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mately $223 million, $47 million, and $114 million, respectively, which were being am-
ortized over 40 years. Sensormatic believed that this goodwill at the end of ¬scal 1995
would be fully recoverable because the acquisitions were made to enhance the revenue
and pro¬t potential for the inde¬nite future of these companies by increasing ef¬cien-
cies, and realizing synergies with Sensormatic™s own core businesses.
The acquisition of direct and indirect distribution channels helped Sensormatic to
reach a wide range of potential customers worldwide. Sensormatic applied the same ap-
proach used in penetrating the U.S. commercial/industrial market to developing a pres-
ence in this market in Europe. The company felt that not only its wide geographical
presence but also its broad product portfolio provided it with a competitive advantage;
if a company used an EAS from Sensormatic, it was also likely to choose Sensormatic
for other related security products such as CCTV and Access Control since compatibility
was an issue. Honeywell, Toshiba, Panasonic, Lux Products, Monsanto, and GTE were
companies that had used Sensormatic™s EAS and chose CCTV/Access Control systems
from Sensormatic.
Management Communications

17-19 Part 3 Business Analysis and Valuation Applications

However, Sensormatic™s management felt that the company had grown faster than its
management and organization. The integration of the Knogo European operations was
Sensormatic Electronics Corporation

slower and costlier than planned. The rapid growth in sales, product diversity, and the
demands of integrating acquired businesses outpaced the growth in corporate infrastruc-
ture and systems, resulting in adverse bottom-line ¬gures in 1995 as expenses grew sig-
ni¬cantly faster than revenues.

MARKETING STRATEGY. Sensormatic™s major retail customers included Block-
buster Video, Sears Roebuck, Kmart, Wal-Mart, J.C. Penney, CVS, and Crown Books.
Retail customers did not want to pay cash for the purchase of anti-theft systems until
they achieved the bene¬ts (payback period for the typical installation was six months).
A key element of Sensormatic™s marketing strategy was to increase market penetration
by providing alternative ¬nancing options to its retail customers (i.e., vendor ¬nancing).
Sensormatic™s management believed that this strategy gave the company a signi¬cant
competitive advantage and helped it rapidly penetrate markets and increase customer loy-
alty. The longer-term ¬nancing arrangements were limited to products which had long
useful lives (i.e., not offered with the sale of products such as disposable tags).
In order to ¬nance customer receivables, Sensormatic entered into an agreement with
a third-party ¬nancing institution whereby it could sell (with recourse) or assign (with-
out recourse) certain pre-approved U.S. accounts receivables. This program also pro-
vided Sensormatic with the expertise of outside parties who were fully dedicated to the
business of collecting receivables.
Checkpoint, a main competitor of Sensormatic, did not depend much on long-term
¬nancing arrangements, such as installment sales and deferred payment sales, to
increase revenue. At Checkpoint, the only sales transactions made under long-term
¬nancing arrangements were sales-type leases, which accounted for a minor percentage
of total sales in 1995. However, Sensormatic believed that Checkpoint would build up
long-term receivables over time as Checkpoint received large orders from discount


Accounting Policy

nized revenue when a customer took title of the product, even though payments were
sometimes not received for a considerable period of time thereafter. The longer term ¬-
nancing arrangements offered by the company included the following (see Exhibit 1 for
the accounting method of alternative ¬nancing options, as reported by Sensormatic):
Installment sales. One ¬nancing option offered by Sensormatic, primarily to U.S. re-
tail customers, was installment sales. Under this option, the purchase price was pay-
704 Management Communications

Management Communications

able in equal installments, normally monthly, over the period of the sales contract,
from one to ¬ve years. The stream of scheduled payments was discounted to its

