the numbers game - babson collegefaculty.babson.edu/halsey/acc7500/revenue recognition -...

Revenue Recognition Concerns Expressed in Recent SEC Pronouncement (12/14/99) 1999 by the Center for Financial Research and Analysis, Inc. (CFRA)

Revenue Recognition Concerns Expressed in Recent SEC Pronouncement 12/14/99 On September 28, 1998, in response to growing concerns about companies managing earnings in order to achieve consensus estimates, SEC Chairman Arthur Levitt gave a memorable speech on the subject entitled The Numbers Game. In the area of premature revenue recognition, Levitt used the following analogy: “Think about a bottle of wine. You wouldn’t pop the cork on that bottle before it was ready. But some companies are doing this with their revenue – recognizing it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void, or delay the sale.” Over the past year, the SEC has issued two staff accounting bulletins (SABs) to address earnings management problems: one in August addressing materiality in the preparation of financial statement (SAB No. 99), and another in November addressing restructuring charges (SAB No. 100). On December 3, 1999, the SEC issued a third SAB, No. 101, which provides guidance on the recognition, presentation, and disclosure of revenue in financial statements. (SABs are not rules; rather they represent interpretations and practices followed by the staff of the Office of the Chief Accountant and the Division of Corporation Finance in administering the federal securities laws.) SAB No. 101 does not change any existing accounting rules for revenue recognition. Rather, it spells out the basic criteria that must be met before companies can record revenue. Those criteria reflect the recurring revenue recognition themes found in the existing accounting literature. This SAB provides guidance in such areas as bill-and hold-transactions, up-front fees when the seller has significant continuing involvement, long-term service transactions, refundable membership fees, and contingent rental income.

Revenue Recognition – General Revenue should not be recognized until it is realized (or realizable) and earned. A company’s revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its major ongoing or central activities. Revenue is considered to have been earned when then that entity has substantially completed this activity. The SEC staff believes that revenue is realized (or realizable) and earned when all of the following criteria are met:

• Persuasive evidence of an arrangement exists • Delivery has occurred or services have been rendered • The seller’s price to the buyer is fixed or determinable • Collectibility is reasonably assured

1999 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

Materiality (12/20/99) 1999 by the Center for Financial Research and Analysis, Inc. (CFRA)

Materiality: Is it Like Truth and Beauty or Subject to Measurement? Question: Have you ever wondered why companies… • sometimes do not restate prior period when making acquisition using the pooling of interest

accounting • can avoid recording losses on the income statement • can capitalize (record as an expense) normal operating expenses • fail to disclose one-time gains or losses as separate line items on the income statement • in short – ignore the normal accounting conventions. How can you convince your independent auditor to allow your company to circumvent normal accounting conventions? The answer -- simply assert the “materiality” exception. In short, if the impact of recording a transaction in a more expedient (although technically, improper) way, has no significant impact on the investor, normal accounting conventions could be ignored. Thus, prior-period financial statements need not be restated if a pooling is deemed “immaterial;” and normal operating expenses could be capitalized if the amount is “insignificant.” Since substantial discretion exists for management (and its independent auditors) to overturn normal accounting conventions invoking the materiality principle, CFRA will provide a review of the authoritative literature on the subject and the insights on how the SEC evaluates “materiality” thresholds and judgments.

Assessing Materiality Because of the subjectivity in assessing materiality, over time, certain quantitative thresholds (“rules of thumb”) have been used. Some use a 5% overstatement of net income as a threshold for materiality. The SEC staff, however, points out that exclusive reliance on any percentage or numerical threshold has no basis in the accounting literature or the law. Quantifying the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot be used as a substitute for a full analysis of all relevant considerations. The FASB stated the essence of materiality in SFAC No. 2 as follows: “The omission or misstatement of an item in a financial report is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” 1999 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

© 1996 by the Center for Financial Research and Analysis (CFRA)

America Online, Inc.

8619 Westwood Center DriveVienna, Virginia 22182-2285

(703) 448-8700

Primary SIC Code: 7375 10/11/96 Close: $24.63 Ticker Symbol: AOL 52-Week: $24.50 - 71.00 Exchange: NYSE Price/Earnings: 95 1996 Fiscal Year-End: 6/30/96 Price/Sales: 2.1 Auditor: Ernst & Young Mkt. Cap.: $2.3 billion

America Online, Inc. ("AOL") provides online computerized services to more than 6 millionsubscribers, who are billed on a monthly basis. Services offered by AOL include electronic mail,conferencing, software, computing support, electronic magazines and newspapers, online classes, andInternet access. The Company has established strategic alliances with hundreds of companies, includingABC, American Express, Bertelsmann, IBM, Knight-Ridder, Time Warner, and Tribune Companies.

Since the beginning of fiscal 1995, the Company has expanded its range of services through severalacquisitions. AOL's new products and services include GNN (a stand-alone direct internet accessservice), NaviPress (Web authoring software), and NaviServer (commercial Web server).

FINANCIAL SUMMARY

($ millions)YearEnded6/96

YearEnded6/95

% Change

Sales 1,093.9 394.3 177.4%

Operating Income 82.2 28.9 184.4%

Net Income 29.8 (33.6) N/M

Working Capital (19.3) 0.3 N/M

L-T Liabilities 156.3 55.2 183.2%

Total Owners’ Equity 512.5 216.8 136.4%

CFFO (66.7) 17.3 N/M

2001 by the Center for Financial Research and Analysis, Inc. (CFRA)

PAREXEL International Corporation 195 West Street

Waltham, Massachusetts 02451 (781) 487-9900

Ticker Symbol: PRXL 3/2/01 Close: $16.50 Exchange: Nasdaq/NMS 52-Week: $8.06 – 17.25 Website: www.parexel.com Price/Earnings: NA 2000 Fiscal Year-End: 6/30/00 Price/Sales: 1.1 Auditor: PricewaterhouseCoopers Mkt. Cap.: $410 million

PAREXEL International Corporation ("PRXL") is a leading contract research, medical marketing

and consulting services organization providing a broad spectrum of services from first-in-human clinical studies through product launch to the pharmaceutical, biotechnology, and medical device industries around the world. The Company's primary objective is to help clients rapidly obtain the necessary regulatory approvals of their products and quickly reach peak sales.

FINANCIAL SUMMARY

($ mils., except EPS & %) 6 Mos. 12/00 6 Mos. 12/99 % Change Year 6/00 Year 6/99 % Change

Revenue 182.5 189.7 (4%) 378.2 348.5 9%

Gross Profit 50.4 60.8 (17%) 117.3 114.8 2%

Operating Income (0.9) 12.0 (108%) 3.6 20.6 (83%)

Net Income 0.9 8.9 (90%) 5.5 15.6 (65%)

EPS (Diluted) $0.03 $0.35 (91%) $0.22 $0.62 (65%)

Cash & Mkt. Securities 82.0 112.2 (27%) 90.2 90.0 0%

Total Receivables 193.3 167.2 16% 161.4 150.5 7%

Total Assets 376.1 371.5 1% 350.9 333.6 5%

Stockholders’ Equity 184.7 198.2 (7%) 190.2 192.0 (1%)

CFFO 4.2 37.0 (89%) 29.6 29.1 2%

Depreciation & Amort. 10.8 10.3 5% 21.9 17.9 22%

Capital Expenditures 7.3 7.9 (8%) 20.1 18.9 6%

Overview of SOP 93-7: Accounting for Direct Respons e Advertising Costs (7/20/00) 2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

Overview of SOP 93-7: Accounting for Direct-Response Advertising Costs, 7/20/00 The AICPA issued its Statement of Position 93-7 in December 1993. The purpose of the Statement was to distinguish advertising costs which should be expensed as they incurred from those advertising costs that should be treated as assets, thus future economic benefits, when the costs are incurred and amortized to expense in the current and subsequent periods. SOP 93-7 provides the following guidance:

• The costs of advertising should be expensed either as incurred, or the first time the advertising takes place, except for direct-response advertising.

