Question 17.3: Revenue Recognition Practices Diebold, Inc. (NYSE: DBD) is a...
Revenue Recognition Practices
Diebold, Inc. (NYSE: DBD) is a leading manufacturer of automated teller machines (ATMs) used in banks, as well as electronic voting machines. Certain of Diebold’s financial results for the years ended 31 December 2006, 2005, and 2004 are summarized as follows:
In its 2006 annual report, Diebold described its revenue recognition practice as follows:
1. The company considers revenue to be realized or realizable and earned when the following revenue recognition requirements are met: persuasive evidence of an arrangement exists, which is a customer contract; the products or services have been provided to the customer; the sales price is fixed or determinable within the contract; and collectibility is probable. (From the Notes to the Financial Statements)
2. Revenue is recognized only after the earnings process is complete. For product sales, the company determines that the earnings process is complete when the customer has assumed risk of loss of the goods sold and all performance requirements are substantially complete. (From the Management Discussion and Analysis)
On 25 July 2007, Diebold announced it would be delaying the release of its earnings for the second quarter due to regulatory questions about the way it reports revenue. The stock had closed on 24 July at $53.71 per share.
On 2 October 2007, Diebold Inc. issued a press release titled “Diebold Provides Update on Revenue Recognition Practice.”
Diebold, Incorporated has been engaged in an ongoing discussion with the Office of the Chief Accountant (OCA) of the Securities and Exchange Commission (SEC) regarding the company’s practice of recognizing certain revenue on a “bill and hold” basis within its North America business segment. As a result of these discussions, Diebold will discontinue the use of bill and hold as a method of revenue recognition in both its North America and international businesses. . . .
The change in the company’s revenue recognition practice, and the potential amendment of prior financial statements, would only affect the timing of recognition of certain revenue. While the percentage of the company’s global bill and hold revenue varied from period to period, it represented 11 percent of Diebold’s total consolidated revenue in 2006. The company does not anticipate that the change in the timing of revenue recognition would impact previously reported cash provided by operating activities or the company’s net cash position. . . .
While the company cannot predict with certainty the length of time it will take to complete this analysis and review, it anticipates the process will take at least 30 days. Upon completing this process, Diebold will be in a position to provide updated revenue and earnings guidance for the full-year 2007.
That day, shares continued a slide that had begun with the announced delay, reaching $44.50. As of late 2007, the stock had fallen more than 20 percent since the initial announcement.
In a document titled “Report Pursuant to Section 704 of the Sarbanes Oxley Act of 2002,” the U.S. Securities and Exchange Commission noted that:
Improper accounting for bill-and-hold transactions usually involves the recording of revenue from a sale, even though the customer has not taken title of the product and assumed the risks and rewards of ownership of the products specified in the customer’s purchase order or sales agreement. In a typical bill-and-hold transaction, the seller does not ship the product or ships it to a delivery site other than the customer’s site. These transactions may be recognized legitimately under GAAP when special criteria are met, including being done pursuant to the buyer’s request.
Based on the information given, address the following problems:
1. State whether bill-and-hold sales are consistent with the revenue recognition practices described in Diebold’s annual report. Explain your response.
2. Describe the incentives for recording revenue on a bill and hold basis.
3. The SEC report notes that bill and hold sales may be appropriate when done at the customer’s request. Explain a circumstance in which a customer may choose to be billed for a product that has not been delivered.
4. Critique the argument in the press release of 2 October 2007 that “the change in the company’s revenue recognition practice, and the potential amendment of prior financial statements, would only affect the timing of recognition of certain revenue.”
5. Describe a warning sign that might alert investors to the presence of improper bill and hold accounting. Illustrate the warning sign for the case of Diebold.
| 2006 | 2005 | 2004 | |
| Revenues | $2,906,232 | $2,587,049 | $2,357,108 |
| Net income | 86,547 | 96,746 | 183,797 |
| Cash flow from operating activities | 250,424 | 102,741 | 221,610 |
| Accounts receivable, net | 610,893 | 676,361 | 583,658 |
| Deferred income | 170,921 | 136,135 | 92,862 |
| Other current liabilities | 258,103 | 228,699 | 202,713 |
Solution to 1. No, they are not consistent. Diebold says it recognizes revenue only after “the products or services have been provided to a customer.” In a bill and hold transaction, “the seller does not ship the product or ships it to a delivery site other than the customer’s site.”
Solution to 2. Incentives include meeting revenue growth expectations or prior company guidance on revenue growth. Investors may reward positive “surprises” in revenues (revenue in excess of expected revenue) with a higher stock price. Conversely, disappointing news with respect to revenue targets may result in stock price declines.
Thus, meeting or exceeding revenue growth expectations can help support the stock price. Furthermore, individual employees may have bonuses that depend in part upon their ability to meet certain sales targets in a given period, creating another incentive to recognize revenue on a bill and hold basis.
In Diebold’s case, it is possible that nearly all of the 12.3 percent growth in revenues was provided by the 11 percent of revenue recorded on a bill-and-hold basis. The accounting for the bill-and-hold transaction was not adequately disclosed in the financial statements, and thus it is no surprise that the practice drew negative attention from regulators.
Solution to 3. Customers may also have incentives to “time” their expenditures. For example, they might have provided their own investors with an indication of how much they planned to invest in new capital and may request that some equipment be provided on a bill-and-hold basis in order to meet that guidance. Alternatively, department heads may want to spend any remaining money in their budget at fiscal year-end to avoid budget cuts the following year, and not be particularly concerned about taking possession at the time of purchase. Another reason could be that the seller offers discounts if the buyer “requests” bill and hold.
Solution to 4. The statement is correct in that the bill and hold revenue recognition involves the timing of revenue recognition. However, the statement is incomplete in not pointing out that the effect of bill and hold sales is to speed up of the recognition of revenue and often to distort the revenue growth rate in a manner that is temporarily favorable to the company.
Solution to 5. The first sign could come from comparing revenue into cash collections from customers. For Diebold, the calculations for 2005 and 2006 are as follows:
In normal circumstances, the relationship between revenue and cash collected from customers would be expected to remain relatively stable. In Diebold’s case, there was a 6.1 percent decrease from 2005 to 2006. In particular, the large increase in accounts receivable in 2005 provided a warning sign more than one year in advance of the restatement. As noted earlier, increases in accounts receivable capture aggressive accruals related to revenue recognition.
The net profit margin declined from 7.8 percent in 2004 to 3.7 percent in 2005 and 3.0 percent in 2006. The declining profitability could have been a signal that the company was pricing aggressively for customers willing to accept early billing.
At the same time, the deferred income rose by 84 percent between 2004 and 2006 while sales grew just 23 percent.
Taking a more holistic approach to analysis, investors should also have been skeptical of the company’s accounting practices on the basis of past infractions. The SEC lawsuit that led to the change was disclosed in the 10-Q filed in August 2006.
| 2006 | 2005 | |
| Revenues | $2,906,232 | $2,587,049 |
| Plus decrease (increase) in accounts receivable | 65,468 | (92,703) |
| Plus increase in deferred income | 34,786 | 43,273 |
| Equals cash collected from customers | $3,006,486 | $2,537,619 |
| Revenue/Cash collected from customers | 96.7% | 101.9% |