Sensormatic Electronics Corporation
present value, using a market rate of interest. This amount was recognized as sales
revenue at the date of shipment. Legal title to the equipment passed to the customer
upon shipment, but Sensormatic normally retained a security interest in the equip-
ment to secure the receivable. The total amount of installment sales receivables on
Sensormatic™s balance sheet represented total outstanding installment sales receiv-
ables less unearned interest income, unearned maintenance fees, and an allowance for
doubtful accounts.
Deferred payment sales (extended credit terms). A second ¬nancing option offered
primarily to U.S. retail customers was deferred payment sales, under which the pay-
ment date was delayed for a speci¬c period, more than 90 days but not more than 365
days after the product shipment date. The accounting treatment was the same as was
used with installment sales”the sales revenue was discounted, using a market rate of
interest, to its present value at the date of shipment. The deferred receivables on the
balance sheet represented the gross receivable less unearned interest income and an
allowance for doubtful accounts.
Sales-type leases. A third alternative was sales-type leases, offered primarily to Eu-
ropean retail customers. Under this option, the Company™s equipment was leased to
the customer for a period generally running between 60 and 72 months. During the
term of these leases, which were noncancelable, all of the bene¬ts and risks of own-
ership were effectively transferred from Sensormatic to the lessee. The sales revenue
recognized on sales-type leases was the present value of the stream of scheduled pay-
ments, using a market rate of interest. The amount reported on Sensormatic™s balance
sheet as “net investment in sales-type leases” represents total lease payments less un-
earned interest income, unearned maintenance fees, and an allowance for doubtful

its investments in receivables and leases by transferring them to ¬nancing institutions.
These receivables and leases were sold with recourse or assigned without recourse.
Sales of Receivables with Recourse. When receivables and leases were sold with re-
course, Sensormatic was obligated to repurchase the receivables and leases, if cus-
tomers were delinquent in their scheduled payments beyond a de¬ned period of time.
Once receivables were sold (with recourse) to a third party, these receivables were re-
moved from Sensormatic™s balance sheet.
Related to the receivables sold with recourse, Sensormatic accrued a liability for
estimated future losses due to the default of customer payments and the repurchase of
receivables from ¬nancial institutions. At June 30, 1994, the company accrued loss con-
4. Excerpts from White Paper, Sensormatic Electronics Corporation, September 1995.
Management Communications

17-21 Part 3 Business Analysis and Valuation Applications

tingencies of $1.3 million related to $199.8 million of receivables and leases sold to and
outstanding with the ¬nancing institutions which were subject to repurchase.5 In ¬scal
Sensormatic Electronics Corporation

1995, Sensormatic repurchased approximately $13 million of receivables/leases sold
with recourse to ¬nancing institutions, of which approximately $8.6 million was out-
standing on Sensormatic™s balance sheet at June 30, 1995. Upon repurchase, these re-
ceivables were accounted for by recording the speci¬c receivables or sales-type leases
on the balance sheet and an allowance for doubtful accounts, if necessary.
Sales of Receivables Without Recourse. Sensormatic also had agreements with third-
party ¬nancing institutions whereby the company assigned receivables without re-
course. Under this agreement, Sensormatic did not have an obligation to repurchase
the receivables assigned, even if customers were delinquent in scheduled payments.
When Sensormatic assigned receivables (without recourse) to a third party, these re-
ceivables were eliminated from Sensormatic™s balance sheet. No liability was ac-
crued with respect to the receivables assigned, because Sensormatic would not incur
any loss even if there was a default.
The receivables sold or assigned usually carried ¬xed interest rates. However, Sen-
sormatic sold them to the ¬nancing institution at a ¬‚oating rate indexed to one month
LIBOR. Any differential in interest (¬xed vs. ¬‚oating) was either paid or received by
Sensormatic. In order to manage the interest rate risk associated with the receivables
sold, Sensormatic entered into interest rate instruments such as ¬‚oating to ¬xed in-
terest rate swaps. This resulted in offsetting interest rate differential payments or

