BCD IMAGING CORPORATION: REVENUE RECOGNITION Sara, a prominent asset management firm's stock analyst, was drafting a report for her fund manager. Her company had invested in BCD Imaging Corporation (BCD), a medical equipment manufacturer with a patented medical imaging technology and a distinct market position. Since its establishment in 2009, BCD has experienced consistent revenue growth. Seeing growth potential, Sara's fund made its first investment in BCD at the beginning of 2018, at a price of $4 per share. After an initial increase of more than 22% to $4.90, the price of BCD began to drop in the second half of 2018. Following the presentation of BCD's first quarter (Q1) earnings on April 10, 2019, BCD's share price dropped to $1.48. Before submitting her report, Sara wanted to have a firm grasp on the causes of the downturn. Specifically, she was aware that her manager would want to know how much of this loss was due to sentiment as opposed to substance; in other words, will BCD be able to recover? As Sara began drafting her report, she was greatly worried by BCD's Q1 2019 sales decline. Sales of equipment, a significant category, fell to barely 1% of the figure reported one year earlier. However, the reported equipment orders only decreased from 19 in the first quarter of 2018 to 15 in the first quarter of 2019. Sara concluded that there must be further causes for the reduction in sales dollars than a decline in orders. Sara noticed in BCD's Q1 earnings report that the company had disclosed a change in how it recognized revenue for its equipment orders, and she wondered how much of the sales reduction could be due to this change. Sara was aware that her company needed to decide swiftly whether investment firms should begin liquidating their holdings in BCD. She was also aware that she would require additional investigation and analysis before providing her management with her final recommendation. Revenue Composition BCD depended on three core revenue streams: equipment sales, maintenance contracts, and sales of pay-per-use. Equipment Sales BCD sold its systems to hospitals and medical centers. The systems sold for approximately $400,000 on average. This all-inclusive price comprised the BCD system and its installation, the BCD station(s) with the corresponding software for performing three-dimensional reconstructions, and a one-year warranty. The initial radiology staff training is included in the BCD purchase price. Hospital budget cycles influenced quite seasonal patterns in equipment sales, especially BCD. As a result, equipment sales revenue was significantly higher in the fourth quarter. In 2018, 75% of BCD's total revenue was derived from the selling of equipment. Although Sara lacked specific information regarding the durability of BCD installations, comparable medical equipment (such as MRI) was typically replaced every 10 years. Maintenance Contracts In addition to the one-year guarantee, BCD also offered equipment owners annual maintenance contracts that commenced after the warranty ended. BCD estimated that over 80% of its installations out of warranty would acquire an ongoing maintenance contract. Depending on the circumstances and customer preferences, maintenance contracts ranged from one to five years in length. In 2018, 22 percent of BCD's revenue came from maintenance contracts, which were reoccurring and generally stable. Pay-per-use BCD also provided software licensing and consulting services on a per-use basis, allowing clients to temporarily use software on a pay-per-use basis. Despite the recurring nature of these services, which were related to BCD's instalment-based revenue model, this revenue was more variable than maintenance contracts. In 2018, it accounted for 3 percent of total income. Financial Performance Between 2012 and 2018, BCD averaged a 25 percent year-over-year increase in revenue. However, in 2018, reported revenue declined by 4.6%, or $35.4 million, despite BCD's continuous expansion and a number of substantial expenditures targeting core and new markets. Sara realized that declining revenues did not tell the entire story. As she examined the income statement, balance sheet, and cash flow statement, it became less clear why investors had suddenly turned against BCD' stock. BCD has also successfully issued $29.5 million in convertible notes and $15 million in new shares to in 2018 to finance its business activity. As of December 31, 2018, BCD had 26,237,907 outstanding common shares. In the first quarter of 2019, BCD failed to reverse the downward trend of the prior year and equipment sales revenue continued to plummet. Sara observed that first-quarter 2019 revenues were around $8 million lower than the same quarter in 2018, suggesting a staggering 99 percent decline. However, she also observed that the 15 BCD equipment orders received in the first quarter of 2019 were only somewhat fewer than the 19 orders obtained in the first quarter of 2018. On the basis of the equipment sales price of $400,000 per order, a reduction of four orders should have resulted in a sales decrease of $1.6 million (about 21 percent of the previous year's income). Sara struggled to see why the money figure and the quantity of orders painted such disparate visions. She had observed a change in revenue recognition processes that required additional investigation. 