BLOCKBUSTER ENTERTAINMENT CORPORATION

I.

POINT OF VIEW
This case takes the point of view of a regulator, the Securities and Exchange Commission.
II.

CASE CONTEXT

Blockbuster Entertainment Corporation (BEC) is the largest videostore chain in the United
States with 415 stores in operation. BECs financials exhibited unusually high growth in just
a few years, consistent with the trend in the video industry.
On May 9, 1989, Bear, Stearns & Co., issued a report critical of BECs accounting, which
also suggested that BECs stock was grossly overvalued. Consequently, BECs shares
dropped from $33 to $30 , and went down further to $26 the next day. Nevertheless,
investment firms still endorsed their buy recommendations.
BECs Chairman and CEO declared that their accounting policies were approved and
endorsed by Arthur Andersen and the SEC. Arthur Andersen responded as well stating that
there has been no reason for them to change their unqualified opinion on BECs 1988 FS.
With the issue raised by Bear, Stearns & Co., the SEC have decided to re-evaluate the FS
of BEC to either validate or disprove these claims.
III.

PROBLEM STATEMENT

Which accounting firms claim, Arthur Andersen or Bear, Sterns & Co., will the SEC
endorse?
IV. FRAMEWORK FOR ANALYSIS
In order for us to establish if BEC's shares were indeed grossly overvalued, the team would
evaluate the quality of Earnings Per Share (EPS) as presented in the financial statements of
BEC in 1988, and as pointed out by Bear Stearns in 1989.
V. ANALYSIS
Earnings per Share (EPS)
In 1988, the Bear Stearns report suggested that BECs shares were grossly overvalued.
Bear Stearns estimated the overvaluation of EPS by $0.50 taking into account the
adjustments for faster goodwill amortization (EPS of $0.14) and change in tape amortization

(EPS of $0.11), product sales to franchisees (EPS of $0.18), and initial franchising fees
(EPS of $0.07).
EPS shows the return to common stock shareholders for each share owned, and so can be
an indicator of a companys profitability. It is calculated as Net Income after deducting
dividends on preferred stock divided by the average number of outstanding shares. As
such, any material changes in the Net Income and number of common shares will influence
the computation of EPS.
Goodwill Amortization
For BECs case in 1988, EPS (diluted) of $0.57 and EPS (basic) of $0.58 were computed
from the Net Income of $15.5M. Note that Operating Expenses of $63.6M which includes
Depreciation and Amortization were accounted to get the posted earnings of $15.5M. BEC
amortized its tangible (videotapes) and intangible (goodwill) assets. Bear Stearns declared
that most of 1988 EPS growth resulted from BECs very slow goodwill amortization and
change in the amortization period of hit tapes.
Goodwill, which BEC refers as intangible assets relating to acquired businesses is the
excess of the acquisition cost over the fair market value of net assets acquired, and is
possible under the purchase method. BEC amortizes the resulting goodwill on a straight-line
basis over a period of 40 years. In contrary, Bear Stearns estimated that 5 years would be
reasonable for videotape stores, and accounted for a reduction in EPS by $0.14.
There is no correct amortization period for goodwill, but the estimate should be reasonable
enough to relate the period to the nature of the business acquired. On a practical note,
videocassette rental (VCR) business, same with other technology-related businesses,
usually has a life cycle of three to five years only, attributable to the game-changers in the
industry from VCR to CD to Blue Ray to USB to Cloud and so on.
Videotape Amortization
Moreover, BEC also slowed the amortization of its videotapes from 9 months straight-line to
36 months accelerated at the start of 1988. As BEC did not disclose how accelerated the
curve is and said that it uses 150.0% of straight-line computed on a monthly basis, Bear
Stearns estimated that the resulting amortization was not very accelerated and was just
close to the straight line. As a result, BEC increased the useful life of its videotapes from 9
months to 36 months, understating the reported expenses under Depreciation and
Amortization, and overstating Net Income and Retained Earnings. Bear Stearns estimated
this overstatement in EPS due to longer tape life as $0.11 per share.
Similar as goodwill amortization, there is no correct tape amortization period and method,
but the Company should select the one which closely approximates the flow of revenues.
The change in amortization period is allowed in accounting yet the justification for such
change should be provided. Given the above, it is evident that a company can manipulate
its earnings by its choice of estimates in this case, the amortization period and method.
Product Sales to Franchisees
Bear Stearns estimated the profit on product sales of BEC to its franchisees at $0.18 per
share. As part of the services provided in the franchise contract, product sales to

