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Textbook: Business Analysis & Valuation using financial statements 4E Palepu & Healy Oracle Systems Corporation I n August 1990 Lawrence J. Ellison, CEO of Oracle Systems Corporation, was facing increasing pressure from analysts about the method the company used to recognize revenue in its financial reports. Analysts' major concerns were clearly articulated by a senior technology analyst at Hambrecht 6c Quist, Inc. in San Francisco: 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 software firms have moved to booking only the revenue that has been shipped. Given its aggressive revenue-recognition policy and relatively high amount of accounts 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. First, he worried that the firm might become a takeover candidate, and second that the low price made it expensive for the firm to raise new equity capital to finance its future growth.' ORACLE'S BUSINESSAND 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 financial reporting, manufacturing management, computer aided systems engineering, computer network communications, and office automation. Finally, Oracle offers extensive maintenance, 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 financial 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. /. Cnoltfiicna Silvfsu/ and Professor Paul M Heafy t>rei>ared this case at the AWT Sloan School of Management The case is intended solely as the basis for class discussion and is not intended to serve as an endorsement, source of/irimary data, or illustration of effective or ineffective management 287 288 Part 4 • Additional Cases • •' , : <": the primary factors underlying oracle's strong performance have been its successes in r&d and its committed sales force. the firm's r&d triumphs are proudly noted in the 1990 annual report: \n 1979, we delivered oracle, the world's first relational database management system and the first product based on sql. in 1983, oracle was the first database management system to run on mainframes, minicomputers, and pcs. in 1986, oracle was the first database management system with distributed capability, making 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 complete 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 traits-actions 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 compensated on the basis of sales, giving it a strong incentive to aggressively court large corporate 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 firm announced a 54 percent jump in quarterly revenues (relative to 1989's results)—but only a 1 percent rise in earnings (see exhibit 2 for quarterly results for 1989 and 1990). management explained that several factors contributed to this poor performance. first, the company had recently redrawn its sales territories and, as a result, for several months salespeople had become unsure of their new responsibilities, leaving some customers dissatisfied. second, there were problems with a number of new products, such as oracle financials, which were released before all major bugs could be fixed. however, the stock market was unimpressed by these explanations, and the firm's stock price dropped by 31 percent with the earnings announcement. 3 • revenue recognition the deterioration in its financial performance prompted analysts to question oracle's method of recognizing revenues. for example, one analyst commented: oracle's accounting practices might have played a role in the low net income results. the top line went up over 50%, though the net bottom line did not do so well, because oracle's running more cash than it should be as a result of financial mismanagement. the company's aggressive revenue-recognition policy and relatively high amount of accounts receivables make the stock risky. oracle's major revenues come from licensing software products to end users, and from sublicensing agreements with original equipment manufacturers (oems) and software value-added relicensors (vars). initial license fees for the oracle database management system range from $199 to over $5,500 on micro- and personal computers, and from $5,100 to approximately $342,000 on mini- and mainframe computers. license fees for oracle financial and oracle government financial products range from $20,000 to $513,000, depending on the platform and number of part 4 • additional cases289 users. a customer may obtain additional licenses at the same site at a discount. oracle recognizes revenues from these licenses when a contract has been signed withi ',5 a financially sound customer, even though shipment of products has not occurred. oem agreements are negotiated on a case-by-case basis. however, under a typical contract oracle receives an initial nonrefundable fee (payable either upon signing the contract or within 30 days of signing) and sublicense fees based on the number of copies distributed. under var agreements the company charges a development license fee on top of the initial nonrefundable fee, and it receives sublicense fees based on the number of copies distributed. sublicense fees are usually a percentage of oracle's list price. the initial nonrefundable payments and development license fees under these arrangements are recorded as revenue when the contracts are signed. sublicense fees are recorded when they are