve consensus estimates, SEC Chairman Arthur Levitt gave a memorable speech on the subject
entitled The Numbers Game. In the area of premature revenue recognition, Levitt used the following
analogy:
“Think about a bottle of wine. You wouldn’t pop the cork on that bottle before it was ready. But some
companies are doing this with their revenue – recognizing it before a sale is complete, before the product
is delivered to a customer, or at a time when the customer still has options to terminate, void, or delay the
sale.”
Over the past year, the SEC has issued two staff accounting bulletins (SABs) to address earnings
management problems: one in August addressing materiality in the preparation of financial statement
(SAB No. 99), and another in November addressing restructuring charges (SAB No. 100). On December
3, 1999, the SEC issued a third SAB, No. 101, which provides guidance on the recognition, presentation,
and disclosure of revenue in financial statements. (SABs are not rules; rather they represent
interpretations and practices followed by the staff of the Office of the Chief Accountant and the Division
of Corporation Finance in administering the federal securities laws.)
SAB No. 101 does not change any existing accounting rules for revenue recognition. Rather, it spells out
the basic criteria that must be met before companies can record revenue. Those criteria reflect the
recurring revenue recognition themes found in the existing accounting literature. This SAB provides
guidance in such areas as bill-and hold-transactions, up-front fees when the seller has significant
continuing involvement, long-term service transactions, refundable membership fees, and contingent
rental income.
Revenue Recognition – General
Revenue should not be recognized until it is realized (or realizable) and earned. A company’s revenueearning activities involve delivering or producing goods, rendering services, or other activities that
constitute its major ongoing or central activities. Revenue is considered to have been earned when then
that entity has substantially completed this activity.
The SEC staff believes that revenue is realized (or realizable) and earned when all of the following
criteria are met:
•
•
•
•
Persuasive evidence of an arrangement exists
Delivery has occurred or services have been rendered
The seller’s price to the buyer is fixed or determinable
Collectibility is reasonably assured
1999 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone:
(301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval
system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information
in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the
Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to
be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.
Revenue Recognition Concerns Expressed in Recent SEC Pronouncement (12/14/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
Materiality: Is it Like Truth and Beauty or Subject to Measurement?
Question: Have you ever wondered why companies…
•
sometimes do not restate prior period when making acquisition using the pooling of interest
accounting
•
can avoid recording losses on the income statement
•
can capitalize (record as an expense) normal operating expenses
•
fail to disclose one-time gains or losses as separate line items on the income statement
•
in short – ignore the normal accounting conventions.
How can you convince your independent auditor to allow your company to circumvent normal accounting
conventions? The answer -- simply assert the “materiality” exception. In short, if the impact of recording
a transaction in a more expedient (although technically, improper) way, has no significant impact on the
investor, normal accounting conventions could be ignored. Thus, prior-period financial statements need
not be restated if a pooling is deemed “immaterial;” and normal operating expenses could be capitalized if
the amount is “insignificant.”
Since substantial discretion exists for management (and its independent auditors) to overturn normal
accounting conventions invoking the materiality principle, CFRA will provide a review of the
authoritative literature on the subject and the insights on how the SEC evaluates “materiality” thresholds
and judgments.
Assessing Materiality
Because of the subjectivity in assessing materiality, over time, certain quantitative thresholds (“rules of
thumb”) have been used. Some use a 5% overstatement of net income as a threshold for materiality.
The SEC staff, however, points out that exclusive reliance on any percentage or numerical threshold has
no basis in the accounting literature or the law. Quantifying the magnitude of a misstatement is only the
beginning of an analysis of materiality; it cannot be used as a substitute for a full analysis of all relevant
considerations.
The FASB stated the essence of materiality in SFAC No. 2 as follows:
“The omission or misstatement of an item in a financial report is material if, in the light of the
surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a
reasonable person relying upon the report would have been changed or influenced by the inclusion or
correction of the item.”
1999 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301)
984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or
transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was
based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and
Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase,
retention, or sale of the securities of the company mentioned.
Materiality (12/20/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
America Online, Inc.
8619 Westwood Center Drive
Vienna, Virginia 22182-2285
(703) 448-8700
Primary SIC Code: 7375
Ticker Symbol: AOL
Exchange: NYSE
1996 Fiscal Year-End: 6/30/96
Auditor: Ernst & Young
10/11/96 Close: $24.63
52-Week: $24.50 - 71.00
Price/Earnings: 95
Price/Sales: 2.1
Mkt. Cap.: $2.3 billion
America Online, Inc. ("AOL") provides online computerized services to more than 6 million
subscribers, who are billed on a monthly basis. Services offered by AOL include electronic mail,
conferencing, software, computing support, electronic magazines and newspapers, online classes, and
Internet access. The Company has established strategic alliances with hundreds of companies, including
ABC, American Express, Bertelsmann, IBM, Knight-Ridder, Time Warner, and Tribune Companies.
Since the beginning of fiscal 1995, the Company has expanded its range of services through several
acquisitions. AOL's new products and services include GNN (a stand-alone direct internet access
service), NaviPress (Web authoring software), and NaviServer (commercial Web server).
FINANCIAL SUMMARY
Year
Ended
6/96
Year
Ended
6/95
%
Change
1,093.9
394.3
177.4%
Operating Income
82.2
28.9
184.4%
Net Income
29.8
(33.6)
N/M
Working Capital
(19.3)
0.3
N/M
L-T Liabilities
156.3
55.2
183.2%
Total Owners’ Equity
512.5
216.8
136.4%
CFFO
(66.7)
17.3
N/M
($ millions)
Sales
© 1996 by the Center for Financial Research and Analysis (CFRA)
PAREXEL International Corporation
195 West Street
Waltham, Massachusetts 02451
(781) 487-9900
Ticker Symbol: PRXL
Exchange: Nasdaq/NMS
Website: www.parexel.com
2000 Fiscal Year-End: 6/30/00
Auditor: PricewaterhouseCoopers
3/2/01 Close: $16.50
52-Week: $8.06 – 17.25
Price/Earnings: NA
Price/Sales: 1.1
Mkt. Cap.: $410 million
PAREXEL International Corporation ("PRXL") is a leading contract research, medical marketing
and consulting services organization providing a broad spectrum of services from first-in-human clinical
studies through product launch to the pharmaceutical, biotechnology, and medical device industries
around the world. The Company's primary objective is to help clients rapidly obtain the necessary
regulatory approvals of their products and quickly reach peak sales.
FINANCIAL SUMMARY
($ mils., except EPS & %)
6 Mos. 12/00
6 Mos. 12/99
% Change
Year 6/00
Year 6/99
% Change
Revenue
182.5
189.7
(4%)
378.2
348.5
9%
Gross Profit
50.4
60.8
(17%)
117.3
114.8
2%
Operating Income
(0.9)
12.0
(108%)
3.6
20.6
(83%)
0.9
8.9
(90%)
5.5
15.6
(65%)
EPS (Diluted)
$0.03
$0.35
(91%)
$0.22
$0.62
(65%)
Cash & Mkt. Securities
82.0
112.2
(27%)
90.2
90.0
0%
Total Receivables
193.3
167.2
16%
161.4
150.5
7%
Total Assets
376.1
371.5
1%
350.9
333.6
5%
Stockholders’ Equity
184.7
198.2
(7%)
190.2
192.0
(1%)
CFFO
4.2
37.0
(89%)
29.6
29.1
2%
Depreciation & Amort.
