Biovail Corporation, a major Canadian pharmaceutical company listed on the New York Stock Exchange, announces that it will miss its quarterly earnings target by $25 to $45 million, blaming $10 to $15 million of the shortfall on a truck accident involving a shipment that left its facility on the last day of the quarter. The case was ultimately prosecuted by the U.S. Securities and Exchange Commission (SEC). The case is centered on the question of revenue recognition and how the company should have accounted for the sales (FOB shipping or FOB destination). However, it also provides a rich setting permitting exploration of peripheral topics around the ethics of earnings management. For example, the case discusses stock analysts’ reactions to the announcement; questions how much product was actually in the truck; questions how aggressively the company responds against the analysts who downgrade the stock; and highlights the role of the SEC in enforcement. Besides that, Biovail’s stock had listed on both the Toronto and New York stock exchanges.
Biovail filed annual reports to the U.S. SEC and prepared financial statements in accordance with both U.S. and Canadian generally accepted accounting principles (GAAP). On 30 September 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 accident near Chicago. The company announced that the loss of the quarterly earnings which target by $260 million is because of the truck accident happened. There are several issues in this case which included accounting policy based on the revenue recognition; how Biovail Corporation should account the sales based on two different “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, downgrade of stock rating on Biovail, bad management control and corporation culture. (Unethical).
Statement of the Problem
1. Accounting policy based on the revenue recognition: How Biovail Corporation should account the sales based on two different “Freight On Board” (FOB) point which are FOB Shipping point and FOB Destination point. According to this article, Biovail’s CFO told the analyst that Biovail’s contract with the Distributor had title change in Manitoba when it left the shipping dock (FOB Shipping point), but the agreement between Biovail and the Distributor provided that the title to, and risk of loss with respect to, the product would not passed to the Distributor until the product was delivered to the Distributor’s facility (FOB Destination). These two different Freight On board (FOB) indicates different moments of revenue recognition. According to the FOB condition: Shipping Point: The Company should recognize revenue at the moment/in the period in which product leaves Biovail shipping dock at the warehouse since in that precise moment both ownership and responsibility over the goods is transferred from Biovail to the client.
Destination: The Company should recognize revenue at the moment/in the period in which product is delivered to the Distributor’s facility since in that precise moment both ownership and responsibility over the goods is transferred from Biovail to the client. Four conditions must be met in order to recognize revenue that recognized by GAAP are ; 1. Persuasive evidence of an arrangement exists: Although the case does not provide extra information on this aspect, it seems clear that there is an ongoing relationship between Biovail and the Distributor and that certainly there was a bill, purchase order and/or invoice in order to support this sale. 2. Seller’s price to the buyer is fixed or determinable: The case provides clear evidence in this aspect. 3. Collection is reasonably assured: given the ongoing relationship between Biovail and the Distributor, it appears evident that this aspect was probably covered as well. 4. Delivery has occurred or services have been rendered: this is the key point of conflict in the Biovail’s case. In this case, by referring the standard by GAAP, Biovail should recognize the revenue based on the agreement as mentioned by the employee from the Distributor. The conditions that indicated by the GAAP has been met. 2. Earning management
Another issue that we discover is about earning management issue. Biovail had released guidance for the quarter ended September 30, 2003 which indicates that the revenue would be in the range of $215 million to $235 million and earnings per share of $0.35 to $0.45, both below previously issued guidance. Meaning that, the revenue had dropped by $25 million to $45 million as compared to the market expectation and prior guidance of approximately $260 million. The company claim that there is a shortfall of revenue for the third quarter due to the truck accident happened. Based on the case, the truck accident happened on the last day of the end of the third quarter, where a truck carrying a shipment of Wellbutrin® XL bound for the North Carolina facility of one of the Biovail’s Distributor.
Biovail estimated that the truck involved will contribute revenue for the third quarter is in the range of $10 million to $20 million. However, the investigation suggest that Biovail might have significantly overestimated the amount of Wellbutrin® XL on the truck because according to the information, the trooper estimated the truck was about one-quarter full and even if there had been $20 million worth of Wellbutrin® XL pills on the truck, the truck should be full of nearly full. According to J.P Morgan, he calculated on how much of the truck would need to be filled to represent the missing revenue. The Biovail Corporation executives were obsessed with meeting quarterly and annual earnings they overstated earning and hid losses in order to deceive investor and created the appearance of achieving goal. Because these issue they were involved in a very serious unethical misconduct and chronic fraudulent conduct, including financial report fraud and other intentional public misrepresentations. The calculation is shown as following:
To calculate volume of ¼ full of trailer:
Interior dimensions of a typical 18-wheeler trailer = 17m x 4.5m x 2.5m Volume= (1,700 x 450 x 250 x ¼) cm3
Therefore, the volume of ¼ full of wheeler trailer is equal to 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
Therefore, the volume of a Wellbutrin® XL tablet is equal to 3.375 cm3 Step 3
Calculate total tablets in the ¼ full of trailer:
= volume of ¼ full of trailer ÷ volume of a Wellbutrin® XL tablet = 47,812,500 cm3 ÷ 3.375 cm3 =14,166,667 tablets
Therefore, a total tablet in the ¼ full of trailer is equal to 14,166,667 tablets. Step 4
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.