• Direct-response advertising is defined as (1) that advertising whose primary purpose is to elicit

sales to customers who could be shown to have responded specifically to the advertising and (2) that advertising which results in probable future economic benefits.

(1) Advertising whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising. To conclude that the advertising cost has met this requirement to be considered direct-response, there must be a means of documenting that response, including a record that can identify the name of the customer and the advertising that elicited the direct response. Direct-response advertising therefore excludes advertising that is directed to an audience which could not be shown to have responded specifically to the direct-response advertising (such as a television commercial announcing that order forms (which are direct response advertising) soon will be distributed directly to some people in the viewing area.

(2) Advertising which results in probable future economic benefits. This condition requires

persuasive evidence, including verifiable historic patterns of results, that the direct-response advertising’s effects will be similar to the effects of responses to past direct-response advertising activities of the entity that resulted in future benefits. In the absence of an operating history for a particular product or service, although industry statistics would not be considered objective evidence that direct-response advertising will result in future benefits, statistics for operating histories of other products or services the company provides may be used if it can be demonstrated that the statistics for the statistics for the other products or services are likely to be highly correlated to the statistics of the particular product or service being evaluated.

Direct-response advertising costs, once capitalized, should be amortized to expense over the period during which the future benefits are expected to be received using the ratio that current period revenues for the direct-response advertising costs bear to the total of current and estimated future-period revenues for that direct-response advertising cost. A search of companies that capitalize direct-response advertising costs provided the following companies and their amortization periods: (See Table 1.) 2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

Overview of Airline Industry Depreciation Policies (12/22/99) 1999 by the Center for Financial Research and Analysis, Inc. (CFRA)

Overview of Airline Industry Depreciation Policies, 12/22/99 CFRA believes that certain airline companies have recently obtained an earnings boost by extending the depreciable lives and increasing the residual values relating to operating aircraft. In addition, some airlines have recently recorded one-time write-downs and losses on the sale of aircraft, leading to questions about the proper depreciable life of aircraft. Typically, an airline’s aircraft depreciation expense is derived by initially estimating both the useful life and the residual value -- or the perceived fair market value of the aircraft at the end of its estimated useful life. To determine the periodic depreciation expense -- which reduces the value of the aircraft on the company’s balance sheet while increasing operating expenses -- the total cost of the aircraft is reduced by the estimated residual value and that sum is divided by the estimated useful life. By increasing the estimated residual value and extending the estimated useful life of its aircraft, an airline company would prospectively record a lower depreciation expense on its income statement and a higher value for each aircraft on its balance sheet. Consequently, the airline would receive a boost to earnings in all future periods and a boost to earnings growth during the four quarters following the change, as prior financial statements are not restated. While near term earnings would be boosted by the reduced depreciation expense, future earnings may be adversely impacted from this change as the reduced depreciation expense leads to higher reported aircraft values and, if upon disposition of the aircraft the book value is in excess of the realizable value, losses will be incurred. Prior to 1998, most major airlines’ depreciable lives for a majority of their aircraft hovered around 20 years with an estimated residual value of generally 5% of the cost of the asset. On January 1, 1998 Continental Airlines, Inc. (“CAL”) was the first of CFRA’s studied universe of 10 major airline companies to change its depreciation policy. Specifically, CAL extended the depreciable lives of certain newer generation aircraft to 30 years from 25 and increased the estimated residual values of those aircraft to 15% from 10%. Following suit were Delta Air Lines, Inc. (“DAL”) and America West Holdings Corporation (“AWA”) during 1998 and Southwest Airlines Company (“LUV”), AMR Corporation (“AMR”), and UAL Corporation (“UAL”) during 1999, while Alaska Airgroup Inc. (“ALK”), Northwest Airlines Corporation (“NWAC”), Trans World Airlines, Inc. (“TWA”), and US Airways Group, Inc. (“U”) have all apparently made no recent changes in their policies. CFRA is especially concerned about these changes in depreciation estimates as many of the companies have recently recorded write-downs or incurred losses on the disposition of certain aircraft. These write-downs and losses indicate that prior estimates of useful lives and residual values were overly ambitious as the current recorded book value of aircraft exceeded the fair market value and thus a lower useful life and residual value might be the more appropriate change as opposed to a higher useful life and residual value. Of the ten companies examined, CFRA believes U and ALK use the most conservative depreciation policies while CAL and TWA appear to employ the most aggressive depreciation policies. Below is a company-by-company analysis of each company’s depreciation policy ranked by those who have enacted recent changes to their policy. 1999 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.


Sykes Enterprises, Incorporated 100 North Tampa Street, Suite 3900

Tampa, Florida 33602 (813) 274-1000

Ticker Symbol: SYKE 2/7/00 Close: $14.25 Exchange: Nasdaq/NMS 52-Week: $17.00 – 52.25 Website: www.sykes.com Price/Earnings: 38 1999 Fiscal Year-End: 12/31/99 Price/Sales: 19.5 Auditor: Ernst & Young Mkt. Cap.: $604.1 million

Sykes Enterprises, Incorporated (“SYKE”) provides information technology outsourcing services, including information technology support services, development services and solutions, on-line clinical managed care services, medical protocol products, employee benefit administration and support services, and customer product services. SYKE also provides outsourced care management services and products, and employee benefit administration services.

FINANCIAL SUMMARY


Revenue 163.6 142.4 15% 575.0 469.5 22%

Gross Profit 56.4 55.3 2% 203.1 179.7 13%

Operating Income 13.1 20.0 (35%) 45.5 58.4 (22%)

Net Income 7.4 11.9 (38%) 27.7 35.8 (23%)

EPS (Diluted) $0.17 $0.28 (39%) $0.60 $0.85 (29%)

Cash & Mkt. Securities NA

36.3 NM NA

36.3 NM

Total Receivables NA

113.8 NM NA

113.8 NM

Total Assets NA

365.1 NM NA

365.1 NM

Total Debt NA

79.4 NM NA

79.4 NM

Stockholders’ Equity 201.1

164.9 22% 201.1

164.9 22%

CFFO NA

27.2 NM NA

41.1 NM

Depreciation & Amort. NA 9.1 NM NA 21.8 NM

Capital Expenditures NA 15.4 NM NA 37.3 NM


Rite Aid Corporation 30 Hunter Lane

Camp Hill, Pennsylvania 17011 (717) 761-2633

Ticker Symbol: RAD 8/3/00 Close: $4.13 Exchange: NYSE 52-Week: $4.13 – 23.25 Website: www.riteaid.com Price/Earnings: NA 2000 Fiscal Year-End: 2/26/00 Price/Sales: 0.1 Auditor: Deloitte & Touche Mkt. Cap.: $1.4 billion

Rite Aid Corporation (“RAD”) is a retail drugstore chain that operates in 30 states and in the District of Columbia. The Company announced on July 12, 2000, that it has agreed to sell its PCS Health Systems, Inc. subsidiary for $1 billion to Advance Paradigm, Inc.