10.8
10.3
5%
21.9
17.9
22%
Capital Expenditures
7.3
7.9
(8%)
20.1
18.9
6%
Net Income
2001 by the Center for Financial Research and Analysis, Inc. (CFRA)
Overview of SOP 93-7: Accounting for Direct-Response Advertising Costs, 7/20/00
The AICPA issued its Statement of Position 93-7 in December 1993. The purpose of the Statement
was to distinguish advertising costs which should be expensed as they incurred from those advertising
costs that should be treated as assets, thus future economic benefits, when the costs are incurred and
amortized to expense in the current and subsequent periods. SOP 93-7 provides the following guidance:
•
The costs of advertising should be expensed either as incurred, or the first time the advertising
takes place, except for direct-response advertising.
•
Direct-response advertising is defined as (1) that advertising whose primary purpose is to elicit
sales to customers who could be shown to have responded specifically to the advertising and (2)
that advertising which results in probable future economic benefits.
(1) Advertising whose primary purpose is to elicit sales to customers who could be shown to have
responded specifically to the advertising. To conclude that the advertising cost has met this
requirement to be considered direct-response, there must be a means of documenting that
response, including a record that can identify the name of the customer and the advertising that
elicited the direct response. Direct-response advertising therefore excludes advertising that is
directed to an audience which could not be shown to have responded specifically to the directresponse advertising (such as a television commercial announcing that order forms (which are
direct response advertising) soon will be distributed directly to some people in the viewing area.
(2) Advertising which results in probable future economic benefits. This condition requires
persuasive evidence, including verifiable historic patterns of results, that the direct-response
advertising’s effects will be similar to the effects of responses to past direct-response advertising
activities of the entity that resulted in future benefits. In the absence of an operating history for a
particular product or service, although industry statistics would not be considered objective
evidence that direct-response advertising will result in future benefits, statistics for operating
histories of other products or services the company provides may be used if it can be
demonstrated that the statistics for the statistics for the other products or services are likely to be
highly correlated to the statistics of the particular product or service being evaluated.
Direct-response advertising costs, once capitalized, should be amortized to expense over the period
during which the future benefits are expected to be received using the ratio that current period revenues
for the direct-response advertising costs bear to the total of current and estimated future-period revenues
for that direct-response advertising cost. A search of companies that capitalize direct-response
advertising costs provided the following companies and their amortization periods: (See Table 1.)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone:
(301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval
system, or transm itted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information
in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the
Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to
be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.
Overview of SOP 93-7: Accounting for Direct Respons e Advertising Costs (7/20/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
Overview of Airline Industry Depreciation Policies, 12/22/99
CFRA believes that certain airline companies have recently obtained an earnings boost by extending
the depreciable lives and increasing the residual values relating to operating aircraft. In addition, some
airlines have recently recorded one-time write-downs and losses on the sale of aircraft, leading to
questions about the proper depreciable life of aircraft.
Typically, an airline’s aircraft depreciation expense is derived by initially estimating both the useful
life and the residual value -- or the perceived fair market value of the aircraft at the end of its estimated
useful life. To determine the periodic depreciation expense -- which reduces the value of the aircraft on
the company’s balance sheet while increasing operating expenses -- the total cost of the aircraft is reduced
by the estimated residual value and that sum is divided by the estimated useful life. By increasing the
estimated residual value and extending the estimated useful life of its aircraft, an airline company would
prospectively record a lower depreciation expense on its income statement and a higher value for each
aircraft on its balance sheet. Consequently, the airline would receive a boost to earnings in all future
periods and a boost to earnings growth during the four quarters following the change, as prior financial
statements are not restated. While near term earnings would be boosted by the reduced depreciation
expense, future earnings may be adversely impacted from this change as the reduced depreciation expense
leads to higher reported aircraft values and, if upon disposition of the aircraft the book value is in excess
of the realizable value, losses will be incurred.
Prior to 1998, most major airlines’ depreciable lives for a majority of their aircraft hovered
around 20 years with an estimated residual value of generally 5% of the cost of the asset. On January 1,
1998 Continental Airlines, Inc. (“CAL”) was the first of CFRA’s studied universe of 10 major airline
companies to change its depreciation policy. Specifically, CAL extended the depreciable lives of certain
newer generation aircraft to 30 years from 25 and increased the estimated residual values of those aircraft
to 15% from 10%. Following suit were Delta Air Lines, Inc. (“DAL”) and America West Holdings
Corporation (“AWA”) during 1998 and Southwest Airlines Company (“LUV”), AMR Corporation
(“AMR”), and UAL Corporation (“UAL”) during 1999, while Alaska Airgroup Inc. (“ALK”), Northwest
Airlines Corporation (“NWAC”), Trans World Airlines, Inc. (“TWA”), and US Airways Group, Inc.
(“U”) have all apparently made no recent changes in their policies.
CFRA is especially concerned about these changes in depreciation estimates as many of the
companies have recently recorded write-downs or incurred losses on the disposition of certain aircraft.
These write-downs and losses indicate that prior estimates of useful lives and residual values were overly
ambitious as the current recorded book value of aircraft exceeded the fair market value and thus a lower
useful life and residual value might be the more appropriate change as opposed to a higher useful life and
residual value.
Of the ten companies examined, CFRA believes U and ALK use the most conservative depreciation
policies while CAL and TWA appear to employ the most aggressive depreciation policies. Below is a
company-by-company analysis of each company’s depreciation policy ranked by those who have enacted
recent changes to their policy.
1999 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone:
(301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval
system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information
in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the
Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to
be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.
Overview of Airline Industry Depreciation Policies (12/22/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
Sykes Enterprises, Incorporated
100 North Tampa Street, Suite 3900
Tampa, Florida 33602
(813) 274-1000
Ticker Symbol: SYKE
Exchange: Nasdaq/NMS
Website: www.sykes.com
1999 Fiscal Year-End: 12/31/99
Auditor: Ernst & Young
2/7/00 Close: $14.25
52-Week: $17.00 – 52.25
Price/Earnings: 38
Price/Sales: 19.5
Mkt. Cap.: $604.1 million
Sykes Enterprises, Incorporated (“SYKE”) provides information technology outsourcing services,
including information technology support services, development services and solutions, on-line clinical
managed care services, medical protocol products, employee benefit administration and support services,
and customer product services. SYKE also provides outsourced care management services and products,
and employee benefit administration services.
FINANCIAL SUMMARY
($ mils., except EPS & %)
3 Mos. 12/99
3 Mos. 12/98
% Change
Year 12/99
Year 12/98
% Change
Revenue
163.6
142.4
15%
575.0
469.5
22%
Gross Profit
56.4
55.3
2%
203.1
179.7
13%
Operating Income
13.1
20.0
(35%)
45.5
58.4
(22%)
Net Income
7.4
11.9
(38%)
27.7
35.8
(23%)
$0.17
$0.28
(39%)
$0.60
$0.85
(29%)
Cash & Mkt. Securities
NA
36.3
NM
NA
36.3
NM
Total Receivables
NA
113.8
NM
NA
113.8
NM
Total Assets
NA
365.1
NM
NA
365.1
NM
Total Debt
NA
79.4
NM
NA
79.4
NM
201.1
164.9
22%
201.1
164.9
22%
CFFO
NA
27.2
NM
NA
41.1
NM
Depreciation & Amort.
NA
9.1
NM
NA
21.8
NM
Capital Expenditures
NA
15.4
NM
NA
37.3
NM
EPS (Diluted)
Stockholders’ Equity
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
Rite Aid Corporation
30 Hunter Lane
Camp Hill, Pennsylvania 17011
(717) 761-2633
Ticker Symbol: RAD
Exchange: NYSE
Website: www.riteaid.com
2000 Fiscal Year-End: 2/26/00
Auditor: Deloitte & Touche
8/3/00 Close: $4.13
52-Week: $4.13 – 23.25
Price/Earnings: NA
Price/Sales: 0.1
Mkt. Cap.: $1.4 billion
Rite Aid Corporation (“RAD”) is a retail drugstore chain that operates in 30 states and in the
District of Columbia. The Company announced on July 12, 2000, that it has agreed to sell its PCS Health
Systems, Inc. subsidiary for $1 billion to Advance Paradigm, Inc.