received from the oem or var. oracle also receives revenues from maintenance agreements under which it provides technical support and telephone consultation on the use of the products and problem resolution, system updates for software products, and user documentation. maintenance fees generally run for one year and are payable at the end of the maintenance period. they range from 7.5 percent to 22 percent of the current list price of the appropriate license. these fees are recorded as unearned revenue when the maintenance contract is signed and are reflected as revenue ratably over the contract period. the major questions about oracle's revenue recognition concern the way the firm recognizes revenues on license fees. there is no currently accepted standard for accounting for these types of revenues.2 however, oracle tends to be one of the more aggressive reporters. the firm's days receivable exceeds 160 days, substantially higher than the average of 62 days receivable for other software developers (see exhibit 3 for a summary of days receivable for other major software developers in \ 989 and 1990). as a result, some analysts argue that the firm should recognize revenue when software is delivered rather than when a contract is signed, consistent with the accounting treatment for the sale of products. in addition, the collectibility of license fees is considered questionable by some analysts, who have urged the firm to recognize revenue only when there is a reasonable basis for estimating the degree of collectibility of a receivable. estimates by oracle's controller indicate that if oracle were to change to a more conservative revenue recognition policy, the firm's days receivable would fall to about 120 days. management's concerns oracle's management was concerned about analysts' opinions and the downturn in the firm's stock. the company had lost credibility with investors and customers due to its recent poor performance and its controversial accounting policies. one of the items on the agenda at the upcoming board meeting was to consider proposals for changing the firm's revenue recognition method and for dealing with its communication challenge. ellison knew that his opinion on this question would be influential. as he saw it, the company had three alternatives. one was to modify the recognition of license fees so that revenue would be recognized only when substantially all the company's contractual obligations had been performed. however, he 2. the financial accounting standards board wos considering tne issue of revenue recognition for software developers at this time. it was widely expected that the board would make a pronouncement on the topk early in 1991. 290 • • , • • :• - part 4 • additional cases worried that such a change would have a negative impact on the firm's bottom line and further depress the stock price. a second possibility was to wait until the fasb announced its position on software revenue recognition before making any changes. finally, the company could make no change and vigorously defend its current accounting method. ellison carefully considered which alternative made the most sense for the firm. questions 1. what factors might have led analysts to question oracle systems' method of revenue recognition in mid-1990? are these legitimate concerns? 2. estimate the earnings impact for oracle from recognizing revenue at delivery, rather than when a contract is signed. 3. what accounting or communication changes would you recommend to oracle's board of directors? v- :i ..' • •« part 4 • additional cases 291 exhibit i oracle systems corporation—consolidated financial statements consolidated balance sheets as of may 31,1990 and 1989 (in $000, except per share data) - 1990 1989 assets current assets: cash and cash equivalents $44,848 $44,848 short-term investments 4,980 4,500 receivables trade, net of allowance for doubtful accounts of $28,445 in 1 990 and $16,829 in 1989 468,071 261,989 other 28,899 16,175 prepaid expenses and supplies 22,459 9,376 total current assets 569,257 336,933 property, net 171,945 94,455 computer software development costs, net of accumulated amortization of $ 1 4,365 in 1 990 and $6, 1 80 in 1 989 33,396 13,942 other assets 12,649 14,879 total assets $787,247 $460,209 liabilities and stockholders' equity current liabilities: notes payable to banks $3 the="" primary="" factors="" underlying="" oracle's="" strong="" performance="" have="" been="" its="" successes="" in="" r&d="" and="" its="" committed="" sales="" force.="" the="" firm's="" r&d="" triumphs="" are="" proudly="" noted="" in="" the="" 1990="" annual="" report:="" \n="" 1979,="" we="" delivered="" oracle,="" the="" world's="" first="" relational="" database="" management="" system="" and="" the="" first="" product="" based="" on="" sql.="" in="" 1983,="" oracle="" was="" the="" first="" database="" management="" system="" to="" run="" on="" mainframes,="" minicomputers,="" and="" pcs.