FINANCIAL SUMMARY


Revenue 3,442.2 3,352.5 3% 14,681.4 12,782.9 15%

Gross Profit 784.3 826.6 (5%) 3,268.7 3,039.1 8%

Net Income (695.4) (43.8) NM (1,143.1) (422.5) NM

EPS (Diluted) ($2.69) ($0.17) NM ($4.45) ($1.64) NM

Cash & Mkt. Securities 114.9 NA NM 184.6 87.3 111%

Total Receivables 116.1 NA NM 756.2 643.2 18%

Inventory 2,745.9 NA NM 2,644.0 2,647.0 0%

Total Assets 9,447.3 NA NM 10,807.9 10,512.5 3%

Total Debt* 6,558.0 NA NM 6,608.9 5,914.8 12%

Stockholders’ Equity (244.7) NA NM 431.5 1,350.6 (68%)

CFFO (9.5) (36.7) NM (410.7) 151.9 (370%)

Depreciation & Amort. 91.7 93.9 (2%) 501.0 399.3 25%

Capital Expenditures 18.9 146.4 (87%) 453.6 1,347.1 (66%)

* Includes capital lease obligations, redeemable preferred stock, and convertible notes.

Rite Aid Corporation (8/4/00) 2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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Update -- Rite Aid Corporation (“RAD”), 8/4/00: Summary of Restatements and Q1 (5/00) Comments

Restatement Summary On July 11, 2000, RAD announced that it had restated its fiscal 1999, 1998, and 1997 (periods ended February) results, following a review by the Company’s new auditors. The restatement included over $1.5 billion in charges. According to the July 2000 press release and conference call, the restatements fell into the following seven principal categories (see Table 1): Inventory and Cost of Goods Sold . RAD adjusted inventory and cost of goods sold by $438.8 million in fiscal 1999, $63.4 million in fiscal 1998, and by $133.8 million in fiscal 1997 to: (1) reverse unearned vendor allowance that had previously reduced cost of goods sold; (2) to establish reserves for inventory obsolescence (which were previously omitted from cost of goods sold); (3) to correctly apply the retail method of accounting; (4) record selling costs such as promotional markdowns and shrink in the appropriate period; and (5) to recognize inventory purchases in the appropriate periods. Purchase Accounting. RAD adjusted certain liabilities and goodwill relating to past acquisitions by $133.9 million in fiscal 1999, $152.1 million in fiscal 1998, and $14.8 million in fiscal 1997 to reduce goodwill and certain liabilities. Accruals for Operating Expenses. RAD adjusted certain operating costs, including vacation pay, payroll, executive retirement plans, insurance claims, and incentive compensation by $123.1 million in 1999, $81.0 million in 1998, $262.2 million in 1997 to expense them in the period incurred and to record a corresponding liability for items not paid at the end of the corresponding period. Property, Plant and Equipment. RAD adjusted PP&E by $110.4 million in fiscal 1999, $246.2 million in fiscal 1998, and $149.6 million in fiscal 1997 to: (1) expense certain items (including repairs, maintenance, interest, and internally developed software) that were previously capitalized; and (2) to increase depreciation expense to reverse the effects of retroactive changes previously made to the useful lives of certain assets and to depreciate assets misclassified as construction in-progress. Lease Obligations. RAD made adjustments to its sale -leaseback transactions, amounting to $13.7 million in fiscal 1999, $40.7 million in fiscal 1998, and $1.1 million to: (1) reverse the asset sales and establish lease obligations; and (2) to record certain leases that were previously classified as operating leases (and therefore were omitted from the balance sheet). Exit Costs and Impairment of Operating and Other Assets. RAD made other adjustments amounting to a $44.7 million benefit in fiscal 1999, $141.2 million charge in fiscal 1998, and $113.8 million in fiscal 1997 to: (1) recognize store closure charges in the appropriate period; (2) to change the method used to evaluate asset impairment; and (3) to record impairment charges in the appropriate period. Income Taxes. RAD adjusted its fiscal 1999 and 1998 financial statements by recording benefits of $237.9 million and $263.6 million, respectively, to: (1) properly reflect the tax effect of all restated adjustments discussed above; and to (2) expense items in the proper period. 2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

Rite Aid Corporation (8/4/00) 2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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Table 1: Restatement Categories, Fiscal 1997-99

($ millions) Fiscal 1999 Fiscal 1998 Fiscal 1997 Total

Inventory & COGS 438.8 63.4 133.8 636.0

Purchase Accounting 133.9 152.1 14.8 300.8

Accruals (Operating Expenses) 123.1 81.0 262.2 466.3

PP&E 110.4 246.2 149.6 506.2

Lease Obligations 13.7 40.7 1.1 55.4

Exit Costs and Other (44.7) 141.2 113.8 210.3

Income Taxes (237.9) (263.6) (225.6) (727.1)

Other - Miscellaneous 28.9 31.1 104.6 164.6

Total 566.2 492.1 554.3 1,612.5 Gross Margin Decline RAD ’s gross margin declined year-over-year during the May 2000 quarter, following a similar decline during fiscal 2000. As shown in Table 2, the gross margin by 190 basis points both in May and in fiscal 2000. According to the Company’s May 2000 10-Q and fiscal 2000 10-K, the decline in both periods resulted from rising third party sales which yield lower margins, and decreasing margins on third party prescription sales. Table 2: Gross Margin, Year-Over-Year

Q1, 5/00 Q1, 5/99 Year Ended 2/00 Year Ended 2/99

GM (%) 22.8% 24.7% 21.9% 23.8%

Change* (190 b.p.) (190 b.p.) * b.p. = basis points Elevated Debt Level RAD’s debt-to-assets ratio increased and remained at a relatively high level in May 2000. As shown in Table 3, the Company’s debt-to-assets ratio amounted to 69% at May 2000, up from 61% at February 2000. Table 3: Total Debt-to-Assets, Quarterly Ratio

($ millions, except %) Q1, 5/00 Q4, 2/00 Q4, 2/99

Total Debt * 6,558.0 6,608.9 5,914.8

Equity (244.7) 431.5 1,350.6

Total Assets 9,447.3 10,807.9 10,512.5

Debt / Total Assets 69% 61% 56% * Includes capital lease obligations, redeemable preferred stock, and convertible notes.