FINANCIAL SUMMARY
($ mils., except EPS & %)
3 Mos. 5/00
3 Mos. 5/99
% Change
Year 2/00
Year 2/99
% Change
3,442.2
3,352.5
3%
14,681.4
12,782.9
15%
Gross Profit
784.3
826.6
(5%)
3,268.7
3,039.1
8%
Net Income
(695.4)
(43.8)
NM
(1,143.1)
(422.5)
NM
EPS (Diluted)
($2.69)
($0.17)
NM
($4.45)
($1.64)
NM
Cash & Mkt. Securities
114.9
NA
NM
184.6
87.3
111%
Total Receivables
116.1
NA
NM
756.2
643.2
18%
Inventory
2,745.9
NA
NM
2,644.0
2,647.0
0%
Total Assets
9,447.3
NA
NM
10,807.9
10,512.5
3%
Total Debt*
6,558.0
NA
NM
6,608.9
5,914.8
12%
Stockholders’ Equity
(244.7)
NA
NM
431.5
1,350.6
(68%)
CFFO
(9.5)
(36.7)
NM
(410.7)
151.9
(370%)
Depreciation & Amort.
91.7
93.9
(2%)
501.0
399.3
25%
Capital Expenditures
18.9
146.4
(87%)
453.6
1,347.1
(66%)
Revenue
* Includes capital lease obligations, redeemable preferred stock, and convertible notes.
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
Update -- Rite Aid Corporation (“RAD”), 8/4/00:
Summary of Restatements and Q1 (5/00) Comments
Restatement Summary
On July 11, 2000, RAD announced that it had restated its fiscal 1999, 1998, and 1997 (periods ended
February) results, following a review by the Company’s new auditors. The restatement included over
$1.5 billion in charges. According to the July 2000 press release and conference call, the restatements fell
into the following seven principal categories (see Table 1):
Inventory and Cost of Goods Sold. RAD adjusted inventory and cost of goods sold by $438.8 million in
fiscal 1999, $63.4 million in fiscal 1998, and by $133.8 million in fiscal 1997 to: (1) reverse unearned
vendor allowance that had previously reduced cost of goods sold; (2) to establish reserves for inventory
obsolescence (which were previously omitted from cost of goods sold); (3) to correctly apply the retail
method of accounting; (4) record selling costs such as promotional markdowns and shrink in the
appropriate period; and (5) to recognize inventory purchases in the appropriate periods.
Purchase Accounting. RAD adjusted certain liabilities and goodwill relating to past acquisitions by
$133.9 million in fiscal 1999, $152.1 million in fiscal 1998, and $14.8 million in fiscal 1997 to reduce
goodwill and certain liabilities.
Accruals for Operating Expenses. RAD adjusted certain operating costs, including vacation pay, payroll,
executive retirement plans, insurance claims, and incentive compensation by $123.1 million in 1999,
$81.0 million in 1998, $262.2 million in 1997 to expense them in the period incurred and to record a
corresponding liability for items not paid at the end of the corresponding period.
Property, Plant and Equipment. RAD adjusted PP&E by $110.4 million in fiscal 1999, $246.2 million in
fiscal 1998, and $149.6 million in fiscal 1997 to: (1) expense certain items (including repairs,
maintenance, interest, and internally developed software) that were previously capitalized; and (2) to
increase depreciation expense to reverse the effects of retroactive changes previously made to the useful
lives of certain assets and to depreciate assets misclassified as construction in-progress.
Lease Obligations. RAD made adjustments to its sale -leaseback transactions, amounting to $13.7 million
in fiscal 1999, $40.7 million in fiscal 1998, and $1.1 million to: (1) reverse the asset sales and establish
lease obligations; and (2) to record certain leases that were previously classified as operating leases (and
therefore were omitted from the balance sheet).
Exit Costs and Impairment of Operating and Other Assets. RAD made other adjustments amounting to a
$44.7 million benefit in fiscal 1999, $141.2 million charge in fiscal 1998, and $113.8 million in fiscal
1997 to: (1) recognize store closure charges in the appropriate period; (2) to change the method used to
evaluate asset impairment; and (3) to record impairment charges in the appropriate period.
Income Taxes. RAD adjusted its fiscal 1999 and 1998 financial statements by recording benefits of
$237.9 million and $263.6 million, respectively, to: (1) properly reflect the tax effect of all restated
adjustments discussed above; and to (2) expense items in the proper period.
2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone:
(301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval
system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information
in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the
Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to
be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.
Rite Aid Corporation (8/4/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
2
Table 1: Restatement Categories, Fiscal 1997-99
Fiscal 1999
Fiscal 1998
Fiscal 1997
Total
Inventory & COGS
438.8
63.4
133.8
636.0
Purchase Accounting
133.9
152.1
14.8
300.8
Accruals (Operating Expenses)
123.1
81.0
262.2
466.3
PP&E
110.4
246.2
149.6
506.2
Lease Obligations
13.7
40.7
1.1
55.4
Exit Costs and Other
(44.7)
141.2
113.8
210.3
Income Taxes
(237.9)
(263.6)
(225.6)
(727.1)
Other - Miscellaneous
28.9
31.1
104.6
164.6
Total
566.2
492.1
554.3
1,612.5
($ millions)
Gross Margin Decline
RAD ’s gross margin declined year-over-year during the May 2000 quarter, following a simila r decline
during fiscal 2000. As shown in Table 2, the gross margin by 190 basis points both in May and in fiscal
2000. According to the Company’s May 2000 10-Q and fiscal 2000 10-K, the decline in both periods
resulted from rising third party sales whic h yield lower margins, and decreasing margins on third party
prescription sales.
Table 2: Gross Margin, Year-Over-Year
Q1, 5/00
Q1, 5/99
Year Ended 2/00
Year Ended 2/99
GM (%)
22.8%
24.7%
21.9%
23.8%
Change*
(190 b.p.)
(190 b.p.)
* b.p. = basis points
Elevated Debt Level
RAD’s debt-to-assets ratio increased and remained at a relatively high level in May 2000. As shown in
Table 3, the Company’s debt-to-assets ratio amounted to 69% at May 2000, up from 61% at February
2000.
Table 3: Total Debt-to-Assets, Quarterly Ratio
($ millions, except %)
Q1, 5/00
Q4, 2/00
Q4, 2/99
Total Debt *
6,558.0
6,608.9
5,914.8
Equity
(244.7)
431.5
1,350.6
Total Assets
9,447.3
10,807.9
10,512.5
69%
61%
56%
Debt / Total Assets
* Includes capital lease obligations, redeemable preferred stock, and convertible notes.
Rite Aid Corporation (8/4/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
3
Sykes Enterprises, Incorporated (“SYKE”), 2/8/00:
Aggressive Revenue Recognition Results in Earnings Restatement
SYKE announced yesterday that it would restate revenue and earnings for the second and third
quarters of fiscal 1999 as a result of improper revenue recognition for certain software contracts. CFRA
notes that the recent announcement heightens our ongoing concerns regarding the Company’s aggressive
accounting procedures.
In our April 1999 report, CFRA expressed concern about the quality of revenue and earnings in
1998 as a result of apparent aggressive revenue recognition. Specifically, the Company recorded $10
million of revenue on a non-monetary transaction with a non-public entity. CFRA believes the
transaction would have been more appropriately classified as an investment rather than a revenuegenerating transaction. As of February 7, 2000, SYKE had yet to collect the receivable related to the
transaction. Moreover, in our July 1999 update, we expressed concern about the possibility of an
earnings boost during the June 1999 quarter as a result of unusual accounting for the sale of a business
unit. Specifically, on June 29, 1999 (two days prior to the end of the quarter), the Company announced
that it had signed a definitive agreement to sell its manufacturing solutions unit with an effective sale date
of April 1, 1999.