2019 Revenue Recognition Method Change BCD's financial statements were prepared according to International Financial Reporting Standards (IFRS). These standards provide managers with a number of principles and specific examples for accurately reporting their operations. However, Sara was astonished to see that managers still had significant discretion over how to apply the criteria to their organizations, potentially allowing enterprises with comparable underlying economics to report different results. Even with the same business, reporting modifications made at the discretion of managers could lead reporting numbers to differ significantly between periods. Transfer of control was a fundamental step in revenue recognition, but one that still required considerable discretion. In 2018 and earlier years, BCD maintained that the transfer of control in its sales agreements occurred when the customer received the equipment for the first time. This normally occurred within a week of the sales contract being finalized. However, installations of the equipment often took between three and twelve months following original delivery. Due to the fact that installation was a prerequisite for payment in the majority of instances, this strategy resulted in a substantial receivables amount on the balance sheet. Beginning in 2019, BCD made major modifications to its typical sales contract for equipment sales. The new contracts included a clause identifying the transfer of control upon the signature of the statement of functioning order, which was normally signed after the installation was finished. In other words, the new sales condition changed the delivery of its equipment, a crucial event in revenue recognition, from its original shipment to its final installation, months later. Although both the old and new approaches centered on delivery, which was also when legal ownership was transferred, the economic factors that triggered delivery were distinct. According to the management team, the primary objective of this move was to better meet the needs of BCD's clients and to conform to industry standards. Although this change in revenue recognition timing had a major negative impact on Q1 2019 sales, management asserted that this new practice will be supported by production and logistics enhancements that would minimize BCD's working capital needs. In turn, this would strengthen the company's financial position and reduce liquidity risks, making BCD more attractive to investors. Sara knew, based on her business school knowledge, that one of the fundamental concepts underlying the IFRS framework of revenue recognition was that revenue should only be recognized once the seller has transferred control of the linked asset to the customer. Therefore, it was essential to determine which of the two triggering events-initial delivery or installation completion-was most consistent with the IFRS regulation. Sara was also curious as to how this new technique will affect BCD's financial statements and earnings in 2019 and beyond. Sara obtained information on the five-step approach for revenue recognition proposed by IFRS 15 to aid in her investigation (see Exhibit 1). She then described the major economic events in the BCD sales cycle, as she understood them: (1) the agreement and signing of the contract to purchase equipment; (2) the receipt of a down payment on the equipment; (3) the delivery of BCD equipment; (4) the installation of BCD equipment by specialist teams; and (5) the receipt of the remaining payment. THE CONCLUSION Sara realized that her key job would be to "clean up" the effect of the change in revenue recognition and reveal the company's underlying economic performance. She believed it would be good to begin by attempting to adjust revenue for the gap in timing between BCD's old and new revenue recognition processes, despite not having exact numbers (see Exhibit 2). Sara also desired to comprehend and communicate to her manager the revenue recognition technique that most accurately reflected BCD's economic reality. Sara questioned if the market had overlooked the change in revenue recognition and overreacted to BCD's reported results. Sara realized that she would need to deliver a specific answer as to whether BCD was a viable investment after considering all of these factors. EXHIBIT 1: IFRS FIVE-STEP REVENUE RECOGNITION MODEL Identifying the contract(s) with a customer