Sykes Enterprises Incorporated (2/8/00) 2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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Sykes Enterprises, Incorporated (“SYKE”), 2/8/00: Aggressive Revenue Recognition Results in Earnings Restatement

SYKE announced yesterday that it would restate revenue and earnings for the second and third quarters of fiscal 1999 as a result of improper revenue recognition for certain software contracts. CFRA notes that the recent announcement heightens our ongoing concerns regarding the Company’s aggressive accounting procedures. In our April 1999 report, CFRA expressed concern about the quality of revenue and earnings in 1998 as a result of apparent aggressive revenue recognition. Specifically, the Company recorded $10 million of revenue on a non-monetary transaction with a non-public entity. CFRA believes the transaction would have been more appropriately classified as an investment rather than a revenue-generating transaction. As of February 7, 2000, SYKE had yet to collect the receivable related to the transaction. Moreover, in our July 1999 update, we expressed concern about the possibility of an earnings boost during the June 1999 quarter as a result of unusual accounting for the sale of a business unit. Specifically, on June 29, 1999 (two days prior to the end of the quarter), the Company announced that it had signed a definitive agreement to sell its manufacturing solutions unit with an effective sale date of April 1, 1999. On January 25, 2000, the Company revised its fourth quarter revenue and earnings estimates downward which, according to the Company, was due to anomalies which included the following: a significant number of customer contracts committed during the fourth quarter for which no revenue was recorded despite considerable costs being incurred, weaker than anticipated results of the Company’s wholly owned subsidiary SHPS, Incorporated, and the negative impact of foreign currency translation. The Company anticipated that revenue relating to these contracts would be included during the first quarter of fiscal 2000 and increased that period’s revenue and earnings’ forecasts accordingly. Subsequently, on February 7, 2000, the Company announced that their auditors suggested that the Company restate revenue and earnings for the second and third quarters of 1999. The restatement related to improper accounting for revenue for SYKE’s AnswerTeam™, a diagnostic desktop tool bundled with the Company’s technical support services. As shown in Table 1, the Company reduced revenue and net income by $20 million and $9.8 million for the September 1999 quarter, and by $12.0 million and $7.5 million for the June 1999 period. Furthermore, CFRA notes that the impact of the Company’s aggressive revenue recognition resulted in a staggering 200% overstatement of earnings during each of the respective periods. While the Company provided little guidance regarding the future impact of its newly adopted accounting method relating to software revenue recognition, it reported that it expects to record the revenue initially recorded during the second and third quarters of 1999 over the next five years (not in the first quarter of fiscal 2000 as originally anticipated). 2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

Sykes Enterprises Incorporated (2/8/00) 2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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Table 1: Revenue and Earnings, Initially Reported versus Adjusted for Improper Revenue Recognition, Q3 (9/99) and Q2 (6/99) Q3, 9/99 Q2, 6/99

($ mils., except EPS) Initially Reported

Adjustment Adjusted Change Initially Reported

Adjustment Adjusted Change

Revenue 161.0 (20.0) 141.0 (14.2%) 146.1 (12.0) 134.1 (9%)

Direct Costs 96.7 (4.2) 92.5 (4.5%) 88.9 -- 88.9 --

General & Admin. 40.1 0.3 40.4 (1%) 37.6 0.2 37.8 NM

Net Income 14.1 (9.8) 4.3 (228%) 11.5 (7.5) 4.0 (186%)

EPS $0.33 ($0.23) $0.10 (230%) $0.27 ($0.18) $0.09 (200%)


Airline Companies which have Recently Changed Depreciation Policies: Continental Air Lines, Inc. (“CAL”) – CAL increased its estimated useful life on certain new generation aircraft and increased the residual value on all aircraft on January 1, 1998. Specifically, CAL changed to an estimated useful life of 30 years from 25 years on newer model planes the Company has recently purchased. Furthermore, CAL increased its estimated residual value on all aircraft to 15% from 10%. CAL officials indicated the change was made because aircraft purchased during the 1970’s were continuing to be used and that newer aircraft were more fuel-efficient. However, in recent years, the Company has recorded two aircraft write-downs: $122 million in the September 1998 quarter and $128 million in the September 1996 period. CAL did not disclose the earnings effect of this change for the year ended December 1998. Delta Air Lines, Inc. (“DAL”) – DAL extended the life of certain new generation aircraft types on July 1, 1998 to 25 years from 20 years. Furthermore, the Company’s residual values for aircraft changed from a policy of 5% of the cost of the aircraft to between 5% to 10% of the cost. This change reduced depreciation expense by $92 million for the fiscal year ended June 1999, resulting in a boost to reported earnings of $0.37. Absent the change CFRA estimates DAL’s fiscal 1999 earnings would have been $6.83 rather than the reported $7.20. Furthermore, we find this change particularly unusual since DAL recorded a charge of $107 million to write-down to estimated fair value aircraft parts and obsolete flight equipment and parts during the September 1999 quarter. America West Holdings Corporation (“AWA”) - On October 1, 1998 AWA increased the average depreciable life of its 737-200 aircraft by four years while holding constant the residual value. The depreciable lives of aircraft prior to that change had been between 11 and 22 years. As a result of this change, depreciation expense was reduced by $2.0 million in each of the subsequent four quarters. Had AWA not made this change, earnings for the nine months ended September would have been reduced by $0.09 per share: to $2.17 from the reported $2.26. Southwest Airlines Company (“LUV”) - Effective January 1, 1999 LUV extended the depreciable lives of its 737-300/500 airplanes to 23 years from 20 years. As a result of this change, depreciation expense for the three and nine months ended September 1999 was reduced by $6.4 million and $19.3 million, respectively. Absent the change in estimate, earnings for the September quarter would have been lower by $3.9 million: to $123.1 million from the reported $127.0 million. Likewise, earnings for the nine months ended September would have been reduced by $11.8 million: to $368.7 million from the reported $380.5 million. Furthermore, the depreciable lives of all other aircraft were apparently extended as well. Specifically, the Company’s 1997 policy had been reported as a useful life of 12 to 20 years, while the 1998 policy was indicated as 20 to 25 years. AMR Corporation (“AMR”) - AMR changed its useful life and residual values for certain aircraft on January 1, 1999. Specifically, the Company lengthened its useful life to 25 years from 20 years and increased the residual values from 5% to 10%. By making this change, AMR reduced its depreciation expense by $39.0 million and $119.0 million for the three and nine months ended September from what would have prevailed absent the change. Had the Company not made this change, earnings for the September 1999 quarter would have been cut by $0.15 per share: to $1.61 from the reported $1.76. Earnings for the nine months ended September would have likewise been reduced by $0.44: to $4.00 from the reported $4.44.


UAL Corporation (“UAL”) - On April 1, 1999 UAL increased the depreciable life of certain aircraft to 25 years from a previous standard of 20 to 23 years. Furthermore, the Company increased the residual values of those same aircraft to 10% from the previously reported 4.5% to 7.3%. As a result of this change, depreciation expense was reduced by $30.0 million during the six months ended September. Had UAL not made this change, earnings for the nine months ended September would have been reduced by $0.27 per share: to $8.92 from the reported $9.19. Airline Companies which have not Changed Depreciation Policies: Alaska Airgroup Inc. (“ALK”) - ALK has maintained constant its depreciation policy at eight to 20 years for aircraft, which ranks as one of the most conservative in the industry. Northwest Airlines Corporation (“NWAC”) - NWAC has held constant its depreciation policy at a range not exceeding 25 years. Trans World Airlines, Inc. (“TWA”) – Although TWA’s depreciation policy has remained unchanged over the past two years, the Company’s policy of a 16 to 30 year useful life is relatively high in comparison to the others in the industry. US Airways Group, Inc. (“U”) - U’s depreciation policy, one of the industry’s most conservative, has remained constant over the past two years at a useful life of eleven to 20 years for aircraft.


