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Challenge Five: Refunds for Dissatisfied Customers
Questions about cash collection can also arise when ¬rms provide open-ended offers to
refund returned merchandise from dissatis¬ed customers. Such is frequently the case for
magazine and textbook publishers. It can also arise for some manufacturers and retailers.
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For example, L. L. Bean, the mail-order clothing retailer, provides its customers the fol-
lowing assurance: “Our products are guaranteed to give 100% satisfaction in every way.
Return anything purchased from us at any time if it proves otherwise. We will replace it,
refund your purchase price or credit your credit card. We do not want you to have any-
thing from L. L. Bean that is not completely satisfactory.” This assurance, of course, cre-
ates a risk for the company if it fails to deliver on its customer satisfaction pledge.
How do ¬rms manage return risks? The most straightforward way is to have a product
or service that is attractive to customers. As a result, these types of offers tend to make
sense only for ¬rms that follow a differentiated strategy, offering their customers a high-
quality product or service at full price. However, even for these ¬rms, it can be dif¬cult
to manage the risks associated with returns. For example, consider L. L. Bean™s risks
from returns by customers who bought incorrectly sized clothing. The company can pro-
vide clear directions to customers on how to estimate their sizes, but it cannot eliminate
these types of returns. At best, the customer will want to replace the clothing for the cor-
rect size. However, if the desired size is out of stock, the company has to refund the pur-
chase price. Given the seasonal nature of the clothing industry, this type of risk may be
largely out of L. L. Bean™s control.
How are customer dissatisfaction and return risks re¬‚ected in ¬nancial reporting?
Typically, the sale is recognized at point of delivery of the product or service, and at the
end of the period an estimate is made for the cost of returns, requiring the exercise of
management judgment. However, SFAS 48 recognizes that this approach only works if
“the amount of future returns can be reasonably estimated.” If such is not the case, the
seller cannot recognize revenues until the return privilege has effectively expired.


Key Analysis Questions
Businesses where there are signi¬cant risks of customer returns and refunds raise
a number of questions for ¬nancial analysts.
• How does the selling firm position its business relative to competitors and
how does that strategy relate to its ability to manage return risks?
• Does the seller have a process in place to help manage return risk? This pro-
cess could include customer satisfaction and/or product/service quality pro-
grams to limit the likelihood of returns.
• Is the estimated allowance for returns consistent with historical data and with
industry norms? If the allowance is lower than these norms, what factors ex-
plain the differences? For example, has the firm changed its strategy, or does
it follow a different strategy from other firms in the industry, making these
norms less reliable benchmarks? Is it growing rapidly and selling to different
types of customers than historically? Has there been any change in product
quality or customer satisfaction with the firm™s product or service that is
likely to impact returns?
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SUMMARY
In this chapter, we overviewed the revenue recognition rule and discussed its implica-
tions for analysis of revenues by ¬nancial statement users. Under the rule, revenues can
be recognized only if (1) the seller has provided all, or substantially all, of the goods or
services to be delivered to the customer, and (2) the customer has paid cash or is expect-
ed to pay cash with reasonable certainty.
For certain types of transactions, implementing this rule can be challenging. For ex-
ample, it can be dif¬cult to assess whether revenues have been earned if:
1. Customers pay for a product or service prior to its delivery, as in the case of mag-
azine subscriptions, property and casualty insurance policies, and service con-
tracts.
2. Products or services are provided over multiple years, as is the case for long-term
construction contracts and frequent flyer awards.
3. Products or services are sold with some residual rights retained by the seller, re-
flected in sales of receivables with recourse and lease agreements.
4. Sellers of products or services provide their customers with long-term financing,
as in the case of some real estate developers.
5. Sellers provide an open-ended offer to refund dissatisfied customers.
In general, corporate managers of the selling ¬rm are likely to have the best informa-
tion on whether revenue has been earned and cash is likely to be received from the cus-
tomer. Revenues (net of estimates of costs for default and returns) then potentially
provide users of ¬nancial statements with information on managers™ assessment of these
risks. However, the value of this information has to be tempered by management™s in-
centive to report favorable information on its stewardship of the ¬rm. This provides a
role for analysis of revenues. Such analysis involves independently assessing whether
revenues have been earned, and whether cash is likely to be collected.