Calculate the actual revenue:
14,166,667 tablets x $ 0.42 per tablet = $5,950,000 (estimated revenue).
Based on this calculation, we can see that the actual revenue of Biovail is $5,950,000.It also prove that Biovail had overestimated their estimation. According to Melnyk, “This accident will have negative financial impact on Biovail’s third quarter revenues”. In fact, the accident was just a cover face for Biovail financial report problem and had no effect on third quarter earnings. The accident was not the root of the problem but it is only the symptoms of the problem that lead to investigate the real problem. The accident was giving Biovail opportunity to provide the marketplace with a partial explanation for the missed earnings because Biovail has doing misleading of report in previous years and Biovail face manufacturing problems. Therefore, it shows that Biovail intentionally misstated both the effect of the accident on third quarter earnings as well as the value of the product involve in the accident. As per Maris state “Biovail should not be able to record revenue from the sale of the drugs in the truck in the third quarter”. 3. Downgrade of stock rating on Biovail
Following the announcement of the truck accident, Canadian Imperial Bank of Commerce announced that it was cutting its stock rating on Biovail to Sector Performer from Sector Outperformer and removing the company from the Special Research Series (SRS), effectively ceasing coverage of the stock. The reasons given for the downgrade cited on-going production delays and operational uncertainties at Biovail. Hence, Maris as an analyst require to evaluate and compare the quality of securities in a given sector or industry and has the responsibility to understand the effect of the accident on the firm before he signed off on his Sell recommendation because he wanted to make sure that he was giving a best advice to his investment clients. For instance, in the case, Maris has to evaluate other analyst responses like the Canadian Imperial Bank of Commerce. This is because Maris had to base on those analysis and make a report with certain recommendations such as buy, sell, strong buy or hold which carry a great deal of weight in the investment.
Bad management control and corporation culture. (Unethical) According to the case, in the April 2002, Treppel found that the revenue and earnings performance of Biovail had not been of high quality and the accounting information was unclear. The truck accident that happened in 2003 indicates that the top of Biovail tended to inflate the revenue and did not comply with the GAAP. More badly, after Treppel writing a ‘sell’ recommendation, Biovail made a number of public statements regarding Treppel’s coverage which lead to investigation of Treppel. These can give us a picture of the dishonest culture and control where Biovail try to hide its inappropriate accounting action by blaming others. This issue refers to the question no 4 of this case. The question is, are you concerned about the company’s treatment of analysis that covers the stock? Would you want to be an analyst covering the company? The answer is yes, I am concerned about the company’s treatment of analysts who cover the stock, for it relates to my employment and reputation. And I would not want to be an analyst covering Biovail because Biovail had a bad management.
Causes of the Problem
This problem might not be happen if the audit committee of Biovail knows their responsibilities and do an ethical behavior. Many audit committee members understandably find themselves somewhat uncertain (or completely at sea) as to how far their responsibilities goes, or how that responsibilities is to be fulfilled. (Young, Farr, & LLP, February 21 – 22, 2008 ). They are not being independent and may unknowingly not report the overestimate problem to the investor. Therefore, it is an unethical things to do because investor does not knows about the overestimate issues and investor puts their trust to the auditor to manage the earning effectively without having conflict of interest.
Without completely understanding the extent of their responsibility, committee members find themselves getting drawn into the details of earning press releases, auditor communications and innumerable intricacies of corporate governance. Exacerbating the uncertainty is a mind-set among some that has resulted in audit committees almost becoming dumping ground for corporate responsibilities. Among the varying responsibilities that have been suggested for audit committee oversight which are environmental compliance, improper payments, conflict of interest, taxes, complex financial instrument, critical business continuity risks, potential legal, compliance and risk management issues that a company may face and compliance with laws and regulations and ethical business practices. (Young, Farr, & LLP, February 21 – 22, 2008 )
Decision Criteria and Alternative Solutions
1. Biovail should strengthen its internal control in order to overcome the earning management. Strong internal control can avoid fraudulent act to occur and able to provide more reliable information to help investors in decision making. 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. By having an effective internal control, it can ensure the company have a proper revenue recognition which under GAAP.
For example, a company that has a good internal control will establish revenue recognition committee that serves as the company’s primary internal control. Duties for this committee was included 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. So, by having this committee, it can ensure that the revenue recognition policies are accepted and complied with GAAP. Hence, by having a good internal control can improve the reliability of the financial information. As a result, a company with strong internal control will enable the business is being well-managed that is expected to succeed.
