September 1998 Issue



By Linda M. Plunkett and Robert W. Rouse

here is a distinct contrast between the management goals of a privately held corporation and those of a publicly held registrant. Typically, the privately held company is more concerned with cash flows than revenues, and external financial reporting may be limited to a few creditors and tax authorities. On the other hand, publicly held companies compete in an atmosphere of widespread and continuous scrutiny. Frequent regulatory filings, press releases, and analysts' discussions can have instantaneous consequences upon stock market prices. In other words, publicly held corporations have the added concern of meeting the expectations of shareholders and analysts and thus desire a positive trend of favorable financial reporting.

In this environment, public companies may attempt to "manage" earnings. U.S. GAAP, while not offering as many opportunities to manage earnings as accounting principles in other countries, does permit some management discretion via the adjustment process. For example, management might be able to tweak the amount of the bad debt provision to produce an extra penny out of earnings per share.

Beyond these discretionary opportunities, managements of publicly held companies may be tempted to "push the envelope" in the interpretation of events to favorably impact their bottom lines. Revenue recognition is one of those areas where aggressiveness can accomplish this goal. Aggressiveness, however, must be tempered with reason and with the realities of the situation.

In this connection, the findings of a recent Securities and Exchange Commission (SEC) investigation of Bausch and Lomb's revenue recognition practices is up for a review [Securities and Exchange Commission Accounting and Auditing Enforcement Release No. 988, November 17, 1997 (lr15562.txt at www.]. A concise analysis of the applicable GAAP will then be presented, and lessons that can be learned from the investigation will be discussed.

A New Market Strategy

Bausch & Lomb (B&L), a New York registrant with headquarters in Rochester, N.Y., is a leading manufacturer of contact lenses and sunglasses. The contact lens division (CLD) is responsible for U.S. contact lens business, and the Asian Pacific Division (APD) manages the sunglass and vision care business in the Pacific Rim.

In the early 1990s, the company faced strategic challenges. Although B&L had been a leader in the traditional lens markets (lenses worn for six months or longer), the company wanted to become a competitor in the disposable lens market (lenses designed to be worn for short intervals of several days to several months).

Although a late entrant, B&L wanted to secure a position in the growing disposable market while maintaining its share of the traditional market, which accounted for a declining percentage of CLD total sales. In late 1993, management concluded the CLD would have to reallocate its marketing efforts to meet its goals.

The CLD sold its products primarily through two channels: 1) direct sales to optical practitioners via its own sales force and 2) distributor sales through authorized optical distributors. A plan was formulated to give the distributors the primary sales responsibility for the traditional lenses so the direct sales force could concentrate its efforts on selling disposable lenses.

The September Promotion

B&L placed great importance on individual operating segments meeting their expected performance goals. The CLD had met or exceeded expectations for 48 consecutive months between 1988 and 1992. Early in the fall of 1993, however, the division was not on target for meeting its goals, and the president of the CLD met with his staff to assess the opportunities for sales growth.

A new promotion was formulated whereby the CLD would sell lenses to distributors significantly in excess of past sales. Discounted prices and extended payments were offered, and the promotion produced sales that surpassed third quarter forecasts. This success was not without a price to the CLD, however, because the additional sales in the third quarter meant the distributors had purchased inventory in excess of fourth quarter needs. Thus, it immediately found itself falling short of fourth quarter expectations in an already saturated market.

The December Program

The president of the CLD launched the December program to facilitate the marketing of traditional lenses by the division's distributors and thereby meet the fourth quarter sales and earnings expectations. The December program did not assess the demands of distributors as the available inventory was divided among distributors according to their pro rata share of past distributor sales. Acceptance of the program was necessary for authorized distributors to retain their status with the company.

As evidence of the December program obligations, the CLD asked distributors to sign notes with June 1994 maturity dates for their purchases. Although most distributors refused to sign the notes, only two distributors refused to participate in the December program. The CLD also offered distributors access to large retail accounts and other incentives, concessions, and variations from the original terms in the program.

Internal estimates prepared by the CLD indicated that some distributors would need as much as two years to sell the quantities they were expected to buy in the last two weeks of the 1993 fiscal year. Shipments of the additional merchandise to distributors were made without required credit analysis. In one case, the SEC investigation found that a distributor with a net worth of $600,000 was asked to purchase $2,500,000 of inventory.

Other questionable business practices of the December Program included the following:

Ultimately, the CLD improperly recognized $22 million in revenue from the December Program.

The Asian Pacific Division

The activities of this division were even more aggressive in recognizing revenue than the CLD. Management in B&L Hong Kong, a segment of the Asian Pacific Division that sold Ray Ban and other sunglasses, may have crossed the line into fraud by recognizing the following transactions as revenue.