="" in="" 1986,="" oracle="" was="" the="" first="" database="" management="" system="" with="" distributed="" capability,="" making="" 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="" complete="" 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="" traits-actions="" 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="" compensated="" on="" the="" basis="" of="" sales,="" giving="" it="" a="" strong="" incentive="" to="" aggressively="" court="" large="" corporate="" 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="" firm="" announced="" a="" 54="" percent="" jump="" in="" quarterly="" revenues="" (relative="" to="" 1989's="" results)—but="" only="" a="" 1="" percent="" rise="" in="" earnings="" (see="" exhibit="" 2="" for="" quarterly="" results="" for="" 1989="" and="" 1990).="" management="" explained="" that="" several="" factors="" contributed="" to="" this="" poor="" performance.="" first,="" the="" company="" had="" recently="" redrawn="" its="" sales="" territories="" and,="" as="" a="" result,="" for="" several="" months="" salespeople="" had="" become="" unsure="" of="" their="" new="" responsibilities,="" leaving="" some="" customers="" dissatisfied.="" second,="" there="" were="" problems="" with="" a="" number="" of="" new="" products,="" such="" as="" oracle="" financials,="" which="" were="" released="" before="" all="" major="" bugs="" could="" be="" fixed.="" however,="" the="" stock="" market="" was="" unimpressed="" by="" these="" explanations,="" and="" the="" firm's="" stock="" price="" dropped="" by="" 31="" percent="" with="" the="" earnings="" announcement.="" 3="" •="" revenue="" recognition="" the="" deterioration="" in="" its="" financial="" performance="" prompted="" analysts="" to="" question="" oracle's="" method="" of="" recognizing="" revenues.="" for="" example,="" one="" analyst="" commented:="" oracle's="" accounting="" practices="" might="" have="" played="" a="" role="" in="" the="" low="" net="" income="" results.="" the="" top="" line="" went="" up="" over="" 50%,="" though="" the="" net="" bottom="" line="" did="" not="" do="" so="" well,="" because="" oracle's="" running="" more="" cash="" than="" it="" should="" be="" as="" a="" result="" of="" financial="" mismanagement.="" the="" company's="" aggressive="" revenue-recognition="" policy="" and="" relatively="" high="" amount="" of="" accounts="" receivables="" make="" the="" stock="" risky.="" oracle's="" major="" revenues="" come="" from="" licensing="" software="" products="" to="" end="" users,="" and="" from="" sublicensing="" agreements="" with="" original="" equipment="" manufacturers="" (oems)="" and="" software="" value-added="" relicensors="" (vars).="" initial="" license="" fees="" for="" the="" oracle="" database="" management="" system="" range="" from="" $199="" to="" over="" $5,500="" on="" micro-="" and="" personal="" computers,="" and="" from="" $5,100="" to="" approximately="" $342,000="" on="" mini-="" and="" mainframe="" computers.="" license="" fees="" for="" oracle="" financial="" and="" oracle="" government="" financial="" products="" range="" from="" $20,000="" to="" $513,000,="" depending="" on="" the="" platform="" and="" number="" of="" part="" 4="" •="" additional="" cases="" 289="" users.="" a="" customer="" may="" obtain="" additional="" licenses="" at="" the="" same="" site="" at="" a="" discount.="" oracle="" recognizes="" revenues="" from="" these="" licenses="" when="" a="" contract="" has="" been="" signed="" with="" i="" ',5="" a="" financially="" sound="" customer,="" even="" though="" shipment="" of="" products="" has="" not="" occurred.="" oem="" agreements="" are="" negotiated="" on="" a="" case-by-case="" basis.="" however,="" under="" a="" typical="" contract="" oracle="" receives="" an="" initial="" nonrefundable="" fee="" (payable="" either="" upon="" signing="" the="" contract="" or="" within="" 30="" days="" of="" signing)="" and="" sublicense="" fees="" based="" on="" the="" number="" of="" copies="" distributed.="" under="" var="" agreements="" the="" company="" charges="" a="" development="" license="" fee="" on="" top="" of="" the="" initial="" nonrefundable="" fee,="" and="" it="" receives="" sublicense="" fees="" based="" on="" the="" number="" of="" copies="" distributed.="" sublicense="" fees="" are="" usually="" a="" percentage="" of="" oracle's="" list="" price.="" the="" initial="" nonrefundable="" payments="" and="" development="" license="" fees="" under="" these="" arrangements="" are="" recorded="" as="" revenue="" when="" the="" contracts="" are="" signed.="" sublicense="" fees="" are="" recorded="" when="" they="" are="" received="" from="" the="" oem="" or="" var.="" oracle="" also="" receives="" revenues="" from="" maintenance="" agreements="" under="" which="" it="" provides="" technical="" support="" and="" telephone="" consultation="" on="" the="" use="" of="" the="" products="" and="" problem="" resolution,="" system="" updates="" for="" software="" products,="" and="" user="" documentation.="" maintenance="" fees="" generally="" run="" for="" one="" year="" and="" are="" payable="" at="" the="" end="" of="" the="" maintenance="" period.="" they="" range="" from="" 7.5="" percent="" to="" 22="" percent="" of="" the="" current="" list="" price="" of="" the="" appropriate="" license.="" these="" fees="" are="" recorded="" as="" unearned="" revenue="" when="" the="" maintenance="" contract="" is="" signed="" and="" are="" reflected="" as="" revenue="" ratably="" over="" the="" contract="" period.="" the="" major="" questions="" about="" oracle's="" revenue="" recognition="" concern="" the="" way="" the="" firm="" recognizes="" revenues="" on="" license="" fees.