Barron™s Criticism
In March 1995, Barron™s, a widely circulated ¬nancial weekly, issued an article criticiz-
ing Sensormatic™s accounting policies as aggressive. The article explained6:
. . . while the 35% gain in revenues and 33% increase in net income that Sensor-
matic reported for its ¬scal ¬rst half are right on the pace it maintained for all of
¬scal 1994, a close reading of its ¬nancials raises the suspicion that it has had to
make increasingly aggressive accounting assumptions to stay on that track.
. . . Sensormatic™s stated policy is to use its balance-sheet heft as a marketing tool
by offering new customers a variety of ¬‚exible deferred payment arrangements.
Thus, it carries a big chunk of receivables on its balance sheet, as well as sales-
type lease arrangements. And, to turn some of that business into cash, it sells part
of its receivables, generally with recourse, to third parties.
What™s notable is that while the receivables on its books increased roughly in
line with sales, to $174.5 million [2nd quarter of ¬scal year 1995] from $127.6

5. Sensormatic disclosed the amount of accrued loss contingencies in 1994 but did not disclose it in the 1995 Annual
6. Excerpts from Barron™s Financial Weekly, March 20, 1995.
706 Management Communications

Management Communications

million [4th quarter of ¬scal year 1994] between June and December, the amount
it expensed as a reserve for doubtful accounts stayed ¬‚at at $10.4 million and thus

Sensormatic Electronics Corporation
dropped, in percentage terms, to 6% from 8% of receivables. A back-of-the-enve-
lope calculation is that, had the reserve stayed at 8%, pretax charges against Sen-
sormatic™s income would have risen by roughly $3.5 million . . .
Moreover, the receivables and leases it had sold to and outstanding with third
parties climbed over that stretch to $273.5 million [2nd quarter of ¬scal year
1995] from $199.9 million [4th quarter of ¬scal year 1994]. Yet the loss contingen-
cies Sensormatic accrued on those grew by all of $500,000 to $1.8 million [2nd
quarter of ¬scal year 1995]. That amounted to 1% of outstandings, a puny per-
centage under any circumstances. But it seems downright skimpy considering the
seemingly endless chain of store closings, restructurings and bankruptcies that
shapes the history of the industry from which Sensormatic draws most of its cus-
tomers. Not to mention the fact that last ¬scal year, it ended up repaying nearly
$13 million, or 5%, of the funds it was advanced for receivables”mostly because
customers turned out to be deadbeats.
. . . If Sensormatic™s business and prospects are as good as it would have the
Street believe, why push the numbers?
It™s worth noting, in that context, that while Sensormatic insiders still own well
over a million of its shares, they™ve blown out all 157,500 shares that they™ve ac-
quired through the exercise of options over the past year. And they™ve sold an ad-
ditional 115,600 shares, at prices ranging from 28 and a fraction all the way up
to the stock™s all-time high of 39. . . .

Sensormatic™s Response
In response to the criticism of Barron™s, Sensormatic™s management argued that the
company followed U.S. GAAP and that their accounting policies were consistent with
the practice of many companies in the EAS industry. Also, Sensormatic issued a “white
paper” which explained its accounting policies in detail (see Exhibit 1).
The white paper tried to answer why the allowance for doubtful accounts did not in-
crease proportionately with revenue growth. Sensormatic™s management explained7:
The Company as well as many ¬nancial analysts believe that the ratio of allow-
ance for doubtful accounts to revenue is far less meaningful than 1) the ratio of
the provision for doubtful accounts to total revenues (expense to revenue) and 2)
the ratio of allowance for doubtful accounts to outstanding receivables and sales-
type leases. The Company routinely reviews the credit quality of each customer
before an order is accepted. Thereafter, the Company continues to evaluate the
collectibility of the accounts and provides for estimated uncollectible amounts. At

7. Excerpts from White Paper, Sensormatic Electronics Corporation, September 1995.
Management Communications

17-23 Part 3 Business Analysis and Valuation Applications

such time, an expense is recorded which re¬‚ects the Company™s best estimate of
the amount which will not be collected. As shown in Exhibit 2, the bad debt ex-
Sensormatic Electronics Corporation

pense as a percentage of revenue has remained fairly constant from ¬scal 1993 to
¬scal 1995, at approximately 1.9 percent.
The Company evaluates the total allowance for doubtful accounts on a quar-
terly basis to ensure that it is adequate, based on recent payment patterns, write-
off amounts, etc., and records additional bad debt expense, if necessary. As shown


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