Identifying the various distinct performance obligations in the contract Determining the transaction price Allocating the transaction price to each performance obligation STEP 1 STEP 2 STEP 3 STEP 4 Recognizing revenue when a performance obligation is satisfied STEP 5 EXHIBIT 2 : ORDER AND INSTALLATION SCHEDULE Sara's Estimate of Order Schedule (Number of Units) 2017 2018 2019 QI 20 19 15 22 21 17 24 23 18 27 25 20 93 88 70 Sara's Estimate of Installation Schedule: Time of order installation Percentage of orders Current quarter 1% First following quarter 24% Second following quarter 50% Third following quarter 25% ASSIGNMENT QUESTIONS 1. Which of BCD' revenue recognition processes is more in line with IFRS? (As a suggestion, follow the IFRS five-step revenue recognition approach.) 2. Which has a greater impact on Q1 2019 equipment sales: the change in revenue recognition methodology or the decline in order numbers? 3. Using Sara's order and installation schedule estimates, compute the 2017-2019 equipment sales revenue (a) under the old practice and (b) under the new practice. Is the revenue change permanent or temporary? (Use data in Excel). 4. Should Sara recommend to her boss that they sell their BCD stake? Q2 Q3 Q4 Total B 1 Equipment sales price per order (000) 5 Q1 6 (number of units) 20 7 Total 8 9 10 11 Q1 12 Total installations (units) ? 13 14 15 Estimate of Installation Schedule Time of order 16 installation 17 Current quarter 18 First following quarter 19 Second following quarter 20 Third following quarter as 2 WN 3 4 Percentage of orders 1% 24% 50% 25% Data Solution C Q2 22 2017 93 2017 Q2 ? D E H 400 Estimate of Order Schedule (Number of Units) 2018 Q3 Q4 Q1 Q2 Q3 24 27 19 21 23 88 Sales (Total installations) using new method 2018 Q3 Q4 Q1 Q2 Q3 ? 22 24 25 22 1 Q4 25 Q4 21 Q1 15 Q1 23 Q2 17 Q2 22 2019 70 2019 Q3 18 Q3 18 - M 04 20 Q4 16 Orders Current quarter First following quarter Second following quarter Third following quarter Equipment sales, new 2019 Equipment sales, old 2019 Equipment sales, new 2019 Equipment sales, old 2019 Sales considering 2019 change of method: Old mehod (number of units) (number of units) (number of units) (number of units) (number of units) (number of units) (thousands) (thousands) $thousands C Q1 01 01 D la 02 02 E 2017 Q3 2017 Q3 2017 Q3 F 04 04 Q4 G Q1 la Q1 H 02 02 02 2018 2018 2018 I 03 Q3 Q3 3 04 2 04 Q4 K Q1 Q1 Q1 L 02 02 02 2019 2019 M 2019 la 03 Q3 N 04 04 04 BCD IMAGING CORPORATION: REVENUE RECOGNITION Sara, a prominent asset management firm's stock analyst, was drafting a report for her fund manager. Her company had invested in BCD Imaging Corporation (BCD), a medical equipment manufacturer with a patented medical imaging technology and a distinct market position. Since its establishment in 2009, BCD has experienced consistent revenue growth. Seeing growth potential, Sara's fund made its first investment in BCD at the beginning of 2018, at a price of $4 per share. After an initial increase of more than 22% to $4.90, the price of BCD began to drop in the second half of 2018. Following the presentation of BCD's first quarter (Q1) earnings on April 10, 2019, BCD's share price dropped to $1.48. Before submitting her report, Sara wanted to have a firm grasp on the causes of the downturn. Specifically, she was aware that her manager would want to know how much of this loss was due to sentiment as opposed to substance; in other words, will BCD be able to recover? As Sara began drafting her report, she was greatly worried by BCD's Q1 2019 sales decline. Sales of equipment, a significant category, fell to barely 1% of the figure reported one year earlier. However, the reported equipment orders only decreased from 19 in the first quarter of 2018 to 15 in the first quarter of 2019. Sara concluded that there must be further causes for the reduction in sales dollars than a decline in orders. Sara noticed in BCD's Q1 earnings report that the company had disclosed a change in how it recognized revenue for its equipment orders, and she wondered how much of the sales reduction could be due to this change. Sara was aware that her company needed to decide swiftly whether investment firms should begin liquidating their holdings in BCD. She was also aware that she would require additional investigation and analysis before providing her management with her final recommendation. Revenue Composition BCD depended on three core revenue streams: equipment sales, maintenance contracts, and sales of pay-per-use. Equipment Sales BCD sold its systems to hospitals and medical centers. The systems sold for approximately $400,000 on average. This all-inclusive price comprised the BCD system and its installation, the BCD station(s) with the corresponding software for performing three-dimensional reconstructions, and a one-year warranty. The initial radiology staff training is included in the BCD