Financial Reporting and Analysis – ACG6175
Revenue Recognition Problems in the Communications Equipment Industry
1 – In late 2000, Lucent announced that revenues would be adjusted downwards by $679 million as a result of revenue recognition problems. Yet the firms market capitalization plummeted by $24.7 billion. Why do you think the market reacted so negatively to Lucent's announcements of the problems?
There is usually a grey zone between aggressive accounting, which is the use of legitimate accounting methods to achieve business purposes, and fraudulent financial reporting, which is the intentional misrepresentation of financial information for business purposes. In this particular case, the company shipped products to distributors when it knew that they may not be able to sell the products (indeed, many of the distributors had a weakened financial position). Therefore, even though these aggressive practices might technically be classified as sales under accounting rules, they distorted the reality of the situation and, ultimately, were fraudulent.
As per the downward adjustment of the company's revenues we can clearly see that company improperly booked those $679 million in revenue. Such announcement was made public little by little in the month of December. The semi-strong efficient market theory states that current market prices reflect all publicly available information, including quarterly reports and SEC filings. So I guess the market realized that Lucent was forging its figures and made a necessary correction in its stock price to reflect the newly reduced earnings per share.
Furthermore, in management's drive to realize revenue, meet internal sales targets and/or obtain sales bonuses they improperly granted and/or failed to disclose various side agreements, credits and other incentives. Eventually the market realized that this move was done to induce Lucent’s customers to purchase the company’s products. The result of these actions was a strong negative market reaction.
2 – What financial statement adjustments will Lucent have to make to correct the revenue recognition problems announced in late 2000?
Given the importance of revenue on the income statement and its direct impacts on earnings, it is not surprising that creative accounting practices often start with revenue recognition. Lucent had to restate $452 million of its revenue due to equipment that was shipped to distributors but never sold. Such practice is known as channel stuffing. Eventually the company had to take back the equipment. The company also adjusted downward another $199 million associated with verbally credits offered to its customers. Later investigation showed that the company was apparently offering special one-time discounts to customers. Finally, $28 million in revenue had been recognized on the sale of a system that was partially shipped. All things considered, we can conclude that Lucent was heavily borrowing from future sales to meet present expectations.
That being said, if Lucent had to adjust the statements for these distortions, the following changes would have to be made to the company's financial report:
In the quarter that the $679 million ($452 + $199 + $28) worth of sales were booked, Sales and Account Receivable would both decline by the same amount. Cost of Sales would decline and Inventory would increase to reflect the reduction in sales. Assuming that the equipment sold was manufactured in the first quarter of 2000, Cost of sales represented 58% of the total sales. Therefore, total reduction in Cost of Sales would be $395 (679*.58). Inventory in turn, would increase to the amount of $395 (679*.58), assuming that it has not suffered any obsolescence. The $ 199 million (125+74) remaining wouldn't be accounted as inventory because they were recorded as credits to customers for use at a later date, therefore falling in Other Current Liabilities (Deferred Revenue). The...