On January 25, 2000, the Company revised its fourth quarter revenue and earnings estimates
downward which, according to the Company, was due to anomalies which included the following: a
significant number of customer contracts committed during the fourth quarter for which no revenue was
recorded despite considerable costs being incurred, weaker than anticipated results of the Company’s
wholly owned subsidiary SHPS, Incorporated, and the negative impact of foreign currency translation.
The Company anticipated that revenue relating to these contracts would be included during the first
quarter of fiscal 2000 and increased that period’s revenue and earnings’ forecasts accordingly.
Subsequently, on February 7, 2000, the Company announced that their auditors suggested that the
Company restate revenue and earnings for the second and third quarters of 1999. The restatement related
to improper accounting for revenue for SYKE’s AnswerTeam™, a diagnostic desktop tool bundled with
the Company’s technical support services.
As shown in Table 1, the Company reduced revenue and net income by $20 million and $9.8 million
for the September 1999 quarter, and by $12.0 million and $7.5 million for the June 1999 period.
Furthermore, CFRA notes that the impact of the Company’s aggressive revenue recognition resulted in a
staggering 200% overstatement of earnings during each of the respective periods. While the Company
provided little guidance regarding the future impact of its newly adopted accounting method relating to
software revenue recognition, it reported that it expects to record the revenue initially recorded during the
second and third quarters of 1999 over the next five years (not in the first quarter of fiscal 2000 as
originally anticipated).
2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone:
(301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval
system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information
in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the
Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to
be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.
Sykes Enterprises Incorporated (2/8/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
2
Table 1: Revenue and Earnings, Initially Reported versus Adjusted for Improper Revenue Recognition, Q3
(9/99) and Q2 (6/99)
Q3, 9/99
Initially
Reported
Adjustment
Revenue
161.0
(20.0)
Direct Costs
96.7
General & Admin.
Q2, 6/99
Change
Initially
Reported
Adjustment
141.0
(14.2%)
146.1
(12.0)
134.1
(9%)
(4.2)
92.5
(4.5%)
88.9
--
88.9
--
40.1
0.3
40.4
(1%)
37.6
0.2
37.8
NM
Net Income
14.1
(9.8)
4.3
(228%)
11.5
(7.5)
4.0
(186%)
EPS
$0.33
($0.23)
$0.10
(230%)
$0.27
($0.18)
$0.09
(200%)
($ mils., except EPS)
Adjusted
Sykes Enterprises Incorporated (2/8/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
Adjusted
3
Change
Airline Companies which have Recently Changed Depreciation Policies:
Continental Air Lines, Inc. (“CAL”) – CAL increased its estimated useful life on certain new
generation aircraft and increased the residual value on all aircraft on January 1, 1998. Specifically, CAL
changed to an estimated useful life of 30 years from 25 years on newer model planes the Company has
recently purchased. Furthermore, CAL increased its estimated residual value on all aircraft to 15% from
10%. CAL officials indicated the change was made because aircraft purchased during the 1970’s were
continuing to be used and that newer aircraft were more fuel-efficient. However, in recent years, the
Company has recorded two aircraft write-downs: $122 million in the September 1998 quarter and $128
million in the September 1996 period. CAL did not disclose the earnings effect of this change for the
year ended December 1998.
Delta Air Lines, Inc. (“DAL”) – DAL extended the life of certain new generation aircraft types on July
1, 1998 to 25 years from 20 years. Furthermore, the Company’s residual values for aircraft changed from
a policy of 5% of the cost of the aircraft to between 5% to 10% of the cost. This change reduced
depreciation expense by $92 million for the fiscal year ended June 1999, resulting in a boost to reported
earnings of $0.37. Absent the change CFRA estimates DAL’s fiscal 1999 earnings would have been
$6.83 rather than the reported $7.20. Furthermore, we find this change particularly unusual since DAL
recorded a charge of $107 million to write-down to estimated fair value aircraft parts and obsolete flight
equipment and parts during the September 1999 quarter.
America West Holdings Corporation (“AWA”) - On October 1, 1998 AWA increased the average
depreciable life of its 737-200 aircraft by four years while holding constant the residual value. The
depreciable lives of aircraft prior to that change had been between 11 and 22 years. As a result of this
change, depreciation expense was reduced by $2.0 million in each of the subsequent four quarters. Had
AWA not made this change, earnings for the nine months ended September would have been reduced by
$0.09 per share: to $2.17 from the reported $2.26.
Southwest Airlines Company (“LUV”) - Effective January 1, 1999 LUV extended the depreciable lives
of its 737-300/500 airplanes to 23 years from 20 years. As a result of this change, depreciation expense
for the three and nine months ended September 1999 was reduced by $6.4 million and $19.3 million,
respectively. Absent the change in estimate, earnings for the September quarter would have been lower
by $3.9 million: to $123.1 million from the reported $127.0 million. Likewise, earnings for the nine
months ended September would have been reduced by $11.8 million: to $368.7 million from the reported
$380.5 million.
Furthermore, the depreciable lives of all other aircraft were apparently extended as well. Specifically, the
Company’s 1997 policy had been reported as a useful life of 12 to 20 years, while the 1998 policy was
indicated as 20 to 25 years.
AMR Corporation (“AMR”) - AMR changed its useful life and residual values for certain aircraft on
January 1, 1999. Specifically, the Company lengthened its useful life to 25 years from 20 years and
increased the residual values from 5% to 10%. By making this change, AMR reduced its depreciation
expense by $39.0 million and $119.0 million for the three and nine months ended September from what
would have prevailed absent the change. Had the Company not made this change, earnings for the
September 1999 quarter would have been cut by $0.15 per share: to $1.61 from the reported $1.76.
Earnings for the nine months ended September would have likewise been reduced by $0.44: to $4.00
from the reported $4.44.
Overview of Airline Industry Depreciation Policies (12/22/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
UAL Corporation (“UAL”) - On April 1, 1999 UAL increased the depreciable life of certain aircraft to
25 years from a previous standard of 20 to 23 years. Furthermore, the Company increased the residual
values of those same aircraft to 10% from the previously reported 4.5% to 7.3%. As a result of this
change, depreciation expense was reduced by $30.0 million during the six months ended September. Had
UAL not made this change, earnings for the nine months ended September would have been reduced by
$0.27 per share: to $8.92 from the reported $9.19.
Airline Companies which have not Changed Depreciation Policies:
Alaska Airgroup Inc. (“ALK”) - ALK has maintained constant its depreciation policy at eight to 20
years for aircraft, which ranks as one of the most conservative in the industry.
Northwest Airlines Corporation (“NWAC”) - NWAC has held constant its depreciation policy at a
range not exceeding 25 years.
Trans World Airlines, Inc. (“TWA”) – Although TWA’s depreciation policy has remained unchanged
over the past two years, the Company’s policy of a 16 to 30 year useful life is relatively high in
comparison to the others in the industry.
US Airways Group, Inc. (“U”) - U’s depreciation policy, one of the industry’s most conservative, has
remained constant over the past two years at a useful life of eleven to 20 years for aircraft.
