Revenue-Recognition Problems in the Communications Equipment Industry Essay

1) In late 2000, lucent announced that evaluate taxation revenue enhancements would be adjusted downward(prenominal)s by $679m as a result of revenue wisdom capers. Yet the fasts grocery store capitalization plummeted by $24.7bn. Why do you deliberate the market reacted so negatively to lucents announcements of the problems?The large conf give in market capitalization is probably due to several pointors. Historic all toldy, bright had successfully met analysts projections for 15 consecutive reaps before announcing, in January 2000, a major short move in profits relative to previous expectations. In June, the every quarter counterweight tacking reported an operating loss of $301m (for the showtime off time since 1998) while warning of weaker profits in Q4. In addition, the revenue recognition issues announced by the new CEO appointed in October were su assert perceived as an indication that Lucents focussing was managing revenues and therefore a possible cause of a time to come day fall in revenues.This led investors to modify their earnings expectations in light of the revenue-recognition problems face by the firm. Since a companys sh ar price reflects forecasts of future cash lessens, and Lucents Q3 and Q4 revenues were well written-down, investors would rationally expect future earnings to be affected as well. In an efficient market environment, the $24.7bn in lost market capitalization would equal the discounted value of these judge cash flows. However, it is in like manner likely that the repeated missed expectations caused an everyplacereaction by investors, as the company was forced to revise its revenues downward 2 times over the span of two quarters. This probably raised fears in the market of to a greater extent than widespread problems with the firms write up practices.It should also be kept in mind that the Internet bubble had just burst and a technology related company announcing an operating loss and lower revenues could slowly cause a panic selloff among investors, as typically happens when a bad bubble bursts.2) What ar the specific revenue recognition problems faced by Lucent? On December 22, 2000, Lucent announced a $679m downward revision in revenuesof their quaternityth-quarter pecuniary account from September 2000. There were four different reasons for the adjustment.First of all, Lucent stated $125m of recorded gross revenue that did non meet the companys revenuerecognition rules. These revenues were included in the financial statement due to misleading documentation and incomplete communications between a sales team and the financial organization.Additionally, Lucent exchange $452m price of equipment to system integrators and distributors and recorded them as revenues. In fact, the products were not passed on to the customers, because of their weakened financial condition, and Lucent had already literally agreed to take patronise the equipment. Therefore, the sales could n ot be accounted as revenues. Thirdly, sales teams had literally offe sanguine assign to customers worth $74m and booked them as revenue in order to rise the fourth-quarter numbers. As the credits were cerebratet for use at a later leave without an actual sale of equipment taking place, these could not be accounted as revenues in the fourth-quarter.Finally, sold equipment worth $28m had not been completely shipped, leaving the service incomplete. Since this go against the first revenue recognition criteria The firm has performed all the function or conveyed the asset to the buyer, recognition of these revenues is not in line with regulation.3) What financial statement adjustments will Lucent have to make to correct the revenue recognition problems announced in late 2000?In our treatment of the write up figures we found it necessary to make assumptions relating to tax rates and COGS, as the selective information is not given extendly. In deciding which tax rate to use for th e adjustments we have two obvious alternatives either assume a merged tax rate of 35%, or calculate the number tax rate based on the presented financial statement. However, due to certain revenues and expenses creation non-taxable we have opted to discard the average tax rate as a suitable estimate, and assumed a corporate tax rate of 35%.In relation to the Cost of Goods Sold, Lucent faces the problem that some oftheir franks are palpable (communications equipment) while some are intangible (software licenses, services etc.). We are aware of the fact that Lucents intangible assets are up to(p) to different costs as itstangible assets, and therefore have to be restated differently. However, we do not know the costs of neither intangible nor tangible assets due to a lack of information and thusly assume a representative cost mix that is proportional to total revenues. Hence, we use the average COGS (69% of revenues in Q4, 2000) when we calculate the restatements. In the proport ion sheet, we treat the physical goods as inventory, and intangible goods as separate current assets.When readjusting the income statement and vestibular sense sheets we need to reduce the revenues by a total of $679mn, with a correspondent reduction in accounts receivable. The cost of goods sold is reduced by $470mn, as per our assumption above relating to the average cost of goods sold. On the balance sheet this is reflected in the increase of inventories for tangible sales, and other current assets for intangible sales. This leads to a reduction of pretax income of $209mn, and subsequently a reduction in income taxes of $73mn. In the balance sheet this is represented by a reduction in the deferred tax liability (current liabilities in Lucents balance sheet), and finally a reduction in var.holders retained equity by $136mn.4) How would you judge whether a firm is likely to face revenue recognition problems? Revenue-recognition problems in Lucents plate emerge from mismanageme nt of the financial statements by all parties involved in compiling them. For instance, the initial $125 million adjustment was due to miscommunication between the sales team and the financial organization. The lack of a proper internal reporting organization or of efficient outside auditors therefore is a sign of increased risk of revenue misrepresentation. It is also important to mention that the events described in the case occurred before the