2. Biovail Corporation should practice an ethical principles in manage their business in order to avoid fraud in misleading the financial statement and earning of the company. It is supposed that, Biovail Corporation should not have a problem regarding to the overstating the revenue loss because they are able to hire a professional in accounting department in order to follow the accounting standard. Therefore, the audit committee need to know their responsibilities which is they are seeking to oversee a company system of financial reporting will find no shortage of checklists. (Young, Farr, & LLP, February 21 – 22, 2008 ) .In other word, this ethical issue will not happen if Biovail hire independent parties to manage their earning management. So, the problem regarding of the overstating revenue will not be occurred.
Recommended Solution, Implementation and Justification
1. Have code of ethics and understanding organization culture of Biovail Through realize on organization culture that can disclose the business ethical which is refer to the moral rules and regulation governing that preserve in the company. Ethical of a management person when process a business will direct affect the benefits for company and investors in the future. So, Davis Maris should understanding the organization culture by attentive and disclose the detail honestly especially if fraudulence issues appear in the organization. In addition, action to review on the business principles in Biovail Corporation also is the one of the suggestions for Davis Maris. This is because business principle is also important for public to keep investing in that company and will influence the organization’s growth. Examples for the business principles are employee’s behavior, legal requirement, sustainable and satisfy the needs of customers. 2. Their employees, especially who are related to financial department, should well-understood about the FOB shipping point and FOB destination to avoid misstatement in financial reporting that will mislead the users of financial statements.
The uncertainty of the shipping term use in the transfer goods is the root of argument happened between Biovail and the Distributor after the accident happened. Therefore, we recommend Davis Maris to examining on the sale documents in order to help him to determine which party should bear the consequences and also to determine whether the accident will give effect on Biovail or not. He also can get more information and help from external parties such as the lawyer to get legal advice about which of these, filing with U.S Securities Exchange and agreement between Biovail and Distributor is more superior. This can help David Maris to decide whether FOB shipping point of FOB Destination is qualified as the accounting policy for them. 3. Improve independent verification and internal control
The CFO should not be the only persons in the company verifying the financial information such as accounting method. Like in the case is there about the disclosure of FOB sales accounting applied by Biovail. Biovail’s CFO, Brian Crombie who told the analyst about their FOB shipping contract with distributor where the title change when the truck left its company shipping dock. Meanwhile, an unknown distributor employee stated that the agreement between Biovail and the Distributor which is FOB destination provided that the ownership title and risk would not have passed to Distributor until the product was reached to Distributor facility.
To avoid such misunderstanding, accounting and other corporate personnel throughout the entire accounting, financial and internal control structure should give the authority and sign off individually to analyst or auditors about any information they control or represent to them.Indirectly, this can help in tightening Biovail’s internal controls in terms of verification of accounting method used by the company. To have a strong internal control, it needs to be reviewed by competent and independent external auditor. The risk of ambiguity and misrepresentation of important accounting information can be minimized by it. Besides, a good internal control helps a company to run efficiently because management can make a better decision in terms of management and accounting data. Conclusion
From the recommendation, we agree that improve independent verification and internal control as the best alternative to solve Biovail Corporation problems. To have a strong internal control, the financial reporting needs to be reviewed by competent and independent external auditor. For this purpose Biovail Corporation need to avoid any fraud in presenting its financial reports. In these cases, the SEC’s complaints allege that each of Biovail’s fraudulent accounting schemes had a material effect on Biovail’ financial statements for the relevant quarters and years. Biovail management also intentionally deceived the company’s outside auditor as to the nature of the transactions. When the truck accident happened, the investors know that the fact about Biovail’s failure to achieve their earnings. Before the competent and independent external auditor audited the financial reporting, Biovail Corporation should make an adjustment for its revenue since they already know that their practice in revenue recognition is wrong and did not follow the U.S GAAP to avoid any legal action.
Donald E. Kieso, J. J. (2011). Intermediate Accounting Volume 1. United States of America: John Wiley & Sons, Inc. Liang, J., & Tober, G. P. (2009). Identifying Accounting Problems and Adopting Practices to Detect Financial Misconduct: A Primer for Lawyers. Financial Fraud Law Report, (October), 14. Young, M. R., Farr, W., & LLP, G. (February 21 – 22, 2008 ). Audit Committee. In A Corporate Governance Guide, Third Edition (pp. 1197-1199). Washington, D.C. . COSO Defination of Internal Controls. (n.d.). Retrieved October 18, 2013, from Minnesota Management & Budget: http://www.beta.mmb.state.mn.us/coso-definitions Flashback: Accounting for Biovail’s Truck Accident (2010) :http://www.complianceweek.com/blogs/enforcement-action/flashback-accounting-for-biovails-truck-accident#.VCe4bRYkz-o SEC Charges Biovail Corporation and Senior Executives With Accounting Fraud (2008) : http://www.sec.gov/news/press/2008/2008-50.html Carton, B. (2010, September). Flashback: Accounting for Biovail’s Truck Accident. Compliance Week .
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