Revenue recognition
Big deal
• Bristol-Myers – channel
stuffing
• Kendall Square Research –
discrepancy between IS and
SCF
Not a big deal
• Walmart – change in
accounting for layaways
• Bally Total Fitness –
recognition of membership
fees
1
Channel stuffing
•
•
When companies give discounts to customers to get them to purchase early,
usually before the end of a quarter or fiscal year. Or the company can say it will
raise prices at the beginning of the next quarter or fiscal year.
Example: BMY in 2001
– From the 2002 10-K MD&A discussion of Net Sales
“A significant portion of the Company's domestic pharmaceutical sales is made to wholesalers. As
a result, the financial results and quarterly comparisons are affected by fluctuations in the
buying patterns of these major wholesalers and the corresponding changes in inventory levels
maintained by these wholesalers. These changes may not reflect underlying prescriber demand.
While the Company cannot verify wholesaler inventory levels, the Company believes average
wholesaler inventories of products in the U.S. increased during 2001 by approximately four
weeks of its average sales to these wholesalers primarily due to sales incentives offered by the
Company to them. As a result, the Company estimates the Company's 2001 domestic
pharmaceutical sales included approximately four weeks of additional sales. The Company
believes current inventories of its products held by wholesalers in the U.S. significantly exceed
levels the Company considers desirable on a going-forward basis. The Company is in the process
of developing a plan to reduce these wholesaler inventory levels. The Company expects this
reduction in wholesaler inventories to lower levels will negatively impact its financial results in
future periods. The Company will make further disclosure later in April 2002 about the plans it is
developing to reduce wholesaler inventory levels and the Company's expectations with respect to
the likely impact on its financial results.”
2
• Additional sleuthing by analysts covering BMY
– Checked price and prescription stats from IMS
Health
• Pharmacy level sales of Pravachol grew by 8%; retail
price increased by 6%; BMY reported a 21% sales
increase for the same period
• Glucophage prescriptions went down by 8%; retail price
increased by 8%; BMY reported an increase of 18% in
sales
3
•
BMY had to file an amended 10-K almost one year later
•
“The Company experienced a substantial buildup of wholesaler inventories in its U.S.
pharmaceuticals business over several years, primarily in 2000 and 2001. This buildup was
primarily due to sales incentives offered by the Company to its wholesalers. These incentives
were generally offered towards the end of a quarter in order to incentivize wholesalers to
purchase products in an amount sufficient to meet the Company's quarterly sales projections
established by the Company's senior management. In April 2002, the Company disclosed this
substantial buildup, and developed and subsequently undertook a plan to work down in an orderly
fashion these wholesaler inventory levels.
In late October 2002, based on further review and consideration of the previously disclosed
buildup of wholesaler inventories in the Company's U.S. pharmaceuticals business and the
incentives offered to certain wholesalers, and on advice from the Company's independent
auditors, PricewaterhouseCoopers LLP, the Company determined that it was required to restate
its sales and earnings to correct errors in timing of revenue recognition for certain sales to certain
U.S. pharmaceuticals wholesalers. Since that time, the Company has undertaken an analysis of its
transactions and incentive practices with U.S. pharmaceuticals wholesalers. The Company has now
determined that certain incentivized transactions with certain wholesalers should be accounted for
under the consignment model rather than recognizing revenue for such transactions upon
shipment.”
4
Warning signs of aggressive revenue recognition
• Increasing DSO
• Disparity between revenues (in the income
statement) and cash received from customers
(in the statement of cash flows)
5
Other things that might indicate aggressive
revenue recognition
– Percentage-of-completion
• Sharp increase in unbilled receivables relative to revenue
• A sharp and unexplained increase in gross profit margins
– Related-party transactions (example: Krispy Kreme)
– Late disclosures; changes in revenue recognition
policy (example: Halliburton)
– Changes in deferred revenue
– Bill-and-hold revenue
– Organic revenue growth that is substantially below
reported levels
6
• Halliburton example (from the 1999 10-K)
“Revenues and income recognition. We recognize revenues as services
are rendered or products are shipped. The distinction between
services and product sales is based upon the overall activity of the
particular business operation. Revenues from engineering and
construction contracts are reported on the percentage of
completion method of accounting using measurements of progress
towards completion appropriate for the work performed. All known
or anticipated losses on contracts are provided for currently. Claims
and change orders which are in the process of being negotiated
with customers, for extra work or changes in the scope of work
are included in revenue when collection is deemed probable. Postcontract customer support agreements are recorded as deferred
revenues and recognized as revenue ratably over the contract
period of generally one year's duration. Training and consulting
service revenues are recognized as the services are performed.
7
• From the 2001 10-K
• Receivables. Our receivables are generally not
collateralized. With the exception of claims and change
orders which are in the process of being negotiated with
customers, unbilled work on uncompleted contracts
generally represents work currently billable, and this work
is usually billed during normal billing processes in the next
several months. The claims and change orders, included in
unbilled receivables, amounted to $234 million at
December 31, 2001 and $113 million at December 31,
2000. Included in notes and accounts receivable are notes
with varying interest rates totaling $19 million at December
31, 2001 and $38 million at December 31, 2000.
8
From the 2001 10-K
9
Expense recognition
– Big baths
• Example: Nortel
(http://online.wsj.com/article/SB108872684123653733
.html)
– Examine rebates
– Examine operating expenses
• Non-operating and/or non-recurring expenses
• Increasing and declining expenses
– One-time changes that change expenses.
– Examples: changes in interest rates, changes in accounting
methods, changes in production method, restructuring,
changes in tax rates
10
• Sources:
– Fridson and Alvarez, Financial Statement Analysis:
A practitioner’s guide
– Del Vecchio and Jacobs, What’s Behind the
Numbers?
– O’Glove, Quality of Earnings
11