DISCUSSION QUESTIONS
1. A customer pays $1,000 in advance for a service agreement. What are the financial
statement effects of this transaction if (a) revenue is recognized at receipt of cash, and
(b) revenue is recognized at delivery of the product? What forecasts, if any, do you
have to make to complete the recording of this transaction? What factors would de-
termine which of these two approaches is appropriate? As a financial analyst, what
questions would you raise with the firm™s CFO?
2. A firm signs a long-term contract to construct a building for $10,000,000. The build-
ing is to be completed in two years at a cost of $8,000,000. At the end of the first year,
$6,000,000 of costs has been incurred. Under the contract terms, the customer pays
for the building during the first year. What are the financial statement effects of this
transaction if (a) revenue is recognized under the completed contract method, and
(b) revenue is recognized using the percentage of completion method? What fore-
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Revenue Analysis




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casts, if any, do you have to make to complete the recording of this transaction? What
factors would determine which of these two approaches is appropriate? As a financial
analyst, what questions would you raise with the firm™s CFO?
3. United Airlines sells a round-trip ticket for a flight from Boston to London for $750.
The customer also receives 5,000 award miles, equivalent to 20 percent of the miles
required for a free domestic flight. United expects 20 percent of its customers to re-
deem awards for future air travel, and the average forgone revenues from these flights
to be $400 per passenger. Finally, United estimates that the incremental costs associ-
ated with redemption of frequent flyer awards amount to $100 per passenger. What
are the financial statement effects of this transaction if (a) the incremental cost ap-
proach is used, and (b) revenue is recognized using the deferred revenue approach?
What forecasts, if any, do you have to make to complete the recording of this trans-
action? What factors would determine which of these two approaches is appropriate?
As a financial analyst, what questions would you raise with the firm™s CFO?
4. A firm sells $200,000 of interest-bearing two-year notes receivable to a bank, with
recourse, for $208,978. The interest rate on the notes is 10 percent, and the bank™s
effective interest rate is 7.5 percent. What are the financial statement effects of this
transaction if (a) the receivable is viewed as sold, and (b) the receivable is viewed as
providing collateral for a bank loan? What forecasts, if any, do you have to make to
complete the recording of this transaction? What factors would determine which of
these two approaches is appropriate? As a financial analyst, what questions would
you raise with the firm™s CFO?
5. Consider a lessor that sells the right to use a depreciable asset, with a book value of
$1,500, to a customer for two years for $1,000 per year, payable at the beginning of
the year. At the end of the lease term, the rights to the asset revert to the seller. As-
suming a discount rate of 10 percent, the present value of the lease payments is
$1,909. What are the financial statement effects of this transaction if (a) revenue is
recognized under the sales-type lease approach, and (b) revenue is recognized using
the operating lease method? What forecasts, if any, do you have to make to complete
the recording of this transaction? What factors would determine which of these two
approaches is appropriate? As a financial analyst, what questions would you raise
with the firm™s CFO?
6. A real estate developer sells land parcels to its customers and provides them with fi-
nancing. In 2000, the first year of operation, the firm signed new land sale contracts
for $25,000,000. This land had originally been acquired for $20,000,000, implying a
gross margin of 20 percent. Customer receipts for the year were $8,000,000 for de-
posits on property sold and $1,000,000 in principal repayments under financing
agreements with customers. What are the financial statement effects of this transac-
tion if (a) revenue is recognized at sale, and (b) revenue is recognized when cash is
received? What forecasts, if any, do you have to make to complete the recording of
this transaction? What factors would determine which of these two approaches is
appropriate? As a financial analyst, what questions would you raise with the firm™s
CFO?
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7. A publishing company delivers 130,000 copies of a new textbook to bookstores dur-
ing the year. The bookstores pay the publisher $10 per book, but have the right to be
reimbursed for any books returned within one year. The cost of the books to the pub-
lisher is $5 per book. What are the financial statement effects of this transaction if (a)
revenue is recognized at sale, and (b) revenue is recognized when return rights ex-
pire? What forecasts, if any, do you have to make to complete the recording of this
transaction? What factors would determine which of these two approaches is appro-
priate? As a financial analyst, what questions would you raise with the firm™s CFO?
Oracle Systems Corporation