Table 1: Companies That Capitalize Direct-Response Advertising Costs and Their Amortization Periods

Company Name Amortization Period

Charter Communications, Inc. (CHTR) 24 – 48 months

Elcom International, Inc. (ELCO) 5 months

Egghead.com, Inc. (EGGS) About 2 months (8 weeks)

Ennis Business Forms Inc. (EBF) 3 – 12 months

Federated Department Stores (FD) 1 – 4 months

J C Penney Company, Inc. (JCP) Not to exceed 6 months

Lands’ End, Inc. (LE) 3 months

Mattel, Inc. (MAT) 3 months

Newport Corporation (NEWP) 12 – 18 months

Nordstrom, Inc. (JWN) Not to exceed 6 months

OfficeMax, Inc. (OMX) 6 months

PETsMART, Inc (PETM) 6 –12 months

PolyMedica Corporation (PLMD) 24 - 48 months

Staples, Inc. (SPLS) 6 months

Time Warner, Inc. (TWX) 36 months

While the amortization terms are only a few months for companies such as retailers, which typically amortize such direct-response costs over the perceived life of a catalog, certain companies amortize their direct-response advertising costs over periods of up to four years. Specifically, Charter Communications, Inc., which operates cable systems, amortizes such costs over two to four years depending on the type of service the customer subscribes to and represents the period the customer is expected to remain connected to the cable system. PolyMedica Corporation, a provider of direct-to-consumer specialty medical products and services primarily focused in the diabetes supplies and consumer healthcare markets, amortizes its direct-response costs related to its diabetes customers on an accelerated basis during the first two years of a four-year period. The amortization rate is such that 55% of such costs are expensed after two years from the date they are incurred, and the remaining 45% is expensed on a straight-line basis over the next two years. PolyMedica justifies its relatively lengthy amortization period by stating that revenue generated from new diabetes customers as a result of direct-response advertising has historically resulted in a revenue stream lasting at least seven years, thus PolyMedica feels that it has selected a more conservative amortization period. In addition, PolyMedica amortizes its direct-response costs related to its Professional Products segment over a two-year period since it believes that historical evidence suggests that revenues generated by new respiratory customers, as a result of direct-response advertising, last on average three years, and again they feel they have selected a more conservative amortization period.


Time Warner, Inc., a media and entertainment company, capitalizes direct-response product promotional mailing costs, broadcast advertising costs, catalogs, and other promotional costs incurred in the Company's direct-marketing businesses. Time Warner generally amortizes its direct-response costs over periods of up to three years subsequent to the promotional event using straight-line or accelerated methods, with a significant portion of such costs amortized in twelve months or less.

PAREXEL International Corporation (3/5/01) 2001 by the Center for Financial Research and Analysis, Inc. (CFRA)

2

PAREXEL International Corporation (“PRXL”), 3/5/01: Increase in Receivables and Restatement of Financial Statements

Increase in Receivables Level PRXL’s balance of total receivables continued to rise significantly faster than revenue in the December 2000 quarter. As measured in days sales outstanding (DSO), receivables amounted to 187 days at December 2000 – up 5 days sequentially (September 2000), 25 days from year-end fiscal 2000, and 63 days from the year-ago period (December 1999). (See Table 1.) PRXL’s clinical research and development contracts are generally fixed price (with some variable components) and range in duration from a few months to several years. The Company recognizes fixed price contract revenue using the percentage of completion method, for which revenue recognition does not necessarily match the time of billing. After receiving a portion of the contract fee at contract inception, PRXL bills the client according to the terms of the contract. But the Company estimates and recognizes project revenue based not upon such billings, but rather based on the ratio that costs incurred to date bear to the Company’s estimated total costs at completion. When revenue recognition in any particular period exceeds the amount billed in that period, the excess is recorded as “unbilled receivables.” PRXL combines its unbilled receivables with billed receivables in the “accounts receivable” line item on its balance sheet. Unbilled Receivables constitutes the gross cumulative amount of revenue recognized which PRXL has not yet billed. In contrast, the Company records “advance billings” to reflect cash payments received for which the Company has not yet recognized revenue. Net of advance billings, PRXL reported that its DSO would have increased to 69 days, from 60 days at year-end fiscal 2000. CFRA finds this increase particularly troublesome given that the Company experienced contract cancellations of $36 million during the six months ended December 31, 2000. Although a decrease from the same period in the prior year ($55 million), we are concerned that the use of the percentage method on contracts which may be terminated with little notice (60-90 days in the case of PRXL) may place a company at risk of recognizing more revenue than the amount for which the customer is willing to pay in the event of termination. Table 1: Receivables, in Days Sales Outstanding (DSO), Based on Quarterly Sales

($ mils., except DSI) Q2, 12/00 Q1, 9/00 Q4, 6/00 Q3, 3/00 Q2, 12/99 Q1, 9/99

Net Revenue 94.3 88.2 91.2 97.3 98.0 91.8

Receivables 193.3 176.3 162.1 136.1 133.2 123.1

DSO 187 182 162 128 124 122 2001 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.


3

Restatement of Fiscal 2000 Financial Statements and Change in December Press Release vs. 10-Q In its December 2000 quarterly 10-Q, PRXL retroactively restated its fiscal 2000 financial statements and reported that the balances of certain accounts as reported in its December 2000 quarterly press release and conference call were misstated. As a result of these two issues, CFRA is concerned about the Company’s financial reporting. Specifically, in its December 2000 10-Q, PRXL reported the following restatement of its financial statements: “Subsequent to the issuance of the June 30, 2000 financial statements, [PRXL] determined that at June 30, 2000, its intercompany accounts did not fully eliminate in consolidation. The unreconciled difference, amounting to $7.6 million, was originally classified as a reduction to advance billings on the consolidated balance sheet. Based on subsequent analysis, [PRXL] determined the appropriate accounts to which the difference previously included in advance billings should have been recorded. Accordingly, the financial statements for the year ended June 30, 2000 have been restated to reflect these changes. The restatement resulted in a decrease of $4.1 million to the June 30, 2000 working capital principally related to currency translation adjustments which increased the previously reported balance for advance billings and correspondingly decreased stockholders' equity. In addition, total assets at June 30, 2000 increased by $1.0 million due primarily to adjustments to unbilled and trade receivables for the same reason. As part of the adjustments described above, the Company also identified certain charges that should have been made to its consolidated statement of income for the fiscal year ended June 30, 2000 of $1.6 million on a pre-tax basis, resulting in a $1.1 million reduction to net income for the year. The restated numbers are properly reflected in the financial statements for the quarter and six months ended December 31, 2000.” PRXL also reported in its December 2000 10-Q the following relating to its results for the December 2000 quarter as originally reported in its quarterly press release and conference call: “In connection with the final quarterly closing process and completion of this report on Form 10-Q for the period ended December 31, 2000, the Company determined that cash and cash equivalents (including marketable securities) at period end was $82.0 million, total assets were $376.1 million, working capital was $124.9 million and stockholder's equity was $184.7 million. In the Company's earnings release and related telephone conference call on January 25, 2001, the Company preliminarily reported these amounts at $91.4 million, $385.5 million, $123.3 million and $183.3 million, respectively. The changes reflected in the final numbers are a result of a $9.4 million re-classification between cash and accounts payable and a $1.4 million favorable working capital adjustment.” Decline in Revenue Growth PRXL’s year-over-year revenue growth rate continued to fall in the December 2000 quarter. As shown in Table 2, the Company’s year-over-year revenue growth fell to negative 3.7% in December after falling by 3.9% in the September quarter, and growing by 3.9% in the June quarter and by 8.0% in the March quarter. The Company attributed a portion of the revenue decline in the December quarter to the impact of cancellations, as discussed in the previous point.


