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Biovail Corporation was one of the Canada’s largest pharmaceutical publicly traded companies which expert in the development and large scale of manufacturing of pharmaceutical products. Biovail Company engaged activities on enhance formulate of the existing drugs, clinical testing, manufacture and commercial pharmaceutical products and utilized advanced drug delivery technologies. In the case, on September 30, 2003 there was a truck carrying a shipment of Wellbutrin® XL from Biovail’s manufacturing facility in Manitabo to Biovail’s Distributor, North Carolina was involved in a multi-vehicle traffic accident near Chicago. From these case, we see that many issues come out when truck accident happen. The outcome was not favourable, as Biovail’s acquisition methods were labelled as unethical and their accounting practices were questioned. The company announced that the loss of the quarterly earnings which target in the range of $215 million to $235 million is because of the truck accident happened that contributed a significant unfavourable variance where the company estimated that revenue of the truck that involved in accident was in the range of $10 million to $20 million.
There are several issues that addressed in this case when truck accident was happen which included accounting policy of the revenue recognition that “Freight On Board” (FOB) point which are FOB Shipping point and FOB Destination point, and ethic of earning management where Biovail is suspected might significantly overestimate the value of the product that involved in the truck accident due to Biovail fail to meet its third quarter 2003 earnings guidance. On October 9, 2003, analysts state there ‘overweight’ rating on Biovail on estimate revenue lost in the accident and have poor earning quality in accounting. Previously year, Trappel mentioned that company’s revenue and earnings performance had not been of high quality. There is having some simulations here during conference call. When the truck accidents happen, Trooper estimated that the truck is not fully filled-up. The investigation suggested that Biovail might have significant overestimated the amount on the truck. They only filled up third-quarter item in that truck. So, because of this accident happen many issues come out and seen they use some magic in presenting their financial report.
2.0 STATEMENT OF THE PROBLEM
Issue 1: Revenue Recognition
Based on Boivail case, one of the issues arises is about accounting policy on their revenue recognition. According to US GAAP a company should recognize revenue according to the SEC, SAB 101. Company are not allowed to recognize revenue until the revenue is realized or realizable and earned. For revenue to be recognized under SAB 101, a company must consider it meet all criteria before recognise as revenue. First criteria are the persuasive evidence of an arrangement exists. This criterion permits identification of the seller’s obligations whether the seller had fulfilled the obligation and earned the related revenue. In this case, there has not stated any information regarding on this criteria. But, it seems that there are high possibility that persuasive evidence exists between Biovoil Corporation and its Distributors. Second criteria, the seller’s price to the buyer is fixed or determinable. This criterion has a complete clear evidence provide in this case. Next, third criterion is the collectability is reasonably assured where collectability is evaluated on a customer-by-customer basis. In this case this criterion was probably covered as well. Lastly, fourth criteria is the Delivery has occurs or services have been rendered. This criterion to ensure the obligation undertaken by sellers has been completed or not. In this case, this criterion is facing problem either FOB Shipping point or FOB Destination point being applied.
Biovail account for their sales either FOB Shipping Point or FOB Destination. This case have mention that Biovail’s chief financial officer, Brian Crombie have make an agreement with Distributors to record the sales on FOB Shipping Point. FOB Shipping Point is where the title of ownership for the goods or products is being transferred from sellers to the buyers at the time when the goods or products are leaving the sellers premises. In FOB Shipping Point, the sales will occur at the shipping point. It also indicates that the buyer is responsibility for the transportation expenses and it will record as Freight-In. But without any concern from Brian Crombie (CFO), the agreement between Biaovail and the Distributors was change from FOB Shipping Point to FOB Destination. It means that, the title of ownership for the goods or products also change. The title of ownership for the goods for FOB Destination will be remains with the seller until the good or product reached at the destination point. This indicates that the sellers remain responsible for the good or product until they reach the location of the buyer and the seller will bear all transportation cost. The sales are not occurred until the buyer receives the goods or product. Biovail should record the goods in transit as an inventory.
During process of transferring the goods or products to the buyers, in this case, Biovail has mention that there was a truck accident which carrying a shipment of Wellbutrin® XL from Biovail’s manufacturing facility in Manitoba, Canada. The accident was happen near Chicago, Illinois at 3 p.m. on September 30, 2003 (same day of truck leave from the manufacturing facility). The company has estimated that the revenue for the truck that has been involved in the accident was around $10 million to $20 million and they also confirmed that the transportation costs have been fully insured. If there any problem during the transportation process, Biovail will not bear any expenses. They also mention that the loss for the third quarterly earnings was because of that accident. According to the question 3, the question was asked whether the accident have given affect to the Biovail’s revenue or not.