franchisees are necessary and are to be recorded by the franchisor in the usual manner.
Though one time and nonrecurring, the sales should be recorded. Hence, Bear Stearns
should not consider the product sales to franchisees as part of overvaluation.
Initial Franchise Fees
Revenue from BECs franchise program come from the following sources: (1) Product sales
to franchise owners, (2) Royalties and other fees, (3) Area development fees and (4) Initial
franchise fees.
Revenue from product sales initial tape inventory, equipment and supplies is recognized
when the products are shipped. Royalty based on monthly revenue and a monthly software
license fee are recognized as revenue when earned. Initial franchise fees and a nonrefundable area development fee under the franchise agreement are recognized as revenue
when the store is opened.
Although BEC recognizes revenue from its franchise program from 4 sources, BEC
presents its revenue in 3 types: (1) Rental revenue, (2) Product sales, and (3) Royalties and
other fees. As pointed out by Bear Stearns, area development fees of $552,000 were
included in Royalties and other fees ($7,590,000) to report the total amount of $8,142,000.
In effect, initial franchise fees appear to be included either in rental revenue or product
sales. Bear Stearns stated that it seems to be buried inexplicably in rental revenues and
estimated this overvaluation of nonrecurring initial and area franchise fees as $0.07 per
share.
However, though the disclosure is somewhat confusing, initial franchise fees should be
recognized and not be part of the overvaluation. Revenue from the initial franchise fees
should be recognized once substantial performance is achieved, which occurs when the
franchisee actually commence operations of the franchise. This is consistent with BECs
revenue recognition. It may be agreed that there is no indication that the stores purchasing
were actually open for business, but there is indeed an increase in the number of franchiseowned stores, and product sales to new franchisees, especially in the fourth quarter for two
consecutive years. The seasonal pattern is another topic to be observed and discussed by
BEC.
Yet again, Bear Stearns should not consider the product sales to franchisees (EPS of $0.18)
and franchising fees (EPS of $0.07) as part of overvaluation. Instead, it should have taken
into account the associated expenses mentioned in Annex A that may have incurred by BEC
as a franchisor. Hence, overvaluation of EPS may not be as high as $0.50.
Business Combinations
BEC merged with or acquired other video companies either through (1) combination of
cash, notes, and shares, or (2) stock-for-stock arrangement. Accounting procedures for
acquisitions was either (1) as purchases or (2) as pooling of interest.
In 1987 and 1988, purchase accounting was used by BEC for acquisitions made through
combinations of cash, notes, and shares. In this type of accounting, net assets of the
acquired companies went onto BECs balance sheet at the amount paid for them. The
assets were revalued at fair value and the excess was reflected as Goodwill. The goodwill
was then amortized over 40 years.

Meanwhile, in 1988 and early part of 1989, pooling of interest accounting was used by BEC
for acquisition made through stock-for-stock arrangement. With the high share price, the
Company was able to make acquisitions at low price and minimize the use of cash. In this
type of accounting, companies that merged were treated as one since the inception date
and corresponding items on their balance sheets were added to achieve the pro forma
consolidated balance sheet. Hence, previous transactions between BEC and acquired
companies were eliminated which translated into lower sales and profits in the previous
year, and higher growth rate in the current year.
Liquidity
Even there was a continuous increase in the business activities of BEC from 1986 to 1988,
indication of liquidity problems started to signify. In 1988, 37.0% of BECs operations was
supplied by its cash inflows, however, the proportion supplied by loan proceeds increased
from 25.0% in 1987 to 30.0% in 1988 (Annex B). The increase in the proportion was
conceivably due to the need for additional funds to support its investing activities which
cant be supported by the operating cash flows alone. The need for additional funds was
also reflected by the negative working capital of $10M in 1988.
Furthermore, BECs current ratio significantly declined by 53.0% from 1.69 in 1987 to 0.79
in 1988 (Annex C). The sharp decline can be attributable to the 222.0% increase in
accounts payable from $10.6M in 1987 to $34.1M in 1988. The Company probably delayed
its payments in order to project positive operating cash flows to support its earnings quality.
The best way to evaluate the quality of EPS is to compare it with operating cash flow per
share (or net income and operating cash flow). Earnings are of a high quality if operating
cash flow per share exceeds reported EPS. It suggests that earnings reflect the company's
operating results as the company is able to generate more cash. Although BEC reported
positive operating cash flow of $48M in 1988, it is worth noting that the amount was brought
by the significant increase in accounts payable and accrued liabilities (from $8.9M in 1987
to $24.8M in 1988).
The Company did not have deviation from GAAP; nevertheless, it stretched its accounting
rules in order to conceal its liquidity problem by reporting a positive operating cash flow and
creating an impression of a healthy company. Minimizing the use of cash and projecting
positive cash flow were strategies used by BEC to keep its share price high which it
subsequently used for stock acquisition of franchises.