4

Table 2: Year-Over-Year Revenue Growth

Q2, 12/00 Q1, 9/00 Q4, 6/00 Q3, 3/00

(3.7%) (3.9%) 3.9% 8.0%

Deterioration in Operating Cash Flows PRXL reported poor operating cash flows during the December quarter of 2000. As shown in Table 3, cash flows from operations (CFFO) plummeted to negative $4.1 million from positive $21.7 million, creating a CFFO-to-net income shortfall of $5.1 million versus a surplus of $16.6 million in the year-ago period. The deterioration in the Company’s December 2000 CFFO appears to relate to the increase in PRXL’s receivables level, as discussed in a prior point. Table 3: Cash Flows from Operations (CFFO) versus Net Income (NI)

($ millions) Q2, 12/00 Q2, 12/99 Six Months 12/00 Six Months 12/99

CFFO (4.1) 21.7 4.2 37.0

NI 1.0 5.1 0.9 8.9

CFFO – NI (5.1) 16.6 3.3 28.1 Continued Decline in Gross Margin PRXL’s gross margin continued to decline year-over-year in the December 2000 quarter. As shown in Table 4, the Company’s margin declined by 370 basis points in the December 2000 quarter, 520 points in the September quarter, 90 points in the June quarter, and 300 points in the March quarter. Table 4: Gross Margin, Compared Year -Over-Year

Q2, December Q1, September Q4, June Q3, March

Fiscal 2001 (6/01) 28.1% 27.1%

Difference (370 b.p.*) (520 b.p.)

Fiscal 2000 (6/00) 31.8% 32.3% 28.9% 31.0%

Difference (90 b.p.) (300 b.p.)

Fiscal 1999 (6/99) 29.8% 34.0% * b.p. = basis points

America Online, Inc. (10/12/96)© 1996 by the Center for Financial Research and Analysis (CFRA) 2

FINDINGSMID/LARGE CAP: #2

Ç Serious Operational ConcernsÇ Artificial Earnings Boost from Aggressive

Accounting Practices

Serious Operational Concerns. CFRA believes that AOL’s aggressive accounting masks some serious operational problems. On three previous occasions (June 1994, October 1995, and June 1996),CFRA has warned of aggressive accounting. We believe that AOL’s operations have continued toweaken, as evidenced by faltering cash flows and slowing revenue growth.

C Deteriorating Operational Cash Flows. An excellent measure of a healthy company is stronggrowth in its cash flows from operations (CFFO). Disappointingly, during the year ended June1996, AOL reported negative CFFO of $66.7 million, compared to a positive $17.3 million duringthe prior-year period. Moreover, during the 1996 period, CFFO lagged behind reported income byan astounding $96.5 million, raising questions about overly aggressive accounting policies used. (See Table 1.)

Table 1: Cash Flows from Operations versus Net Income

Year Ended June 1996 Year Ended June 1995

Cash Flows from Operations(CFFO)

($66.7 million) $17.3 million

Net Income (NI) $29.8 million ($35.8 million)

CFFO - NI ($96.5 million) $53.1 million

C Slowing Revenue Growth. After several periods of explosive growth, it appears AOL’s rate ofgrowth is slowing. As Table 2 illustrates, AOL’s total revenue growth slowed to 120% in the June1996 quarter (relative to the prior-year quarter). By contrast, total revenues had grown by 226% asrecently as the December 1995 quarter.

© 1996 by the Center for Financial Research and Analysis (CFRA), 10800 Mazwood Place, Rockville, MD, 20852; Phone: (301) 984-1001;Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, inwhole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based onsources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and ExchangeCommission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention,or sale of the securities of the company mentioned.


The more moderate growth appears related to a decreasing customer retention rate. Apparently,AOL added 1.8 million subscribers in the June quarter, but lost 1.5 million, resulting in a net gain ofonly 300,000, down significantly from prior quarters. AOL is also considering offering a flat ratefee for unlimited Internet access, which would likely lead to lower revenues.

One reason for the slowdown in revenue growth is the Company’s new pricing strategy. Starting inJuly 1996, AOL began offering 20 hours of on-line access for $19.95, down from its prior rate of$54.20, a reduction of 63.2%. Furthermore, AOL has recently announced that it would consideroffering lower flat rate fees, another drag on revenue growth.

Table 2: Recent Quarterly Revenue Growth, Versus Prior Year Quarter and Sequentially

June 1996Quarter

March 1996Quarter

Dec. 1995Quarter

Sept. 1995Quarter

June 1995Quarter

Total Revenues, versusyear-ago quarter

120.3% 186.3% 226.1% 247.5% 275.7%

Total Revenues, versusprior quarter

7.1% 25.4% 25.9% 54.6% 20.2%

Artificial Earnings Boost from Aggressive Accounting Practices. CFRA believes that AOL’saggressive accounting practices allow the Company to artificially inflate reported earnings by asignificant amount. Specifically, as outlined below, AOL treats marketing costs and productdevelopment costs in an aggressive manner.

C Aggressive Accounting for Marketing Costs. Despite its negative operating cash flows, AOL isable to post profits by using aggressive accounting policies, particularly related to marketing costs. If AOL had used more conservative (and in our judgment, proper) accounting policies, it wouldhave reported losses in line with its negative cash flows.

AOL capitalizes and writes off over 24 months certain marketing costs. CFRA believes such costsshould be expensed as incurred or, at a minimum, amortized more quickly. We consider marketingexpenses normal recurring operating costs, which should be expensed as incurred. Had AOL takenthis approach, the Company would have posted an operating loss of $154.8 million for the yearended June 1996, rather than an $82.2 million profit. Additionally, it would have suffered a netloss of roughly $124.2 million, or $1.14 per share, rather than the reported net income of $29.8million, or $0.28 per share. (See Table 3.)

Moreover, the gap between reported earnings and earnings adjusted for the effect of capitalizingsuch costs will likely increase in the future, as AOL increases its marketing expenditures. Accordingto AOL, “the Company anticipates lower direct response rates, and as a result, cost per registrationfor the AOL service is expected to increase.” The cost of acquiring customers already exploded toroughly $270 each in the June quarter, up significantly from only $130 in the March quarter. AOLalso stated that the declining retention rate resulted primarily from:


“(1) competition from an increasing number of service providers; (2) the availability ofalternative pricing models from competitors, including unlimited use pricing; and (3) anincrease in less-qualified new subscribers as a result of increased direct marketing to themass consumer audience.”