purchase price. Hospital budget cycles influenced quite seasonal patterns in equipment sales, especially BCD. As a result, equipment sales revenue was significantly higher in the fourth quarter. In 2018, 75% of BCD's total revenue was derived from the selling of equipment. Although Sara lacked specific information regarding the durability of BCD installations, comparable medical equipment (such as MRI) was typically replaced every 10 years. Maintenance Contracts In addition to the one-year guarantee, BCD also offered equipment owners annual maintenance contracts that commenced after the warranty ended. BCD estimated that over 80% of its installations out of warranty would acquire an ongoing maintenance contract. Depending on the circumstances and customer preferences, maintenance contracts ranged from one to five years in length. In 2018, 22 percent of BCD's revenue came from maintenance contracts, which were reoccurring and generally stable. Pay-per-use BCD also provided software licensing and consulting services on a per-use basis, allowing clients to temporarily use software on a pay-per-use basis. Despite the recurring nature of these services, which were related to BCD's instalment-based revenue model, this revenue was more variable than maintenance contracts. In 2018, it accounted for 3 percent of total income. Financial Performance Between 2012 and 2018, BCD averaged a 25 percent year-over-year increase in revenue. However, in 2018, reported revenue declined by 4.6%, or $35.4 million, despite BCD's continuous expansion and a number of substantial expenditures targeting core and new markets. Sara realized that declining revenues did not tell the entire story. As she examined the income statement, balance sheet, and cash flow statement, it became less clear why investors had suddenly turned against BCD' stock. BCD has also successfully issued $29.5 million in convertible notes and $15 million in new shares to in 2018 to finance its business activity. As of December 31, 2018, BCD had 26,237,907 outstanding common shares. In the first quarter of 2019, BCD failed to reverse the downward trend of the prior year and equipment sales revenue continued to plummet. Sara observed that first-quarter 2019 revenues were around $8 million lower than the same quarter in 2018, suggesting a staggering 99 percent decline. However, she also observed that the 15 BCD equipment orders received in the first quarter of 2019 were only somewhat fewer than the 19 orders obtained in the first quarter of 2018. On the basis of the equipment sales price of $400,000 per order, a reduction of four orders should have resulted in a sales decrease of $1.6 million (about 21 percent of the previous year's income). Sara struggled to see why the money figure and the quantity of orders painted such disparate visions. She had observed a change in revenue recognition processes that required additional investigation. 2019 Revenue Recognition Method Change BCD's financial statements were prepared according to International Financial Reporting Standards (IFRS). These standards provide managers with a number of principles and specific examples for accurately reporting their operations. However, Sara was astonished to see that managers still had significant discretion over how to apply the criteria to their organizations, potentially allowing enterprises with comparable underlying economics to report different results. Even with the same business, reporting modifications made at the discretion of managers could lead reporting numbers to differ significantly between periods. Transfer of control was a fundamental step in revenue recognition, but one that still required considerable discretion. In 2018 and earlier years, BCD maintained that the transfer of control in its sales agreements occurred when the customer received the equipment for the first time. This normally occurred within a week of the sales contract being finalized. However, installations of the equipment often took between three and twelve months following original delivery. Due to the fact that installation was a prerequisite for payment in the majority of instances, this strategy resulted in a substantial receivables amount on the balance sheet. Beginning in 2019, BCD made major modifications to its typical sales contract for equipment sales. The new contracts included a clause identifying the transfer of control upon the signature of the statement of functioning order, which was normally signed after the installation was finished. In other words, the new sales condition changed the delivery of its equipment, a crucial event in revenue recognition, from its original shipment to its final installation, months later. Although both the old and new approaches centered on delivery, which was also when legal ownership was transferred, the economic factors that triggered delivery were distinct. According