Class 5 case study (Lucent) (z3249378)

Yue Wang

1. In late 2000, Lucent announced that revenues would be adjusted downwards by $679 million as a result of revenue recognition problems. Yet the firm s market capitalization plummeted by $24.7 billion. Why do you think the market reacted so negatively to Lucent s announcements of the problems? To investors, the discovery of Lucent s accounting problem is an indication that the board is managing the profit. The truth that they want to cover up is the evidences indicating its underperformance in late 2000 and potential risks in the future. The major incentive for Lucent to manage its profit was because of the pressure from competitors. The new solutions in networking enabled Lucent s competitor Nortel Networks to capture larger market share. Due to that reason, Lucent s performance in 2000 was not outstanding. It even had to finance its capital through secret asset selling. The first problem of Lucent is its off-balance sheet activities. To attract customers and enhance their loyalty, Lucent provided medium to long-term financing and financing guarantees to its customers. The extended credit to customers will affect the receivable accounts and might give rise to allowance for bad debts and bad debts expense. Therefore, recognized revenue will be boosted in this period by putting next year s profit at risk. In addition, the financing guarantees provided to customers might result in cash flow shortage in the future if those guarantees are called on. It is not hard for investors with insights to realize the potential risk and quit the game as soon as possible. Lucent replaced its CFO in August 2000 and assigned huge bonus to him. This increased the incentive for management to manipulate financial information. Not surprisingly, an amount of $125 million revenue adjustment was made later due to the financial department s misunderstanding of the revenue recognition rules. From my personal perspective, it was simply an excuse for the manipulating conduct. Investors with the same feeling could have reacted very negatively to the revealed truth. The later discovery of premature revenue recognition done by its sales team provided a convincing evidence for such kind of thoughts. All those factors, including its underperformance and the future financial risk due to current accounting policy, together lead to the lowered confidence of analysts

Class 5 case study (Lucent) (z3249378)

Yue Wang

and the market. 2. What financial statement adjustments will Lucent have to make to correct the revenue recognition problems announced in late 2000? y Medium to long-term financing and financing guarantee: Firstly, the revenue might be decreased since such kind sales with long-term payment method may not meet the revenue recognition rule of Lucent. In addition, the provision for doubtful debt should be increased to inform the stakeholders about the potential failure to collect cash in the future. Therefore, both of the operating profit on the income statement and the total assets in balance sheet should be reduced. Alternatively, another item contingent liability could be added on the balance sheet. This will also affect the tax payable and deferred tax asset account. For the financing guarantee provided, Lucent could have record it under contingent liability on balance sheet or make it easy to notice in the footnotes. Revenue adjustments: Revenue had been adjusted for several times in the fourth quarter of 2000. For each adjustment, revenue would be reduced and the tax payable and deferred tax asset would be adjusted accordingly. Equipment selling: This will reduce the total assets balance. Also, the amortization of those equipment should be written off as well. 3. How would you judge whether a firm is likely to face revenue recognition problems? From my perspective, this company definitely had serious problem with revenue recognition. The initial revenue adjustment for fiscal 2000 was attributed to the misleading documentation and incomplete communication between a sales team and the financial organization with respect to offering a customer credits in connection with a software license . Later, it was discovered that a verbally offered credits was provided to customer for the purpose of improving the fourth-quarter sales. This event was merely human manipulation that managers could find no excuse to argue. Finally, investigation revealed that another amount of revenue was recorded while the products had not been completely shipped.

Class 5 case study (Lucent) (z3249378)

Yue Wang

All those facts contribute to the reliability of Lucent s revenue recognition and it should be the number one suspect account in its financial statements. 4. Assess whether any of Lucent s competitors are likely to face revenue recognition problems in the coming quarters. Lucent s major competitors are Cisco Systems, Juniper Networks and Nortel Networks. Lucent s revenue recognition problem is mainly reflected on the amount of account receivable related to the amount of its revenue. Comparing the four company s receivable to revenue ratio we can find that Lucent s account receivable is much higher than its sales in the fourth quarter of 2000. In contrast, Cisco Systems and Juniper Networks receivables were only half as much as their revenue in the same period. Nortel Networks corresponding ratio was also relatively high, indicating that it was possible to have the same revenue recognition problem as Lucent.