Table 3: Effects of Capitalization of Marketing Costs on Nine Months Ended March 1996

Reported Adjustment* CFRA-Adjusted

Operating Income $82.2 million ($237.0 million) ($154.8 million)

Net Income $29.8 million ($154.0 million) ($124.2 million)

EPS $0.28 ($1.42) ($1.14)* Assuming a 35% tax rate

It is noteworthy that AOL’s accounting policies have become progressively more aggressive overthe last few years, as the Company has lengthened its amortization period. Initially, theamortization period was 12 months. But it was increased to 18 months, and then (right before a1995 stock offering) to 24 months. The effect of its most recent change was to artificially boost netincome for the year ended June 1996 by $48.1 million (to the reported $29.8 million, from a netloss of $18.3 million). (See Table 4.)

Table 4: Effects of Lengthening Amortization Period on Nine Months Ended March 1996

Reported Adjustment* CFRA-Adjusted

Operating Income $82.2 million ($74.0 million) $8.2 million

Net Income $29.8 million ($48.1 million) ($18.3 million)

EPS $0.28 ($0.45) ($0.17)* Assuming a 35% tax rate

C Aggressive Accounting for Product Development Costs. In addition to boosting income bystretching out its amortization of marketing costs, AOL also capitalizes product development costsand amortizes them over five years. Had AOL expensed all such costs as incurred, then net incomefor the year ended June 1996 would have declined by an additional $16.5 million (to $13.3 millionfrom the reported $29.8 million). (See Table 5.)

Table 5: Effects of Capitalization of Product Development Costs on Nine Months Ended March 1996

Reported Adjustment CFRA-Adjusted

Operating Income $82.2 million ($25.4 million) $56.8 million

Net Income $29.8 million ($16.5 million) $13.3 million

EPS $0.28 ($0.15) $0.13


0

50

100

150

200

250

300

350

Quarter Ended:

Bal

ance

in M

illio

ns

6/95 9/95 12/95 3/96 6/96

Deferred Subcriber Acquisition Costs

C Summary and CFRA Commentary. As outlined above, AOL’s earnings appear to be more theresult of aggressive accounting than of a profitable business. A far better gauge to measure AOL’seconomic health is the Company’s cash flow from operations.

For the year ended June 1996, AOL generated negative cash flows of $66.7 million, despitereporting net income of $29.8 million. During that same nine-month period, the Company’s balancesheet account “Deferred Subscriber Acquisition Costs” increased an astounding $237.0 million, to$314.2 million from $77.2 million. (See Chart 1 and Table 6.) Since this account represents cashpaid for marketing costs not yet charged against income, it appears AOL has shifted substantialoperating losses to the balance sheet.

Chart 1: Recent Growth in Deferred Subscriber Acquisition Costs

Table 6: Recent Ending Balances of Deferred Subscriber Acquisition Costs

($ millions)June1995

September1995

December1995

March1996

June1996

Ending Balance of DeferredSubscriber Acquisition Costs

77.2 132.8 189.4 277.6 314.2

America Online, Inc.

October 12, 1996


Moreover, the Supreme Court has held that a fact is material if there is: “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” Interpreting Materiality Rather than relying on a numerical threshold, materiality judgments should be based on all the facts, qualitative and quantitative. The SEC staff (in Staff Accounting Bulletin No. 99) provides certain valuable insights to help investors make materiality judgments. According the SEC’s SAB No. 99, among the considerations that may well render material a quantitatively small misstatement of a financial statement item are – • whether the misstatement arises from an item capable of precise measurement or whether it arises

from an estimate and, if so, the degree of imprecision inherent in the estimate • whether the misstatement masks a change in earnings or other trends • whether the misstatement hides a failure to meet analysts' consensus expectations for the

enterprise • whether the misstatement changes a loss into income or vice versa • whether the misstatement concerns a segment or other portion of the registrant's business that has

been identified as playing a significant role in the registrant's operations or profitability • whether the misstatement affects the registrant's compliance with regulatory requirements • whether the misstatement affects the registrant's compliance with loan covenants or other

contractual requirements • whether the misstatement has the effect of increasing management's compensation – for example,

by satisfying requirements for the award of bonuses or other forms of incentive compensation whether the misstatement involves concealment of an unlawful transaction.

This is not an exhaustive list of the circumstances that may affect the materiality of a quantitatively small misstatement. Among other factors, the demonstrated volatility of the price of a company’s securities in response to certain types of disclosures may provide guidance as to whether investors regard quantitatively small misstatements as material. Consideration of potential market reaction to disclosure of a misstatement is by itself "too blunt an instrument to be depended on" in considering whether a fact is material. When, however, management or the independent auditor expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative market reaction, that expected reaction should be taken into account when considering whether a misstatement is material.


Attempt to Manage Earnings The SEC staff will likely consider material even small intentional misstatements in financial statements, for example, those actions designed to “manage earnings.” Investors generally would regard as significant a management practice to “overstate” or “understate” earnings to up to an amount just short of a percentage threshold in order to manage earnings. Considerations of the Books and Records Provisions Under the Exchange Act Even if misstatements are immaterial, companies must comply with Sections 13(b)(2) - (7) of the Securities Exchange Act of 1934 (the "Exchange Act"). Under these provisions, companies must make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the registrant and must maintain internal accounting controls that are sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit the preparation of financial statements in conformity with GAAP. In this context, determinations of what constitutes "reasonable assurance" and "reasonable detail" are based not on a "materiality" analysis but on the level of detail and degree of assurance that would satisfy prudent officials in the conduct of their own affairs. Accordingly, failure to record accurately immaterial items, in some instances, may result in violations of the securities laws. In a 1981 speech, former Chairman Harold M. Williams noted that, like materiality, "reasonableness" is not an "absolute standard of exactitude for corporate records." Unlike materiality, however, "reasonableness" is not solely a measure of the significance of a financial statement item to investors. "Reasonableness," in this context, reflects a judgment as to whether an issuer's failure to correct a known misstatement implicates the purposes underlying the accounting provisions of the Exchange Act. In assessing whether a misstatement results in a violation of a company's obligation to keep books and records that are accurate "in reasonable detail," companies and their auditors should consider, in addition to the factors discussed above concerning an evaluation of a misstatement's potential materiality, the following issues. • The significance of the misstatement. Though the SEC staff does not believe that companies need

to make finely calibrated determinations of significance with respect to immaterial items, plainly it is "reasonable" to treat misstatements whose

effects are clearly inconsequential differently than more significant ones. • How the misstatement arose. It is unlikely that it is ever "reasonable" for companies to record

misstatements or not to correct known misstatements – even immaterial ones – as part of an ongoing effort directed by or known to senior management for the purposes of "managing" earnings. On the other hand, insignificant misstatements that arise from the operation of systems or recurring processes in the normal course of business generally will not cause a registrant's books to be inaccurate "in reasonable detail."

• The cost of correcting the misstatement. The books and records provisions of the Exchange Act

do not require companies to make major expenditures to correct small misstatements. Conversely, where there is little cost or delay involved in correcting a misstatement, failing to do so is unlikely to be "reasonable."


• The clarity of authoritative accounting guidance with respect to the misstatement. Where reasonable minds may differ about the appropriate accounting treatment of a financial statement item, a failure to correct it may not render the company's financial statements inaccurate "in reasonable detail." Where, however, there is little ground for reasonable disagreement, the case for leaving a misstatement uncorrected is correspondingly weaker.

