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Ben Bittrolff Mark Mitchell Andrea Ranalli Ryan Ricci Sonia Varkey

Ben Bittrolff Mark Mitchell Andrea Ranalli Ryan Ricci Sonia Varkey. Background. World’s largest supplier of Database Management Software Develops additional products including applications in financial reporting, manufacturing management, systems engineering and office automation

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Ben Bittrolff Mark Mitchell Andrea Ranalli Ryan Ricci Sonia Varkey

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  1. Ben Bittrolff Mark Mitchell Andrea Ranalli Ryan Ricci Sonia Varkey

  2. Background • World’s largest supplier of Database Management Software • Develops additional products including applications in financial reporting, manufacturing management, systems engineering and office automation • KSF – strong R&D and committed sales force

  3. Problem Identification • In August 1990, the CEO of Oracle faced increasing pressure from analysts regarding the methods used to recognize revenue in its financial reports • Currently, Oracle recognizes any revenue that they BELIEVE will be shipped within the next twelve months • Industry Standard – book only the revenue that has been shipped

  4. Primary Stakeholders • Employees • Stockholders/Investors • Analysts • Clients • Financial Institutions (i.e. lending)

  5. Analysis • Threat of New Entrants (MODERATE): • Legal barriers • Scale economies • 1st mover advantage • Rivalry Among Existing Firms (HIGH): • Growing industry • Product differentiation • High switching costs • Bargaining Power of Buyers (HIGH): • High switching costs • Alternative products • Quality and costs important • High volume purchase • Aggressive sales • Bargaining Power of Suppliers (LOW): • Internally manufactured • Threat of Substitutes (MODERATE): • Similar price and performance • Willingness to switch • Disruptive technology

  6. Competitive Advantage Differentiation • Unique products and services • Investment in brand image and R&D • Focus on innovation in R&D and control systems • Product quality and variety

  7. Aggressive Revenue Recognition Policy • Oracle recognizes revenue when a contract is signed • Effect • Revenue is recognized early • 162 days between recognition and collection

  8. Oracle’s Assumptions • All major services have been performed • The contract is legally binding • Oracle can collect on the contracts • $453 million owed

  9. Strengths • Aggressive revenue recognition exaggerates quarterly and annual growth • Meet or exceed analyst estimates. Affects stock performance • Appear to take market share. Affects customer buying decisions • Strengthens internal morale through performance bonuses • Management and sales force bonuses are larger (In the short run)

  10. Weaknesses • Aggressive revenue recognition increases quarterly and annual revenue and profit volatility • Looser credits terms result in lower quality customers • Receivables are twice the level of competitors. Serious exposure • Must eventually write off non-performing accounts • Financial transparency is sacrificed • Management may loose credibility with analysts and investors • Negative effect on company valuation • Increase stock volatility • May have to periodically ‘restate’ earnings • Could leave the company exposed to legal action. Class action suits

  11. Opportunities • Convince analysts and investors that receivables are collectible • Demonstrate that appropriate financial constraints are in place • Announce and commence a stock repurchase program • Would send positive signal and increase confidence

  12. Threats • Survivability • Reduced earnings from an accounting change could deter enough future customers to seriously affect real earnings • Impact on lending agreements. A change to more conservative account methods would result in Oracle violating lending covenants • Conservative accounting may inhibit Oracles ability to raise capital, especially for R&D

  13. Accounting Analysis • Accounting Policies • Recognize license revenue at time of product shipment or at time of agreement if customer is creditworthy • Recognize maintenance service revenue after services are performed on a proportionate basis over the maintenance period • Recognize consulting service revenue under the percentage of completion method • There is No Accounting Standard for Recognizing License Fee Revenues

  14. Accounting Analysis • High level of days receivable (160 days vs 62 day average for industry) • Credit policy: balances are to be paid/received within one year

  15. Stop and Think • Oracle’s assumptions when recording revenue at time contract is signed: • All major services have been performed • Contract is largely binding • Can collect the fees • Are their assumptions reasonable? Are there possible underlying forces influencing Oracle’s management: • Aggressive sales policy putting pressure to grow sales • May be relying on customers that may cancel or not able to pay • Selling products that have defects

  16. Rule of Thumb for Earnings Recognition High Collection Risk Low Collection Risk Moderate Risk Early Recognition Usual Recognition Late Recognition Order Placed Goods/Services Delivered Cash Collected

  17. Aggressive Revenue Recognition Risks • Customer default • Returns • Defects • Inability of Oracle to deliver product/service • Are contracts legally binding  These also double as risks of carrying high days receivables

  18. Analyst Concerns • “Oracle’s accounting practices might have played a role in the low net income results. The top line went up over 50%, though net bottom line did not do so well . . . The company’s aggressive revenue-recognition policy and relatively high amount of accounts receivables make the stock risky.”

  19. Analyst Concerns • Prefer Oracle to recognize licensing revenue when software is delivered rather than when contract is signed • Should recognize these revenues only when they can reasonably estimate the degree of collectibility of those revenues (receivables)

  20. Management Concerns • Analysts’ opinions (credibility with investors) • Downturn in Oracle’s stock • Credibility with customers

  21. Accounting Alternatives • Change to more conservative accounting method but make no retroactive adjustment • Change to more conservative accounting method and make retroactive adjustment • Make no changes and wait for FASB to announce its position on software revenue recognition or vigorously defend its current policies

  22. Impact of Revenue Recognition Change on Earnings

  23. Impact of Revenue Recognition Change on Earnings

  24. Impact of Revenue Recognition Change on Earnings

  25. Factors to Consider with Accounting Change • Impact on Stock Price • If doesn’t affect cash flow, should be no impact on share price • If investors feel accounting change is management’s way of tackling some of Oracle’s problems (ex. Aggressive selling):  share price • Could signal that management is not confident in value of receivables and revenue recognition assumptions:  share price

  26. Factors to Consider with Accounting Change • Impact on Customers • Current customers might see change to accounting method that decreases net income as threat to Oracle’s long-term survival, impact services needs • Could deter future customers as future sales dependent on referrals/word of mouth

  27. Factors to Consider with Accounting Change • Impact on Lending Agreements • If changes to more conservative accounting, will violate debt covenants? • If changes are retroactive, will violate covenants? • Oracle will have to look at options if accounting change violates debt covenants • Also, reduced EPS is less attractive to lenders • How to fund R&D expenses in future?

  28. Factors to Consider with Accounting Change • Impact on Management Compensation • Management does not have incentive to keep accounting policy as is. Compensation based on stock price, not EPS • If compensation tied to earnings or revenue then more conservative accounting would be resisted • CEO (Ellison) owns 26% Oracle stock

  29. Recommendations Alternatives • Change to more conservative accounting method but make no retroactive adjustment • Change to more conservative accounting method and make retroactive adjustment • Make no changes and wait for FASB to announce its position on software revenue recognition or vigorously defend its current policies Consider Impact on • Managers • Lending Agreements • Customers • Stock Price

  30. Actual Events – Post 1990 • August 27th, 1990 – announced it would change method of recognizing revenues • Net Income (1990) would have dropped from $117,410 to $83,654 • 26% drop in stock price • September 9th, 1990 • Loss of $27.4M for the first quarter • Laid of 10% of its domestic workforce • Initiation of Cash Collection program

  31. Actual Events Continued • 1991 - Oracle uncovered errors in recording its revenues • A number of top executives were fired (i.e. CFO) • Changes to payment terms (bills now paid in 30 days compared to 9 months) • Capital expenditures and hiring frozen • Replaced short-term debt with long-term financing • 1992 – completed restructurings and returned to profitability with net income of $61.5M

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