="" there="" is="" no="" currently="" accepted="" standard="" for="" accounting="" for="" these="" types="" of="" revenues.2="" however,="" oracle="" tends="" to="" be="" one="" of="" the="" more="" aggressive="" reporters.="" the="" firm's="" days="" receivable="" exceeds="" 160="" days,="" substantially="" higher="" than="" the="" average="" of="" 62="" days="" receivable="" for="" other="" software="" developers="" (see="" exhibit="" 3="" for="" a="" summary="" of="" days="" receivable="" for="" other="" major="" software="" developers="" in="" \="" 989="" and="" 1990).="" as="" a="" result,="" some="" analysts="" argue="" that="" the="" firm="" should="" recognize="" revenue="" when="" software="" is="" delivered="" rather="" than="" when="" a="" contract="" is="" signed,="" consistent="" with="" the="" accounting="" treatment="" for="" the="" sale="" of="" products.="" in="" addition,="" the="" collectibility="" of="" license="" fees="" is="" considered="" questionable="" by="" some="" analysts,="" who="" have="" urged="" the="" firm="" to="" recognize="" revenue="" only="" when="" there="" is="" a="" reasonable="" basis="" for="" estimating="" the="" degree="" of="" collectibility="" of="" a="" receivable.="" estimates="" by="" oracle's="" controller="" indicate="" that="" if="" oracle="" were="" to="" change="" to="" a="" more="" conservative="" revenue="" recognition="" policy,="" the="" firm's="" days="" receivable="" would="" fall="" to="" about="" 120="" days.="" management's="" concerns="" oracle's="" management="" was="" concerned="" about="" analysts'="" opinions="" and="" the="" downturn="" in="" the="" firm's="" stock.="" the="" company="" had="" lost="" credibility="" with="" investors="" and="" customers="" due="" to="" its="" recent="" poor="" performance="" and="" its="" controversial="" accounting="" policies.="" one="" of="" the="" items="" on="" the="" agenda="" at="" the="" upcoming="" board="" meeting="" was="" to="" consider="" proposals="" for="" changing="" the="" firm's="" revenue="" recognition="" method="" and="" for="" dealing="" with="" its="" communication="" challenge.="" ellison="" knew="" that="" his="" opinion="" on="" this="" question="" would="" be="" influential.="" as="" he="" saw="" it,="" the="" company="" had="" three="" alternatives.="" one="" was="" to="" modify="" the="" recognition="" of="" license="" fees="" so="" that="" revenue="" would="" be="" recognized="" only="" when="" substantially="" all="" the="" company's="" contractual="" obligations="" had="" been="" performed.="" however,="" he="" 2.="" the="" financial="" accounting="" standards="" board="" wos="" considering="" tne="" issue="" of="" revenue="" recognition="" for="" software="" developers="" at="" this="" time.="" it="" was="" widely="" expected="" that="" the="" board="" would="" make="" a="" pronouncement="" on="" the="" topk="" early="" in="" 1991.="" 290="" •="" •="" ,="" •="" •="" :•="" -="" part="" 4="" •="" additional="" cases="" worried="" that="" such="" a="" change="" would="" have="" a="" negative="" impact="" on="" the="" firm's="" bottom="" line="" and="" further="" depress="" the="" stock="" price.="" a="" second="" possibility="" was="" to="" wait="" until="" the="" fasb="" announced="" its="" position="" on="" software="" revenue="" recognition="" before="" making="" any="" changes.="" finally,="" the="" company="" could="" make="" no="" change="" and="" vigorously="" defend="" its="" current="" accounting="" method.="" ellison="" carefully="" considered="" which="" alternative="" made="" the="" most="" sense="" for="" the="" firm.="" questions="" 1.="" what="" factors="" might="" have="" led="" analysts="" to="" question="" oracle="" systems'="" method="" of="" revenue="" recognition="" in="" mid-1990?="" are="" these="" legitimate="" concerns?="" 2.="" estimate="" the="" earnings="" impact="" for="" oracle="" from="" recognizing="" revenue="" at="" delivery,="" rather="" than="" when="" a="" contract="" is="" signed.="" 3.="" what="" accounting="" or="" communication="" changes="" would="" you="" recommend="" to="" oracle's="" board="" of="" directors?="" v-="" :i="" ..'="" •="" •«="" part="" 4="" •="" additional="" cases="" 291="" exhibit="" i="" oracle="" systems="" corporation—consolidated="" financial="" statements="" consolidated="" balance="" sheets="" as="" of="" may="" 31,1990="" and="" 1989="" (in="" $000,="" except="" per="" share="" data)="" -="" 1990="" 1989="" assets="" current="" assets:="" cash="" and="" cash="" equivalents="" $44,848="" $44,848="" short-term="" investments="" 4,980="" 4,500="" receivables="" trade,="" net="" of="" allowance="" for="" doubtful="" accounts="" of="" $28,445="" in="" 1="" 990="" and="" $16,829="" in="" 1989="" 468,071="" 261,989="" other="" 28,899="" 16,175="" prepaid="" expenses="" and="" supplies="" 22,459="" 9,376="" total="" current="" assets="" 569,257="" 336,933="" property,="" net="" 171,945="" 94,455="" computer="" software="" development="" costs,="" net="" of="" accumulated="" amortization="" of="" $="" 1="" 4,365="" in="" 1="" 990="" and="" $6,="" 1="" 80="" in="" 1="" 989="" 33,396="" 13,942="" other="" assets="" 12,649="" 14,879="" total="" assets="" $787,247="" $460,209="" liabilities="" and="" stockholders'="" equity="" current="" liabilities:="" notes="" payable="" to="" banks="">