I
n August 1990 Lawrence J. Ellison, CEO of Oracle Systems Corpora-
tion, was facing increasing pressure from analysts about the method the company used
to recognize revenue in its ¬nancial reports. Analysts™ major concerns were clearly ar-
ticulated by a senior technology analyst at Hambrecht & Quist, Inc. in San Francisco: 2
Business Analysis and Valuation Tools

Under Oracle™s current set of accounting rules, Oracle can recognize any revenue
they believe will be shipped within the next twelve months. . . . Many other soft-
ware ¬rms have moved to booking only the revenue that has been shipped.
Given its aggressive revenue-recognition policy and relatively high amount of ac-
counts receivable, many analysts argued that Oracle™s stock was a risky buy. As a result,
the company™s stock price had plummeted from a high of $56 in March to around $27 in
mid-August. This poor stock performance concerned Larry Ellison for two reasons. 6
First, he worried that the ¬rm might become a takeover candidate, and second that the Revenue Analysis


low price made it expensive for the ¬rm to raise new equity capital to ¬nance its future
growth.


ORACLE™S BUSINESS AND PERFORMANCE
Since its formation in California in June 1977, Oracle Systems Corporation has grown
rapidly to become the world™s largest supplier of database management software. Its
principal product is the ORACLE relational database management system, which runs on
a broad range of computers, including mainframes, minicomputers, microcomputers,
and personal computers. The company also develops and distributes a wide array of
products to interface with its database system, including applications in ¬nancial report-
ing, manufacturing management, computer aided systems engineering, computer
network communications, and of¬ce automation. Finally, Oracle offers extensive main-
tenance, consulting, training, and systems integration services to support its products.
Oracle™s leadership in developing software for database management has enabled it
to achieve impressive ¬nancial growth. As reported in Exhibit 1, the company™s sales
grew from $282 million in 1988 to $971 million two years later. Larry Ellison was proud
of this rapid growth and committed to its continuance. He often referred to Genghis
Khan as his inspiration in crushing competitors and achieving growth.

.........................................................................................................................
This case was prepared for class discussion by Cholthicha Srivisal and Paul M. Healy of the MIT Sloan School of
Management.




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The primary factors underlying Oracle™s strong performance have been its successes
in R&D and its committed sales force. The ¬rm™s R&D triumphs are proudly noted in
the 1990 annual report:
In 1979, we delivered ORACLE, the world™s ¬rst relational database management
system and the ¬rst product based on SQL. In 1983, ORACLE was the ¬rst database




Oracle Systems Corporation
management system to run on mainframes, minicomputers, and PCs. In 1986,
ORACLE was the ¬rst database management system with distributed capability, mak-
ing access to data on a network of computers as easy as access on a single computer.
We continued our tradition of technology leadership in 1990, with three key
achievements in the area of client-server computing. First, we delivered software
that allows client programs to automatically adapt to the different graphical user
interfaces on PCs, Macintoshes, and workstations. Second, we delivered our com-
plete family of accounting applications running as client programs networked to
an ORACLE database server. Third, the ORACLE database server set performance
records of over 400 transactions per second on mainframes, 200 transactions per
second on minicomputers, and 20 transactions per second on PCs.
Oracle™s sales force has also been responsible for its success. The sales force is com-
pensated on the basis of sales, giving it a strong incentive to aggressively court large cor-
porate customers. In some cases salespeople even have been known to offer extended
payment terms to a potentially valuable customer to close a sale.
Oracle™s growth slowed in early 1990. In March the ¬rm announced a 54 percent
jump in quarterly revenues (relative to 1989™s results)”but only a 1 percent rise in earn-
ings (see Exhibit 2 for quarterly results for 1989 and 1990). Management explained that

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