Overview of Airline Industry Depreciation Policies (12/22/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
Table 1: Companies That Capitalize Direct-Response Advertising Costs and Their Amortization Periods
Company Name
Charter Communications, Inc. (CHTR)
Elcom International, Inc. (ELCO)
Egghead.com, Inc. (EGGS)
Amortization Period
24 – 48 months
5 months
About 2 months (8 weeks)
Ennis Business Forms Inc. (EBF)
3 – 12 months
Federated Department Stores (FD)
1 – 4 months
J C Penney Company, Inc. (JCP)
Not to exceed 6 months
Lands’ End, Inc. (LE)
3 months
Mattel, Inc. (MAT)
3 months
Newport Corporation (NEWP)
12 – 18 months
Nordstrom, Inc. (JWN)
Not to exceed 6 months
OfficeMax, Inc. (OMX)
6 months
PETsMART, Inc (PETM)
6 –12 months
PolyMedica Corporation (PLMD)
24 - 48 months
Staples, Inc. (SPLS)
6 months
Time Warner, Inc. (TWX)
36 months
While the amortization terms are only a few months for companies such as retailers, which typically
amortize such direct-response costs over the perceived life of a catalog, certain companies amortize
their direct-response advertising costs over periods of up to four years.
Specifically, Charter Communications, Inc., which operates cable systems, amortizes such costs over
two to four years depending on the type of service the customer subscribes to and represents the period
the customer is expected to remain connected to the cable system.
PolyMedica Corporation, a provider of direct-to-consumer specialty medical products and services
primarily focused in the diabetes supplies and consumer healthcare markets, amortizes its directresponse costs related to its diabetes customers on an accelerated basis during the first two years of a
four-year period. The amortization rate is such that 55% of such costs are expensed after two years
from the date they are incurred, and the remaining 45% is expensed on a straight-line basis over the
next two years. PolyMedica justifies its relatively lengthy amortization period by stating that revenue
generated from new diabetes customers as a result of direct-response advertising has historically
resulted in a revenue stream lasting at least seven years, thus PolyMedica feels that it has selected a
more conservative amortization period. In addition, PolyMedica amortizes its direct-response costs
related to its Professional Products segment over a two-year period since it believes that historical
evidence suggests that revenues generated by new respiratory customers, as a result of direct-response
advertising, last on average three years, and again they feel they have selected a more conservative
amortization period.
Overview of SOP 93-7: Accounting for Direct Respons e Advertising Costs (7/20/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
Time Warner, Inc., a media and entertainment company, capitalizes direct-response product
promotional mailing costs, broadcast advertising costs, catalogs, and other promotional costs incurred
in the Company's direct-marketing businesses. Time Warner generally amortizes its direct-response
costs over periods of up to three years subsequent to the promotional event using straight-line or
accelerated methods, with a significant portion of such costs amortized in twelve months or less.
Overview of SOP 93-7: Accounting for Direct Respons e Advertising Costs (7/20/00)
2000 by the Center for Financial Research and Analysis, Inc. (CFRA)
PAREXEL International Corporation (“PRXL”), 3/5/01:
Increase in Receivables and Restatement of Financial Statements
Increase in Receivables Level
PRXL’s balance of total receivables continued to rise significantly faster than revenue in the December
2000 quarter. As measured in days sales outstanding (DSO), receivables amounted to 187 days at
December 2000 – up 5 days sequentially (September 2000), 25 days from year-end fiscal 2000, and 63
days from the year-ago period (December 1999). (See Table 1.)
PRXL’s clinical research and development contracts are generally fixed price (with some variable
components) and range in duration from a few months to several years. The Company recognizes fixed
price contract revenue using the percentage of completion method, for which revenue recognition does
not necessarily match the time of billing. After receiving a portion of the contract fee at contract
inception, PRXL bills the client according to the terms of the contract. But the Company estimates and
recognizes project revenue based not upon such billings, but rather based on the ratio that costs incurred
to date bear to the Company’s estimated total costs at completion.
When revenue recognition in any particular period exceeds the amount billed in that period, the excess is
recorded as “unbilled receivables.” PRXL combines its unbilled receivables with billed receivables in the
“accounts receivable” line item on its balance sheet. Unbilled Receivables constitutes the gross
cumulative amount of revenue recognized which PRXL has not yet billed. In contrast, the Company
records “advance billings” to reflect cash payments received for which the Company has not yet
recognized revenue. Net of advance billings, PRXL reported that its DSO would have increased to 69
days, from 60 days at year-end fiscal 2000.
CFRA finds this increase particularly troublesome given that the Company experienced contract
cancellations of $36 million during the six months ended December 31, 2000. Although a decrease from
the same period in the prior year ($55 million), we are concerned that the use of the percentage method on
contracts which may be terminated with little notice (60-90 days in the case of PRXL) may place a
company at risk of recognizing more revenue than the amount for which the customer is willing to pay in
the event of termination.
Table 1: Receivables, in Days Sales Outstanding (DSO), Based on Quarterly Sales
($ mils., except DSI)
Q2, 12/00
Q1, 9/00
Q4, 6/00
Q3, 3/00
Q2, 12/99
Q1, 9/99
Net Revenue
94.3
88.2
91.2
97.3
98.0
91.8
Receivables
193.3
176.3
162.1
136.1
133.2
123.1
187
182
162
128
124
122
DSO
2001 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone:
(301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval
system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information
in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the
Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to
be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.
PAREXEL International Corporation (3/5/01)
2001 by the Center for Financial Research and Analysis, Inc. (CFRA)
2
Restatement of Fiscal 2000 Financial Statements and Change in December Press Release vs. 10-Q
In its December 2000 quarterly 10-Q, PRXL retroactively restated its fiscal 2000 financial statements and
reported that the balances of certain accounts as reported in its December 2000 quarterly press release and
conference call were misstated. As a result of these two issues, CFRA is concerned about the Company’s
financial reporting.
Specifically, in its December 2000 10-Q, PRXL reported the following restatement of its financial
statements:
“Subsequent to the issuance of the June 30, 2000 financial statements, [PRXL] determined that at June
30, 2000, its intercompany accounts did not fully eliminate in consolidation. The unreconciled difference,
amounting to $7.6 million, was originally classified as a reduction to advance billings on the consolidated
balance sheet. Based on subsequent analysis, [PRXL] determined the appropriate accounts to which the
difference previously included in advance billings should have been recorded. Accordingly, the financial
statements for the year ended June 30, 2000 have been restated to reflect these changes. The restatement
resulted in a decrease of $4.1 million to the June 30, 2000 working capital principally related to currency
translation adjustments which increased the previously reported balance for advance billings and
correspondingly decreased stockholders' equity. In addition, total assets at June 30, 2000 increased by
$1.0 million due primarily to adjustments to unbilled and trade receivables for the same reason.
As part of the adjustments described above, the Company also identified certain charges that should have
been made to its consolidated statement of income for the fiscal year ended June 30, 2000 of $1.6 million
on a pre-tax basis, resulting in a $1.1 million reduction to net income for the year.
The restated numbers are properly reflected in the financial statements for the quarter and six months
ended December 31, 2000.”
PRXL also reported in its December 2000 10-Q the following relating to its results for the December
2000 quarter as originally reported in its quarterly press release and conference call:
“In connection with the final quarterly closing process and completion of this report on Form 10-Q for the
period ended December 31, 2000, the Company determined that cash and cash equivalents (including
marketable securities) at period end was $82.0 million, total assets were $376.1 million, working capital
was $124.9 million and stockholder's equity was $184.7 million. In the Company's earnings release and
related telephone conference call on January 25, 2001, the Company preliminarily reported these amounts
at $91.4 million, $385.5 million, $123.3 million and $183.3 million, respectively. The changes reflected
in the final numbers are a result of a $9.4 million re-classification between cash and accounts payable and
a $1.4 million favorable working capital adjustment.”