Sarbanes-Oxley get along was enacted. This means that, at the time, financial statements did not require a cachet of approval from top management in order to be published. The fact that these reports were approved and published suggests awareness and involvement of the board of administrators in the revenue-recognition problems. make CEOs accountablefor the financial statements was an important step toward prevention of unwanted report practices.From a broader perspective, companies are constantly subject to the need of reaching and whipping the markets profitability expectations. Missing these targets may result in a steep share price fall, especially considering the herd nous that is prevalent during market bubbles. Investors will typically overreact at the first sign of negative news from a company, triggering sharp sell offs in stock, as was the case with Lucent, during the height of the dotcom bubble. Further revenue misrepresentation drivers we bed deduce from Lucents case are firstly, firms providing financing solutions to customers may fall into the temptation of using these tools in order to boost their quarterly revenues by granting credits to lymph glands. In fact, computing Lucents visor Receivables / Turnover ratio, it is observable that average collection days increase corporeally from 1998 (85 days) to 2000 (119 days).This means that Lucent was interchange products extending financing rather than collecting cash. Secondly, when companies rely on a distribution network rather than on direc t sale it is easier for them to engineer revenue-boosting activities (e.g. provide distributors with more than what can be sold and take back the equipment later on). Thirdly, relying on big clients accounting for a large percentage of revenues increases may enhance corporate kins, thus facilitating non-transparent verbal agreements or offbalance-sheet operations (e.g. financing, discounts). In addition, any changes in accounting practices and assumptions accounted for in the income statement should be investigated closer as a possible case of accounting fraud, as in the case of Lucent. In the 1st quarter of fiscal 1999 $1.3bn is booked as a cumulative effect of accounting change. This is enough to say that a revenue recognition problem exists, but certainly warrants further investigation.Finally, inducings of a more general constitution to accounting malpractice include regular evaluation of company credit calibre by rating agencies, and distorted compensation incentives for man agement. The former occur at regular intervals, providing incentives for management to polish a firms balance sheet prior to evaluations by the agencies, while the latter usuallyinvolves stock options. Since employees are only allowed to sell their options at certain dates, they have an incentive to push the companys share price up with accounting manipulation, prior to executing their options.5) Assess whether any of Lucents competitors are likely to face revenue recognition problems in the flood tide quarters.cisco Systems multichannel approach to sales and marketing includes a direct sales force to distributors, value-added resellers and system integrators. This could allow them to boost their revenues by selling extravagant amounts to distributors close to the end of a quarter and taking the equipment back afterwards. On the other hand, cisco does not rely on a superstar client, but has a diversified client base. In addition, the financing that Cisco provides is clearly repo rted on the balance sheet as dead long-term lease receivables, which clearly differs to Lucents approach concerning verbal agreements about credits to clients. Unlike Cisco, Juniper Networks mainly relies on unrivaled large customer, WorldCom, who generated 18% of their revenues in 2000.Thus, they were highly dependent on that client and had most likely build up a close relationship with them, both concerning equipment sales and credit granting. This increases the risk of false revenue recognition due to either channel stuffing or the sale of equipment (meant to be taken back if not sold) close to the end of the quarter. Nortel is mainly a service provider, in fact 82% of its revenues are made up by services. This could be a red flag for revenue-recognition issues as services may have no clear delivery date and thus allow revenue management. In addition, Nortel granted credit to its customers of $5.6bn, of which only $1.5bn had been used. This could mean that Nortel is trying to a ttract customers by aggressively offering financing. On the other hand, Nortel does not depend on any single client.We did not abide by any significant pattern in insiders dispositions of their stock options to indicate two-faced activity, neither for Lucent or any of their competitors. We also closely examined the two key ratios Account Receivables Turnover and Cash scat Return for Lucent and its competitors (Juniper Networks has been excluded due to data absence). As can be seen inthe following(a) graph all cash flow returns recently started to eliminate, which could raise concerns with regards to their revenue recognition policy.In Ciscos and Nortels case champion can see that this change is due to a parallel decline in cash flow from operations as well as an increase in sales. However, this movement by itself is not a red flag and could be due to other factors, which calls for a more expand investigation. We can see that the suspicious decrease in cash flow return is main ly due to a substantial increase in sales and can also be seen in a substantial increase in accounts receivables. Hence, we looked at accounts receivable turnover or more precisely days sales outstanding and found that the average direct over the course of the previous three years stays virtually the said(prenominal) while showing a negative trend for Cisco and even constantly decreased slightly for Nortel. This is a very good sign and means that these two still manage to collect their receivables in a timely manner although sales increase rapidly. Cash Flow Returns should therefore stabilize again in the near future. Lucents Account receivables turnover on the other hand, as already expatiate in the previous question, steeply increases. This may indicate Lucent was selling products by extending financing to customers rather than collecting cash since we cannot apply the same argumentation as for Cisco and Nortel in Lucents case.