GAAP Precedence over Industry Practice

Some argue that companies should be permitted to follow an industry accounting practice even though that practice is inconsistent with authoritative accounting literature. This situation might occur if a practice is developed when there are few transactions and the accounting results are clearly inconsequential, and that practice never changes despite subsequent growth in the number or materiality of such transactions. The SEC strongly disagrees with this argument and believes that the authoritative literature takes precedence over industry practice that is contrary to GAAP.


I. Persuasive evidence of an arrangement exists

(a) Determine that the seller followed its normal and usual internal procedures required before revenue is recognized. If such practices require a written sales agreement signed by the legal department, then an oral agreement consummated on the last day of the quarter would permit no revenue to be reported during that period.

(b) Ascertain that risks and rewards of ownership of the product and title transferred seller (or

consignor) to buyer. Thus, products delivered to a consignee pursuant to a consignment arrangement are not sales and do not qualify for revenue recognition until a sale occurs.

(c) Other situations may exist where title to delivered product passes to a buyer, but the substance of

the transaction is that of a consignment or a financing. The following characteristics in a transaction may preclude revenue recognition even if title to the product has passed to the buyer.

1. The buyer has the right to return the product 2. The seller is required to repurchase the product at specified prices 3. The transaction possesses the characteristics set forth in EITF Issue No. 95-1, Revenue Recognition

on Sales with a Guaranteed Minimum Resale Value 4. The product is delivered for demonstration purposes II. Delivery has occurred or services have been rendered

(a) Delivery is not considered to have occurred unless the customer has taken title and assumed the risks and rewards of ownership of the products specified in the purchase order or sales agreement. Typically this occurs when a product is delivered to the customer’s delivery site (when terms are FOB destination) or when a product is shipped to the customer (when terms are FOB shipping point).

(b) The SEC still permits revenue recognition when no delivery has occurred when the following

criteria are met: 1. The risks of ownership have passed to the buyer 2. The customer made a fixed commitment to purchase the goods, preferably in writing 3. The buyer, not the seller, must request that the transaction be on a bill-and-hold basis. The buyer

must have a substantial purpose for ordering the goods on a bill-and-hold basis. 4. There must be a fixed schedule for delivery that is reasonable and consistent with the buyer’s

business purpose. 5. The seller must not have retained any specific performance obligations such that the earning process

is not complete 6. The ordered goods must have been segregated from the seller’s inventory and not subject to being

used to fill other orders. 7. The equipment (product) must be complete and ready for shipment.

(c) Layaway sales to customers. Provided the other criteria for revenue recognition are met, a seller should recognize revenue from sales made under its layaway program upon delivery of merchandise to its customer. Until then, any cash received should be recognized as a liability -- “deposits received from customers for layaway sales.” The seller is not permitted to record revenue at the earlier stage when collecting as cash deposit because the risk of ownership still remains with the seller.


(d) Revenue recognition related to nonrefundable, up-front fees. (Examples include: (1) selling a lifetime membership to a health club, (2) receiving an “activation fee” when entering into an arrangement to provide telecommunications services, or (3) receiving a nonrefundable “technology access fee” for providing research and development services.

According to the SEC, deferral of revenue is generally appropriate in each case; unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of the earnings process. Since customers are buying on-going rights, revenue should be deferred. The up-front fees (even if nonrefundable) are earned as the product and/or services are delivered and/or are performed and generally should be deferred and recognized systematically over the periods that the fees are earned. III. The seller’s price to the buyer is fixed or determinable Cancellation and termination clauses provide complications in making revenue recognition decisions. Close attention should be given to “side” agreements. If the cancellation privileges expire ratably over a stated contract term, the sales price is considered to become determinable ratably over the stated term. Companies that derive revenue from membership fees (e.g., Costco, MemberWorks, and Cendant) must defer recognition of revenue from any fees paid in advance when the customer has the unilateral right to cancel at any time and still receive a full refund since the SEC believes that the sales price in such arrangements is neither fixed nor determinable. Thus, when the cancellation privilege expires over the term of the contract, the SEC believes that the sales price becomes determinable ratably over that period. Therefore, the membership fee should be credited to a monetary liability account such as “customers’ refundable fees,” and no revenue should be recorded until the membership period has lapsed without the refund being granted. Nonetheless, the SEC notes that over the years the accounting for membership refunds has evolved from SFAS No. 48 – a standard that permitted revenue recognition (net of estimated refunds) under certain circumstances. For the SEC to prohibit such accounting may result in a significant change in practice. Thus, pending further action on the matter by the FASB, the SEC staff will not object to this practice, providing each of the following criteria are met:

(1) The estimates of terminations or cancellations and refunded revenues are made from large homogeneous pools

(2) Reliable estimates of the expected refunds can be made on a timely basis (3) There is a sufficient company-specific historical basis upon which to estimate the refunds and the

company believes that such historical experience is predictive of future events (4) The amount of the membership fee specified in the agreement at the outset of the arrangement is

fixed, other than the customer’s right to request a refund

Gross vs. Net Revenue When is it appropriate for an internet company to record “grossed-up revenue” (including the cost of sales), rather than a net-revenue basis (similar to a commission)?

• Illustration: Company A operates an internet site from which it will sell Company T’s products. Customers place their orders for the product by making a product selection directly from the internet site and providing a credit card number for payment. Company A receives the order, processes the credit card and passes the order on to Company T. Company T ships the product directly to the customer. Company A does not take title to the product and has no risk of loss or other responsibility for the product. The product typically sells for $175 of which Company A


receives $25. In the event a credit card transaction is rejected, Company A loses its margin on the sale (i.e., $25). How much is Company A’s revenue on the transaction?

• The answer is $25. It would be incorrect to “gross-up” the revenue to $175 (include the $150

cost of sales). In general, to determine whether revenue should be reported gross, consider if the Company:

• acts as principal (not sales agent) in the transaction; • takes title to the products; • has risks and reward of ownership, such as the risk of loss for collection, delivery, or returns; and • acts as an agent or broker (including performing services as such) with compensation on a

commission or fee basis. If the Company performs as an agent or broker without assuming the risks and reward of ownership of the goods, sales should be reported on a net basis.

Disclosure Requirement The SEC stated in Financial Reporting Release 36 (FRR 36) that Management Discussion and Analysis (MD&A) should “give investors an opportunity to look at the registrant through the eyes of management by providing historical and prospective analysis of the registrant’s financial condition and results of operations, with a particular emphasis on the registrant’s prospects for the future.” Examples of such revenue transactions or events that the staff has asked to be discussed are: 1. Shipments of product at the end of a reporting period that significantly reduce customer backlog and

that reasonably might be expected to result in lower shipments and revenue in the next period. 2. Granting extended payment terms that will result in a longer collection period for accounts receivable

and slower cash inflows from operations, and the effect on liquidity and capital resources. 3. Changing trends in shipments into, and sales from, a sales channel or separate class of customer that

could be expected to have a significant effect on future sales or sales returns. 4. An increasing trend toward sales to a different class of customer, such as a reseller distribution

channel that has a lower gross profit margin than existing sales that are principally made to end users. 5. Seasonal trends or variations in sales. 6. A gain or loss from the sale of an asset.

the numbers game - babson collegefaculty.babson.edu/halsey/acc7500/revenue recognition -...

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