Decline in Revenue Growth
PRXL’s year-over-year revenue growth rate continued to fall in the December 2000 quarter. As shown in
Table 2, the Company’s year-over-year revenue growth fell to negative 3.7% in December after falling
by 3.9% in the September quarter, and growing by 3.9% in the June quarter and by 8.0% in the March
quarter. The Company attributed a portion of the revenue decline in the December quarter to the impact
of cancellations, as discussed in the previous point.
PAREXEL International Corporation (3/5/01)
2001 by the Center for Financial Research and Analysis, Inc. (CFRA)
3
Table 2: Year-Over-Year Revenue Growth
Q2, 12/00
Q1, 9/00
Q4, 6/00
Q3, 3/00
(3.7%)
(3.9%)
3.9%
8.0%
Deterioration in Operating Cash Flows
PRXL reported poor operating cash flows during the December quarter of 2000. As shown in Table 3,
cash flows from operations (CFFO) plummeted to negative $4.1 million from positive $21.7 million,
creating a CFFO-to-net income shortfall of $5.1 million versus a surplus of $16.6 million in the year-ago
period. The deterioration in the Company’s December 2000 CFFO appears to relate to the increase in
PRXL’s receivables level, as discussed in a prior point.
Table 3: Cash Flows from Operations (CFFO) versus Net Income (NI)
($ millions)
CFFO
NI
CFFO – NI
Q2, 12/00
Q2, 12/99
Six Months 12/00
Six Months 12/99
(4.1)
21.7
4.2
37.0
1.0
5.1
0.9
8.9
(5.1)
16.6
3.3
28.1
Continued Decline in Gross Margin
PRXL’s gross margin continued to decline year-over-year in the December 2000 quarter. As shown in
Table 4, the Company’s margin declined by 370 basis points in the December 2000 quarter, 520 points in
the September quarter, 90 points in the June quarter, and 300 points in the March quarter.
Table 4: Gross Margin, Compared Year -Over-Year
Fiscal 2001 (6/01)
Difference
Fiscal 2000 (6/00)
Difference
Fiscal 1999 (6/99)
Q2, December
Q1, September
28.1%
27.1%
(370 b.p.*)
(520 b.p.)
31.8%
32.3%
Q4, June
Q3, March
28.9%
31.0%
(90 b.p.)
(300 b.p.)
29.8%
34.0%
* b.p. = basis points
PAREXEL International Corporation (3/5/01)
2001 by the Center for Financial Research and Analysis, Inc. (CFRA)
4
FINDINGS
MID/LARGE CAP: #2
‚ Serious Operational Concerns
‚ Artificial Earnings Boost from Aggressive
Accounting Practices
Serious Operational Concerns. CFRA believes that AOL’s aggressive accounting masks some
serious operational problems. On three previous occasions (June 1994, October 1995, and June 1996),
CFRA has warned of aggressive accounting. We believe that AOL’s operations have continued to
weaken, as evidenced by faltering cash flows and slowing revenue growth.
C
Deteriorating Operational Cash Flows. An excellent measure of a healthy company is strong
growth in its cash flows from operations (CFFO). Disappointingly, during the year ended June
1996, AOL reported negative CFFO of $66.7 million, compared to a positive $17.3 million during
the prior-year period. Moreover, during the 1996 period, CFFO lagged behind reported income by
an astounding $96.5 million, raising questions about overly aggressive accounting policies used.
(See Table 1.)
Table 1: Cash Flows from Operations versus Net Income
Cash Flows from Operations
(CFFO)
Net Income (NI)
CFFO - NI
C
Year Ended June 1996
Year Ended June 1995
($66.7 million)
$17.3 million
$29.8 million
($35.8 million)
($96.5 million)
$53.1 million
Slowing Revenue Growth. After several periods of explosive growth, it appears AOL’s rate of
growth is slowing. As Table 2 illustrates, AOL’s total revenue growth slowed to 120% in the June
1996 quarter (relative to the prior-year quarter). By contrast, total revenues had grown by 226% as
recently as the December 1995 quarter.
© 1996 by the Center for Financial Research and Analysis (CFRA), 10800 Mazwood Place, Rockville, MD, 20852; Phone: (301) 984-1001;
Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in
whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on
sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange
Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention,
or sale of the securities of the company mentioned.
America Online, Inc. (10/12/96)
© 1996 by the Center for Financial Research and Analysis (CFRA)
2
The more moderate growth appears related to a decreasing customer retention rate. Apparently,
AOL added 1.8 million subscribers in the June quarter, but lost 1.5 million, resulting in a net gain of
only 300,000, down significantly from prior quarters. AOL is also considering offering a flat rate
fee for unlimited Internet access, which would likely lead to lower revenues.
One reason for the slowdown in revenue growth is the Company’s new pricing strategy. Starting in
July 1996, AOL began offering 20 hours of on-line access for $19.95, down from its prior rate of
$54.20, a reduction of 63.2%. Furthermore, AOL has recently announced that it would consider
offering lower flat rate fees, another drag on revenue growth.
Table 2: Recent Quarterly Revenue Growth, Versus Prior Year Quarter and Sequentially
June 1996
Quarter
March 1996
Quarter
Dec. 1995
Quarter
Sept. 1995
Quarter
June 1995
Quarter
Total Revenues, versus
year-ago quarter
120.3%
186.3%
226.1%
247.5%
275.7%
Total Revenues, versus
prior quarter
7.1%
25.4%
25.9%
54.6%
20.2%
Artificial Earnings Boost from Aggressive Accounting Practices. CFRA believes that AOL’s
aggressive accounting practices allow the Company to artificially inflate reported earnings by a
significant amount. Specifically, as outlined below, AOL treats marketing costs and product
development costs in an aggressive manner.
C
Aggressive Accounting for Marketing Costs. Despite its negative operating cash flows, AOL is
able to post profits by using aggressive accounting policies, particularly related to marketing costs.
If AOL had used more conservative (and in our judgment, proper) accounting policies, it would
have reported losses in line with its negative cash flows.
AOL capitalizes and writes off over 24 months certain marketing costs. CFRA believes such costs
should be expensed as incurred or, at a minimum, amortized more quickly. We consider marketing
expenses normal recurring operating costs, which should be expensed as incurred. Had AOL taken
this approach, the Company would have posted an operating loss of $154.8 million for the year
ended June 1996, rather than an $82.2 million profit. Additionally, it would have suffered a net
loss of roughly $124.2 million, or $1.14 per share, rather than the reported net income of $29.8
million, or $0.28 per share. (See Table 3.)
Moreover, the gap between reported earnings and earnings adjusted for the effect of capitalizing
such costs will likely increase in the future, as AOL increases its marketing expenditures. According
to AOL, “the Company anticipates lower direct response rates, and as a result, cost per registration
for the AOL service is expected to increase.” The cost of acquiring customers already exploded to
roughly $270 each in the June quarter, up significantly from only $130 in the March quarter. AOL
also stated that the declining retention rate resulted primarily from:
America Online, Inc. (10/12/96)
© 1996 by the Center for Financial Research and Analysis (CFRA)
3
“(1) competition from an increasing number of service providers; (2) the availability of
alternative pricing models from competitors, including unlimited use pricing; and (3) an
increase in less-qualified new subscribers as a result of increased direct marketing to the
mass consumer audience.”
Table 3: Effects of Capitalization of Marketing Costs on Nine Months Ended March 1996
Reported
Adjustment*
CFRA-Adjusted
Operating Income
$82.2 million
($237.0 million)
($154.8 million)
Net Income
$29.8 million
($154.0 million)
($124.2 million)
$0.28
($1.42)
($1.14)
EPS
* Assuming a 35% tax rate
It is noteworthy that AOL’s accounting policies have become progressively more aggressive over
the last few years, as the Company has lengthened its amortization period. Initially, the
amortization period was 12 months. But it was increased to 18 months, and then (right before a
1995 stock offering) to 24 months. The effect of its most recent change was to artificially boost net
income for the year ended June 1996 by $48.1 million (to the reported $29.8 million, from a net
loss of $18.3 million). (See Table 4.)