As we can see that they are no relationship between the accidents of the truck with the revenue recognition under FOB Destination. This is because under FOB Destination, the ownership will be transferred only after the goods reached the North Carolina facility. Biovail are still cannot recognised it as a revenue because the goods was not arrived at the buyers place. It shows that the ownership was not yet passed to the Distributor. Thus the accident was not giving any impact to the revenues. If under FOB Shipping Point, there are also does not have any relationship between them. Biovail will record revenue after the truck was leaving the company facility. It means that the title of ownership have been transferred from the Biovail to the Distributor. If there any happen on the truck, the buyer will bear the costs. Hence, the truck accident does not bring any affect to the Biovail’s revenue. Issues 2 : Earning Management
The second issues that our group have been discover in Biovail case is about earning management. Healy and Wahlen (1998) said that earnings management occurs when managers use judgment in financial reporting and structuring transactions to modify financial report in order to mislead some stakeholders about the economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. (Md., Mohammad, & Md., 2013). Earning management is one of strategy that can be used by management in order to make their financial reporting impress. There are five (5) patterns of earning management that company can be used which are “Taking a bath”, “Income minimization”, “Income maximization”, “Income Smoothing” and “Cooking jar”. Taking a bath will take place during periods of organizational stress or reorganization, when hiring a new management or CEO or if net income less than bogey (standard or minimum score). Next is about income minimization. Actually it is similar to taking a bath, but less extreme.
It takes place during period of high profitability for company having high political cost. It is use for the companies that politically can be seen during period of high profitability or if net income above the cap (upper score or upper limit). While, Income maximization is for bonuses purposes and company that close to debt covenant violations. It uses the accounting policies and procedures that can increase an income. In this case, manager may report high reported income. Forth is Income smoothing where it is to maintain the good reputation of management or CEO. Consequently, smooth reported earnings over time to time are to receive relatively constant compensation. The more unstable the stream of reported net income, the higher the probability that covenant violation will occur. If manager feel that they may be fired when reported earnings are low, income smoothing can reduce the likelihood of reporting low earning. Therefore, the company may smooth net income for external reporting purposes. Lastly, cooking jar pattern. Cooking jar is an accounting practice in which a company uses generous reserves from good years against losses that might be incurred in bad years. It seems reasonably effective as an earning management device since it can be hard to detect. (Godfrey, Hodgson, Holmes, & Tarca, 2006). However, earning management is illegal in accounting term but it was not unethical.
Based on Biovail case, we can see that the company have already used the earning management when they are preparing the financial reporting. As a fact, before this according Jerry Treppel who was the analyst from Banc of America Securities (BAS) before Maris has stated that the quality of the company’s revenue is not good. Even though the information was unclear, he was concerned about the sustainability of the rapid sales growth that Biovail was reporting. Biovail may use one of these five methods of earning management in their financial reporting. Unfortunately we cannot decide on which one they use because we have lack of information based on the case given. Another issue that we discover about earning management issue is about overestimated the amount of Wellbutrin® XL on the truck. Earlier, Biovail had released guidance for the quarter ended September 30, 2003, which indicates that revenues would be in the range of $215 million to $235 million and earnings per share is $0.35 to $0.45.
Compared to the market expectation and prior guidance, the revenue should be $260 million. Therefore, the revenue had dropped by $25 million to $45 million. The company have blame that the truck accident was reason why there are shortfall of revenue for the third quarter of the Biovail. The truck accident was happen near Chicago that carrying a shipment of Wellbutrin® XL. The company estimated that the revenue associated with this shipment was in the range of $10 million and $20 million and confirmed that the manufacturing cost value of this shipment had been fully insured. But, the trooper was estimating that the truck only contain one-quarter full. After the investigation done, the analyst stated that if there is $20 million worth of Wellbutrin® XL pills on the truck, it would have been full or nearly full. So, these are the calculation to prove the above statement:
To calculate volume of ¼ full of trailer:
Interior dimensions of a typical wheeler trailer: 17m x 4.5m x 2.5m Volume of a rectangular prism = a x b x c
Volume= (1,700 x 450 x 250 x ¼) cm3
Thus, volume of ¼ full of wheeler trailer = 47,812,500 cm3
Calculate volume of a Wellbutrin® XL tablet which was 0.5cm3 and 1.00cm3 as packing space for each tablet: Length x Width x Height = (1.5 x 1.5 x 1.5) cm3 = 3.375 cm3
Calculate total tablets in the ¼ full of trailer:
47,812,500 cm3 ÷ 3.375 cm3 =14,166,667 tablets
Extract 400% mark up for Distributor and 35% wholesaler margin from the wholesale acquisition price to arrive at the original price charged by Biovail which is $ 0.42 per tablet. Biovail
Calculate the actual revenue:
14,166,667 tablets x $ 0.42 per tablet = $5,950,000, (estimated revenue) Hence, this proves that Biovail did overestimate their lost in comparison between the calculation and their early estimation which is between $10 million to $20 million. The actual value of revenue is only about $5,950,000. We can see that Biovail had overestimated the amount of Wellbutrin® XL on the truck. As a fact, the accident does not have any relationship with the shortfall of revenue in third quarter.
