Revenue recognition

1. Revenue recognition Big deal Not a big deal Walmart – change in accounting for layaways Bally Total Fitness – recognition of membership fees • Bristol-Myers – channel stuffing • Kendall Square Research – discrepancy between IS and SCF

2. 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.”

3. 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

4. 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.”

5. 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)

6. 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: KrispyKreme) • 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

7. 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. Post-contract 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.

8. 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.

9. From the 2001 10-K

10. 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

11. 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