to the management team, the primary objective of this move was to better meet the needs of BCD's clients and to conform to industry standards. Although this change in revenue recognition timing had a major negative impact on Q1 2019 sales, management asserted that this new practice will be supported by production and logistics enhancements that would minimize BCD's working capital needs. In turn, this would strengthen the company's financial position and reduce liquidity risks, making BCD more attractive to investors. Sara knew, based on her business school knowledge, that one of the fundamental concepts underlying the IFRS framework of revenue recognition was that revenue should only be recognized once the seller has transferred control of the linked asset to the customer. Therefore, it was essential to determine which of the two triggering events-initial delivery or installation completion-was most consistent with the IFRS regulation. Sara was also curious as to how this new technique will affect BCD's financial statements and earnings in 2019 and beyond. Sara obtained information on the five-step approach for revenue recognition proposed by IFRS 15 to aid in her investigation (see Exhibit 1). She then described the major economic events in the BCD sales cycle, as she understood them: (1) the agreement and signing of the contract to purchase equipment; (2) the receipt of a down payment on the equipment; (3) the delivery of BCD equipment; (4) the installation of BCD equipment by specialist teams; and (5) the receipt of the remaining payment. THE CONCLUSION Sara realized that her key job would be to "clean up" the effect of the change in revenue recognition and reveal the company's underlying economic performance. She believed it would be good to begin by attempting to adjust revenue for the gap in timing between BCD's old and new revenue recognition processes, despite not having exact numbers (see Exhibit 2). Sara also desired to comprehend and communicate to her manager the revenue recognition technique that most accurately reflected BCD's economic reality. Sara questioned if the market had overlooked the change in revenue recognition and overreacted to BCD's reported results. Sara realized that she would need to deliver a specific answer as to whether BCD was a viable investment after considering all of these factors. EXHIBIT 1: IFRS FIVE-STEP REVENUE RECOGNITION MODEL Identifying the contract(s) with a customer Identifying the various distinct performance obligations in the contract Determining the transaction price Allocating the transaction price to each performance obligation STEP 1 STEP 2 STEP 3 STEP 4 Recognizing revenue when a performance obligation is satisfied STEP 5 EXHIBIT 2 : ORDER AND INSTALLATION SCHEDULE Sara's Estimate of Order Schedule (Number of Units) 2017 2018 2019 QI 20 19 15 22 21 17 24 23 18 27 25 20 93 88 70 Sara's Estimate of Installation Schedule: Time of order installation Percentage of orders Current quarter 1% First following quarter 24% Second following quarter 50% Third following quarter 25% ASSIGNMENT QUESTIONS 1. Which of BCD' revenue recognition processes is more in line with IFRS? (As a suggestion, follow the IFRS five-step revenue recognition approach.) 2. Which has a greater impact on Q1 2019 equipment sales: the change in revenue recognition methodology or the decline in order numbers? 3. Using Sara's order and installation schedule estimates, compute the 2017-2019 equipment sales revenue (a) under the old practice and (b) under the new practice. Is the revenue change permanent or temporary? (Use data in Excel). 4. Should Sara recommend to her boss that they sell their BCD stake? Q2 Q3 Q4 Total B 1 Equipment sales price per order (000) 5 Q1 6 (number of units) 20 7 Total 8 9 10 11 Q1 12 Total installations (units) ? 13 14 15 Estimate of Installation Schedule Time of order 16 installation 17 Current quarter 18 First following quarter 19 Second following quarter 20 Third following quarter as 2 WN 3 4 Percentage of orders 1% 24% 50% 25% Data Solution C Q2 22 2017 93 2017 Q2 ? D E H 400 Estimate of Order Schedule (Number of Units) 2018 Q3 Q4 Q1 Q2 Q3 24 27 19 21 23 88 Sales (Total installations) using new method 2018 Q3 Q4 Q1 Q2 Q3 ? 22 24 25 22 1 Q4 25 Q4 21 Q1 15 Q1 23 Q2 17 Q2 22 2019 70 2019 Q3 18 Q3 18 - M 04 20 Q4 16 Orders Current quarter First following quarter Second following quarter Third following quarter Equipment sales, new 2019 Equipment sales, old 2019 Equipment sales, new 2019 Equipment sales, old 2019 Sales considering 2019 change of method: Old mehod (number of units) (number of units) (number of units) (number of units) (number of units) (number of units) (thousands) (thousands) $thousands C Q1 01 01 D la 02 02 E 2017 Q3 2017 Q3 2017 Q3 F 04 04 Q4 G Q1 la Q1 H 02 02 02 2018 2018 2018 I 03 Q3 Q3 3 04 2 04 Q4 K Q1 Q1 Q1 L 02 02 02 2019 2019 M 2019 la 03 Q3 N 04 04 04