Ben Bittrolff

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Ben Bittrolff Mark Mitchell Andrea Ranalli Ryan
Ricci Sonia Varkey
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Background

• Worlds largest supplier of Database Management
  Software
• Develops additional products including
  applications in financial reporting,
  manufacturing management, systems engineering and
  office automation
• KSF strong RD and committed sales force

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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

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Primary Stakeholders

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

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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

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Competitive Advantage

• Differentiation
• Unique products and services
• Investment in brand image and RD
• Focus on innovation in RD and control systems
• Product quality and variety

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Aggressive Revenue Recognition Policy

• Oracle recognizes revenue when a contract is
  signed
• Effect
• Revenue is recognized early
• 162 days between recognition and collection

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Oracles Assumptions

• All major services have been performed
• The contract is legally binding
• Oracle can collect on the contracts
• 453 million owed

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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)

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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

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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

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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 RD

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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

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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

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Stop and Think

• Oracles 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 Oracles
  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

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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
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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

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Analyst Concerns

• Oracles 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 companys aggressive
  revenue-recognition policy and relatively high
  amount of accounts receivables make the stock
  risky.

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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)

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Management Concerns

• Analysts opinions (credibility with investors)
• Downturn in Oracles stock
• Credibility with customers

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Accounting Alternatives

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

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Impact of Revenue Recognition Change on Earnings
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Impact of Revenue Recognition Change on Earnings
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Impact of Revenue Recognition Change on Earnings
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Factors to Consider with Accounting Change

• Impact on Stock Price
• If doesnt affect cash flow, should be no impact
  on share price
• If investors feel accounting change is
  managements way of tackling some of Oracles
  problems (ex. Aggressive selling) ? share
  price
• Could signal that management is not confident in
  value of receivables and revenue recognition
  assumptions ? share price

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Factors to Consider with Accounting Change

• Impact on Customers
• Current customers might see change to accounting
  method that decreases net income as threat to
  Oracles long-term survival, impact services
  needs
• Could deter future customers as future sales
  dependent on referrals/word of mouth

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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 RD expenses in future?

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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

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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

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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

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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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