3.0 CAUSES OF THE PROBLEM
The possible cause of the issue arises in Biovail case is maybe because of the manager’s self-interest. As instance, the CEO of Biovail is interested in the amount of bonuses he/she will received at the end of the year so it is important for them to control the figure in the income statement in order to get the shareholders’ favour. This also can be relating with agency theory whereby it explains the relationship between principals and agents in business. Agency theory is concerned with resolving problems that can exist in agency relationships that is, between principals (such as shareholders) and agents of the principals (for example, company executives). The two problems that agency theory addresses are the problems that arise when the desires or goals of the principal and agent are in conflict, and the principal is unable to verify (because it difficult and/or expensive to do so) what the agent is actually doing.
The second one is the problems that arise when the principal and agent have different attitudes towards risk. Because of different risk tolerances, the principal and agent may each be inclined to take different actions. Besides, the other reason is that the company wanted to maintain their reputation. This is because their reputation can directly affect their share price. For example if company show decrease in earning for that year the share price will drop. The other reasons of why the issue is arises, we can see miscommunication in the company management structure. Where the changes of FOB agreement between distributor and company was not notify to Brian Crombie the CFO whom we see a significantly important person in the Biovail Corporation.
4.0 DECISION CRITERIA AND ALTERNATIVE SOLUTIONS
1. Enhance their management authority
Issue revenue recognition arises when the content of agreement deal at first with Distributor was changes but CFO doesn’t notices. To avoid from this matter happen in the future Biovail should enhance their management authority. Where board of director of company should segregate responsible and duties of each committee well and concern them where and who their work information should be inform, update and reported. For example, in this case one position should responsible to deal and authorize any changes of agreement with Distributor. If there any changes occurred, the particular person responsible should inform the board of members in the board meeting to make sure all member been updated with latest information and also can avoid miscommunication. 2. Having an effective internal control
According to COSO, internal control is defined as a process, affected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance to ensure the effectiveness and efficiency of operations, reliability of financial reporting and compliance with applicable laws and regulations. In this case having an effective internal control can help company in their revenue recognition which under GAAP. Biovail can enhance their internal control by establish revenue recognition committee. Where the committee responsible to establish and ensure compliance with the company’s revenue recognition policies and procedures and conduct meetings at least quarterly to review and discuss significant transactions. Thus by having this committee, it can ensure that the revenue recognition policies are accepted and complied with GAAP and also can improve the reliability of the financial information.
Besides that effective internal control also can overcome the ethical issue in earning management. Strong internal control can avoid unethical act to occur and able to provide more reliable information to help investors in decision making. For example, Biovail’s internal auditors are required to report all significant deficiencies and material weaknesses, in writing, to the audit committee. A significant deficiency (SD) is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the organization’s financial reporting. Hence, the company must have a robust internal control. By having an robust internal control, it can ensure that the company can be prevented from misstatement, overestimated amount and manipulate the data.As a result, a company with strong internal control will enable the business is being well-managed that is expected to succeed. 3. Having Code of Ethics in their management
Biovail Corporation should have the code of ethics in their management to prevent unethical earning management. In calculating revenue, FOB structure of the product should have been understood in deep. The overestimated of the Wellbutrin XL should be avoided because it can lead to bad reputation. This overestimated of lost involved in accident has make the public look at Biovail Corporation as the firm that are not efficient in management. Other than that, it will give bad reputation to Biovail because it seem like Biovail lied to get the insurance claim. Biovail also should follow conservatism principle in record the loss and revenue in uncertainty situation. By having the code of ethics in following each of the product term and ethics following the accounting principles can avoid the company from doing unethical work.
4. Having the Good Corporate Governance Structure
One of the causes of the problem in this case is management self-interest. To overcome this matter Biovail Corporation should investigate the background of the Corporate Governance before hire or select them as one of the board in the company. This action must be make taken to sure that they are independent and free from bias. 5.0 RECOMMMENDED SOLUTION, IMPLEMENTATION AND JUSTIFICATION
Regarding this Biovail Corporation case, we recommend that Biovail Corporation should enhance their internal control to overcome the issues arising in the company as has been explained in the alternative section.
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