Fictitious sunglasses sales for the Asian Pacific Division were initiated by phone calls or by orders on stationery that appeared genuine. APD warehouse personnel received instructions from management to deviate from normal processing and delivery procedures. Supporting documentation was generated as if the sales were legitimate, but warehouse staff were instructed to ignore the addresses on the delivery notes and forward the merchandise to a warehouse. The merchandise was titled in the name of a freight forwarder. Receipt acknowledgments were either forged or obtained from cooperating customers.

These apparently fraudulent transactions were augmented by "refreshing" transactions. Management had to mask the rising account receivable balances while avoiding increasing the bad debt provision. To effect this deception, APD conducted exchange transactions where customers would receive credits to their accounts and were allowed to repurchase goods. However, little, if any, physical transfer of merchandise occurred. APD personnel prepared false support for the transactions, and the warehouse manager falsified documentation to facilitate the scheme. Customers' accounts receivable balances were thus "refreshed" with the aid of personnel who manually altered the computer-prepared aging report.

A B&L audit team began an investigation of the transactions. Management in Rochester received an anonymous report that possible fraudulent transactions were being recorded within the APD and assigned additional staff to the investigation. B&L replaced the Hong Kong personnel responsible for the scheme. Following the SEC investigation, B&L was found to be in violation of the antifraud, reporting, recordkeeping, and internal control provisions of the Exchange Act.

However, neither the expertise of the SEC nor an internal audit team is needed to recognize the problematic nature of some of the items B&L called revenue at the end of 1993. A review of GAAP relevant to revenue recognition frames the widespread violation of the company's aggressive reporting.

Revenue Recognition

According to Statement of Financial Accounting Concepts No. 5, revenue is recognized when the transaction is both realized (or realizable) and earned. Revenue is realized (or realizable) when products are exchanged for cash or for assets that are readily convertible to cash. Revenue is earned when the seller has substantially fulfilled all requirements necessary to receive the benefits associated with the revenue. In transactions in which a right of return exists--such as the case of the December Program--SFAS No. 48, Revenue Recognition When Right of Return Exits, requires that revenue be recognized at the time of sale only if all of the following six criteria have been met:

Clearly, B&L did not meet all of the above conditions when it recognized revenues from its 1993 sales promotions. For example, many distributors alerted B&L that, despite the liberal credit terms, they would be unable to pay for the lenses until the lenses were resold. The obligation to pay the seller (B&L) appeared to be contingent upon selling the inventory.

Additionally, many distributors refused to sign promissory notes and thus failed to obligate themselves for the inventory assigned to them. Cooperative dealers and distributors were given assurances they could return unsold inventory and renegotiate payment terms. Given these circumstances, the buyers were not obligated to pay the seller. In substance, many of the December Program transactions were consignment sales, rather than bona fide sales.

B&L also recognized revenue on sales of inventory that was not received by "buyers." The CLD arranged freight forwarders and warehouse facilities--in some cases at the CLD expense--to hold inventories until distributors would accept delivery. In other cases, the CLD offered storage and delayed shipping to secure distributors' participation in the December Program. B&L would have had difficulty in forcing buyers to pay for undeliverable goods when the company actually held the inventory.

B&L apparently had obligations for future performances with regard to these sales. To encourage distributors to participate in its scheme, the CLD offered to provide optical practitioners with incentives to buy traditional lenses from distributors. This plan purportedly would help distributors resell excessive inventory.

The requirement that future returns be reasonably estimated was not met. Distributors obtained written or oral assurances from the CLD representatives that they could return unsold traditional lenses for credit. In many cases, distributors made purchases when they may have had no intention of reselling the inventory because of the return policy. Returns were not estimable in such cases, and it is possible the sales were, in fact, buy-back arrangements.

The SEC Settlement

As a result of the questionable transactions of the CLD and the APD divisions, B&L overstated revenue and net income for 1993 by a total of $42.1 million and $17.6 million respectively. In the first quarter of 1996, B&L amended its Form 10-K for 1993 and 1994 to restate the financial statements to account for these corrections.

Of the several forms of resolutions that can be reached between the SEC and a registrant, two types of settlements were reached in the B&L case. In administrative proceedings, Bausch and Lomb, the president of the CLD, the controller and vice-president of finance of the CLD, and the CLD's director of distributor sales agreed to a cease-and-desist order. Without admitting or denying the findings, the respondents agreed to the entry of the order. A second settlement involved a litigation release and the issuance of an injunction against the former regional sales director in the CLD.

The Importance of Controls

The temptation to "push the envelope" must be addressed, and the requisite internal controls must be in place and operable to ensure the accounting for all transactions be transparent and reflective of the realities of the situation. Many registrants are now involved in many countries with many cultures that view how business should be transacted very differently. Constant monitoring of these foreign activities by an independent internal audit function is essential. *

Linda M. Plunkett, PhD, CPA, and Robert W. Rouse, PhD, CPA, are professors of accounting and legal studies at the University of Charleston (S.C.).

Douglas R. Carmichael,
Baruch College

John F. Burke, CPA
The CPA Journal

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