Table 4: Effects of Lengthening Amortization Period on Nine Months Ended March 1996
Reported
Adjustment*
CFRA-Adjusted
Operating Income
$82.2 million
($74.0 million)
$8.2 million
Net Income
$29.8 million
($48.1 million)
($18.3 million)
$0.28
($0.45)
($0.17)
EPS
* Assuming a 35% tax rate
C
Aggressive Accounting for Product Development Costs. In addition to boosting income by
stretching out its amortization of marketing costs, AOL also capitalizes product development costs
and amortizes them over five years. Had AOL expensed all such costs as incurred, then net income
for the year ended June 1996 would have declined by an additional $16.5 million (to $13.3 million
from the reported $29.8 million). (See Table 5.)
Table 5: Effects of Capitalization of Product Development Costs on Nine Months Ended March 1996
Reported
Adjustment
CFRA-Adjusted
Operating Income
$82.2 million
($25.4 million)
$56.8 million
Net Income
$29.8 million
($16.5 million)
$13.3 million
$0.28
($0.15)
$0.13
EPS
America Online, Inc. (10/12/96)
© 1996 by the Center for Financial Research and Analysis (CFRA)
4
C
Summary and CFRA Commentary. As outlined above, AOL’s earnings appear to be more the
result of aggressive accounting than of a profitable business. A far better gauge to measure AOL’s
economic health is the Company’s cash flow from operations.
For the year ended June 1996, AOL generated negative cash flows of $66.7 million, despite
reporting net income of $29.8 million. During that same nine-month period, the Company’s balance
sheet account “Deferred Subscriber Acquisition Costs” increased an astounding $237.0 million, to
$314.2 million from $77.2 million. (See Chart 1 and Table 6.) Since this account represents cash
paid for marketing costs not yet charged against income, it appears AOL has shifted substantial
operating losses to the balance sheet.
Chart 1: Recent Growth in Deferred Subscriber Acquisition Costs
Balance in Millions
350
300
250
200
150
100
50
0
6/95
9/95
12/95
3/96
6/96
Quarter Ended:
Deferred Subcriber Acquisition Costs
Table 6: Recent Ending Balances of Deferred Subscriber Acquisition Costs
($ millions)
Ending Balance of Deferred
Subscriber Acquisition Costs
June
1995
September
1995
December
1995
March
1996
June
1996
77.2
132.8
189.4
277.6
314.2
America Online, Inc. (10/12/96)
© 1996 by the Center for Financial Research and Analysis (CFRA)
5
America Online, Inc.
October 12, 1996
Moreover, the Supreme Court has held that a fact is material if there is:
“a substantial likelihood that the … fact would have been viewed by the reasonable investor as having
significantly altered the total mix of information made available.”
Interpreting Materiality
Rather than relying on a numerical threshold, materiality judgments should be based on all the facts,
qualitative and quantitative. The SEC staff (in Staff Accounting Bulletin No. 99) provides certain
valuable insights to help investors make materiality judgments.
According the SEC’s SAB No. 99, among the considerations that may well render material a
quantitatively small misstatement of a financial statement item are –
•
whether the misstatement arises from an item capable of precise measurement or whether it arises
from an estimate and, if so, the degree of imprecision inherent in the estimate
•
whether the misstatement masks a change in earnings or other trends
•
whether the misstatement hides a failure to meet analysts' consensus expectations for the
enterprise
•
whether the misstatement changes a loss into income or vice versa
•
whether the misstatement concerns a segment or other portion of the registrant's business that has
been identified as playing a significant role in the registrant's operations or profitability
•
whether the misstatement affects the registrant's compliance with regulatory requirements
•
whether the misstatement affects the registrant's compliance with loan covenants or other
contractual requirements
•
whether the misstatement has the effect of increasing management's compensation – for example,
by satisfying requirements for the award of bonuses or other forms of incentive compensation
whether the misstatement involves concealment of an unlawful transaction.
This is not an exhaustive list of the circumstances that may affect the materiality of a quantitatively small
misstatement. Among other factors, the demonstrated volatility of the price of a company’s securities in
response to certain types of disclosures may provide guidance as to whether investors regard
quantitatively small misstatements as material. Consideration of potential market reaction to disclosure of
a misstatement is by itself "too blunt an instrument to be depended on" in considering whether a fact is
material. When, however, management or the independent auditor expects (based, for example, on a
pattern of market performance) that a known misstatement may result in a significant positive or negative
market reaction, that expected reaction should be taken into account when considering whether a
misstatement is material.
Materiality (12/20/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
Attempt to Manage Earnings
The SEC staff will likely consider material even small intentional misstatements in financial statements,
for example, those actions designed to “manage earnings.” Investors generally would regard as
significant a management practice to “overstate” or “understate” earnings to up to an amount just short of
a percentage threshold in order to manage earnings.
Considerations of the Books and Records Provisions Under the Exchange Act
Even if misstatements are immaterial, companies must comply with Sections 13(b)(2) - (7) of the
Securities Exchange Act of 1934 (the "Exchange Act"). Under these provisions, companies must
make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of assets of the registrant and must maintain internal accounting controls
that are sufficient to provide reasonable assurances that, among other things, transactions are recorded
as necessary to permit the preparation of financial statements in conformity with GAAP. In this context,
determinations of what constitutes "reasonable assurance" and "reasonable detail" are based not on a
"materiality" analysis but on the level of detail and degree of assurance that would satisfy prudent
officials in the conduct of their own affairs. Accordingly, failure to record accurately immaterial items,
in some instances, may result in violations of the securities laws.
In a 1981 speech, former Chairman Harold M. Williams noted that, like materiality, "reasonableness" is
not an "absolute standard of exactitude for corporate records." Unlike materiality, however,
"reasonableness" is not solely a measure of the significance of a financial statement item to investors.
"Reasonableness," in this context, reflects a judgment as to whether an issuer's failure to correct a known
misstatement implicates the purposes underlying the accounting provisions of the Exchange Act.
In assessing whether a misstatement results in a violation of a company's obligation to keep books and
records that are accurate "in reasonable detail," companies and their auditors should consider, in addition
to the factors discussed above concerning an evaluation of a misstatement's potential materiality, the
following issues.
•
The significance of the misstatement. Though the SEC staff does not believe that companies need
to make finely calibrated determinations of significance with respect to immaterial items, plainly
it is "reasonable" to treat misstatements whose
effects are clearly inconsequential differently than more significant ones.
•
How the misstatement arose. It is unlikely that it is ever "reasonable" for companies to record
misstatements or not to correct known misstatements – even immaterial ones – as part of an
ongoing effort directed by or known to senior
management for the purposes of "managing" earnings. On the other hand, insignificant
misstatements that arise from the operation of systems or recurring processes in the normal course
of business generally will not cause a registrant's books to be inaccurate "in reasonable detail."
•
The cost of correcting the misstatement. The books and records provisions of the Exchange Act
do not require companies to make major expenditures to correct small misstatements. Conversely,
where there is little cost or delay involved in correcting a misstatement, failing to do so is
unlikely to be "reasonable."
Materiality (12/20/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
•
The clarity of authoritative accounting guidance with respect to the misstatement. Where
reasonable minds may differ about the appropriate accounting treatment of a financial statement
item, a failure to correct it may not render the company's financial statements inaccurate "in
reasonable detail." Where, however, there is little ground for reasonable disagreement, the case
for leaving a misstatement uncorrected is correspondingly weaker.
GAAP Precedence over Industry Practice
Some argue that companie s should be permitted to follow an industry accounting practice even
though that practice is inconsistent with authoritative accounting literature. This situation might
occur if a practice is developed when there are few transactions and the accounting results are
clearly inconsequential, and that practice never changes despite subsequent growth in the number
or materiality of such transactions. The SEC strongly disagrees with this argument and believes
that the authoritative literature takes precedence over industry practice that is contrary to GAAP.
Materiality (12/20/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
Materiality (12/20/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
I. Persuasive evidence of an arrangement exists
(a) Determine that the seller followed its normal and usual internal procedures required before
revenue is recognized. If such practices require a written sales agreement signed by the legal
department, then an oral agreement consummated on the last day of the quarter would permit no
revenue to be reported during that period.
(b) Ascertain that risks and rewards of ownership of the product and title transferred seller (or
consignor) to buyer. Thus, products delivered to a consignee pursuant to a consignment
arrangement are not sales and do not qualify for revenue recognition until a sale occurs.
(c) Other situations may exist where title to delivered product passes to a buyer, but the substance of
the transaction is that of a consignment or a financing. The following characteristics in a
transaction may preclude revenue recognition even if title to the product has passed to the buyer.
1. The buyer has the right to return the product
2. The seller is required to repurchase the product at specified prices
3. The transaction possesses the characteristics set forth in EITF Issue No. 95-1, Revenue Recognition
on Sales with a Guaranteed Minimum Resale Value
4. The product is delivered for demonstration purposes
II. Delivery has occurred or services have been rendered
(a) Delivery is not considered to have occurred unless the customer has taken title and assumed the
risks and rewards of ownership of the products specified in the purchase order or sales agreement.
Typically this occurs when a product is delivered to the customer’s delivery site (when terms are
FOB destination) or when a product is shipped to the customer (when terms are FOB shipping
point).
(b) The SEC still permits revenue recognition when no delivery has occurred when the following
criteria are met:
1. The risks of ownership have passed to the buyer
2. The customer made a fixed commitment to purchase the goods, preferably in writing
3. The buyer, not the seller, must request that the transaction be on a bill-and-hold basis. The buyer
must have a substantial purpose for ordering the goods on a bill-and-hold basis.
4. There must be a fixed schedule for delivery that is reasonable and consistent with the buyer’s
business purpose.
5. The seller must not have retained any specific performance obligations such that the earning process
is not complete
6. The ordered goods must have been segregated from the seller’s inventory and not subject to being
used to fill other orders.
7. The equipment (product) must be complete and ready for shipment.
(c) Layaway sales to customers. Provided the other criteria for revenue recognition are met, a seller
should recognize revenue from sales made under its layaway program upon delivery of
merchandise to its customer. Until then, any cash received should be recognized as a liability -“deposits received from customers for layaway sales.” The seller is not permitted to record
revenue at the earlier stage when collecting as cash deposit because the risk of ownership still
remains with the seller.
Revenue Recognition Concerns Expressed in Recent SEC Pronouncement (12/14/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
(d) Revenue recognition related to nonrefundable, up-front fees. (Examples include: (1) selling a
lifetime membership to a health club, (2) receiving an “activation fee” when entering into an
arrangement to provide telecommunications services, or (3) receiving a nonrefundable
“technology access fee” for providing research and development services.
According to the SEC, deferral of revenue is generally appropriate in each case; unless the up-front fee is
in exchange for products delivered or services performed that represent the culmination of the earnings
process. Since customers are buying on-going rights, revenue should be deferred. The up-front fees
(even if nonrefundable) are earned as the product and/or services are delivered and/or are performed and
generally should be deferred and recognized systematically over the periods that the fees are earned.
III. The seller’s price to the buyer is fixed or determinable
Cancellation and termination clauses provide complications in making revenue recognition decisions.
Close attention should be given to “side” agreements. If the cancellation privileges expire ratably over a
stated contract term, the sales price is considered to become determinable ratably over the stated term.
Companies that derive revenue from membership fees (e.g., Costco, MemberWorks, and Cendant) must
defer recognition of revenue from any fees paid in advance when the customer has the unilateral right to
cancel at any time and still receive a full refund since the SEC believes that the sales price in such
arrangements is neither fixed nor determinable. Thus, when the cancellation privilege expires over the
term of the contract, the SEC believes that the sales price becomes determinable ratably over that period.
Therefore, the membership fee should be credited to a monetary liability account such as “customers’
refundable fees,” and no revenue should be recorded until the membership period has lapsed without the
refund being granted. Nonetheless, the SEC notes that over the years the accounting for membership
refunds has evolved from SFAS No. 48 – a standard that permitted revenue recognition (net of estimated
refunds) under certain circumstances. For the SEC to prohibit such accounting may result in a significant
change in practice. Thus, pending further action on the matter by the FASB, the SEC staff will not object
to this practice, providing each of the following criteria are met:
(1) The estimates of terminations or cancellations and refunded revenues are made from large
homogeneous pools
(2) Reliable estimates of the expected refunds can be made on a timely basis
(3) There is a sufficient company-specific historical basis upon which to estimate the refunds and the
company believes that such historical experie nce is predictive of future events
(4) The amount of the membership fee specified in the agreement at the outset of the arrangement is
fixed, other than the customer’s right to request a refund
Gross vs. Net Revenue
When is it appropriate for an internet company to record “grossed-up revenue” (including the cost of
sales), rather than a net-revenue basis (similar to a commission)?
•
Illustration: Company A operates an internet site from which it will sell Company T’s products.
Customers place their orders for the product by making a product selection directly from the
internet site and providing a credit card number for payment. Company A receives the order,
processes the credit card and passes the order on to Company T. Company T ships the product
directly to the customer. Company A does not take title to the product and has no risk of loss or
other responsibility for the product. The product typically sells for $175 of which Company A
Revenue Recognition Concerns Expressed in Recent SEC Pronouncement (12/14/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
receives $25. In the event a credit card transaction is rejected, Company A loses its margin on the
sale (i.e., $25). How much is Company A’s revenue on the transaction?
•
The answer is $25. It would be incorrect to “gross-up” the revenue to $175 (include the $150
cost of sales).
In general, to determine whether revenue should be reported gross, consider if the Company:
•
•
•
•
acts as principal (not sales agent) in the transaction;
takes title to the products;
has risks and reward of ownership, such as the risk of loss for collection, delivery, or returns; and
acts as an agent or broker (including performing services as such) with compensation on a
commission or fee basis.
If the Company performs as an agent or broker without assuming the risks and reward of ownership of the
goods, sales should be reported on a net basis.
Disclosure Requirement
The SEC stated in Financial Reporting Release 36 (FRR 36) that Management Discussion and Analysis
(MD&A) should “give investors an opportunity to look at the registrant through the eyes of management
by providing historical and prospective analysis of the registrant’s financial condition and results of
operations, with a particular emphasis on the registrant’s prospects for the future.” Examples of such
revenue transactions or events that the staff has asked to be discussed are:
1. Shipments of product at the end of a reporting period that significantly reduce customer backlog and
that reasonably might be expected to result in lower shipments and revenue in the next period.
2. Granting extended payment terms that will result in a longer collection period for accounts receivable
and slower cash inflows from operations, and the effect on liquidity and capital resources.
3. Changing trends in shipments into, and sales from, a sales channel or separate class of customer that
could be expected to have a significant effect on future sales or sales returns.
4. An increasing trend toward sales to a different class of customer, such as a reseller distribution
channel that has a lower gross profit margin than existing sales that are principally made to end users.
5. Seasonal trends or variations in sales.
6. A gain or loss from the sale of an asset.
Revenue Recognition Concerns Expressed in Recent SEC Pronouncement (12/14/99)
1999 by the Center for Financial Research and Analysis, Inc. (CFRA)
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