Biovail Corporation: Revenue Recognition and FOB Sales Accounting Background Late on October 9, 2003, David Maris, an analyst at Banc of America Securities (BAS), was trying to interpret the shocking events of the previous few days and finish the write-up of his first report on the Canadian pharmaceutical firm, Biovail Corporation. Maris didn't like what he saw at the company, but he never liked writing "Sell" recommendations. In any event, he wanted to make sure he was giving the best advice to his investment clients. Biovail Corporation was one of Canada's largest publicly traded pharmaceutical companies. For many years, Biovail had applied advanced drug-delivery technologies to improve the clinical effectiveness of medicines. The company commercialized its products, both directly (in Canada) and through strategic partners (internationally). Historically, its main therapeutic areas of focus had been central nervous system disorders, pain management, and cardiovascular disease. Biovail's core competency was its expertise in the development and large-scale manufacturing of pharmaceutical products. It leveraged this expertise by focusing on (1) enhanced formulations of existing drugs, (2) combination products that incorporated two or more different therapeutic classes of drugs, and (3) difficult-to-manufacture generic pharmaceuticals. In the United States, Biovail distributed a number of pharmaceutical products. These included Zovirax@ ointment and cream (topical anti-viral drugs) and Cardizem@ LA (for hypertension), which were marketed by strategic partners. In addition, Biovail distributed a number of branded off-patent products referred to as "Legacy" products. The Legacy products portfolio included the well-known brands Cardizem@ CD, Ativan@, Vasotec@, Vaseretic@, and Isordil@. These products were not actively promoted by Biovail and represented non-core assets for which patent protection had Biovail's stock was listed on both the Toronto and New York stock exchanges. As a foreign private issuer, Biovail filed annual reports to the U.S. SEC on Form 20-F and furnished interim financial statements on Form 6-K. In 2003 Biovail included in its annual and interim reports financial statements purportedly prepared in accordance with both U.S. and Canadian generally accepted accounting principles (GAAP). Craig Chapman, Senior Lecturer, Kellogg School of Management, prepared this case specifically for the Harvard Business Publishing Brief Case Collection. This case was prepared solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. This case was developed from published sources.expired. While the products were well respected by the medical community, prescription volumes were expected to decline as competing generic formulations became more readily available.2 The Truck Accident and Revised Earnings Guidance A few days earlier, Biovail had released guidance for the quarter ended September 30, 203.3, indicating that revenues would be in the range of $215 million to $235 million3 and earnings per share of $0.35 to $0.45} both below previously issued guidance. The company stated in its press release that the loss of revenue and income was associated with a significant iii-transit shipment loss of Wellbutrini) XL, Biovail's antidepressant product. due to a traffic accident that contributed signicantly to this unfavorable variance. As far as Maris was aware, this was the first time that Biovail had nussed its quarterly guidance. After leaving Biovail's manufacturing facility in Manitoba, Canada, on September 30, 2003, a truck carrying a shipment of Wellbutrin XL, bound for the North Carolina facility of one of Biovail's strategic partnersa major international pharmaceutical company that distributed the product (the Distributor}, was involved in a multi-vehicle traffic accident near Chicago, Illinois, at apprmdmately 3 pm. Central Daylight Time the following day. Eight people were killed and 16 injured in the accident, when an 13-wheeler plowed into the back of a tour bus, which then collided with Biovail's contract carrier. All the fatalities were on the busi" Biovail announced that the product on the truck might still be salable in the future. However, it would need to be returned for inspection to Biovail's manufacturing facility in Manitoba to ensure that it was still within acceptable specifications The company estimated that revenue associated with this shipment was in the range of $10 million to $20 million and conrmed that the manufacturing cost value of this shipment had been fully insured. Biovail's most recent filing with the US, Securities Exchange Commission stated that they recognized product sales revenue when the product was shipped to the customer provided that the firm had not retained any signicant risks of ownership or future obligations with respect to the product shipped Revenue from product sales was recognized net of reserves for estimated product returns, recalls, rebates, and chargebacks. These reserves were established in the same period in which the related product sales were recorded and were based on estimates of the proportion of product sales subject to return, recall, rebate, or chargebackr In a conference call following the earnings guidance, Biovail's chief nancial ofcer, Brian Crombie, told analysts that Biovail's contract with the Distributor had title change in Manitoba when it left the shipping dock [FOB shipping point}.fl However, unknown to Crombie, an employee from the Distributor had previously called and emailed Kenneth Howling, Biovail's vice president of Finance who reported to Crumble, to correct the statement about when title to the product passed to the Distributor. The agreement between Biovail and the Distributor provided that title to, and risk of loss with respect to, the product would not have passed to the Distributor until the product was delivered to the Distributor's facility (FOB destination). The Response of Other Analysts On October 3, 2003, immediately 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 ongoing production delays and operational uncertainties at Biovail?' In contrast. ].P. Morgan Securities Inc. was more upbeat.\" On October '9, 21203, analysts there reiterated their \"Oven-veight\" rating on Eiovail, highlighting that {i} Biovail remained firm on its estimate of $10 million to $20 million in Wellbutrini XL revenues lost in the accident, (ii) Biovail's low quality of earnings in the past should not be news to those familiar with Biovail, and (iii) poor earnings quality doesn't equal bad accounting. In particular, ].P'. Morgan calculated how much of the truck would need to be lled to represent the missing revenue, suggesting that it would make a wonderful interview question for management consultants.9 The majority of Wellbutrin XL on the truck consisted of bulk tablets in Eel-gallon drums.m Each soc mg Wellbutrin XL tablet was estimated to be roughly 0.5 cm! with an additional 1.00 cm3 per tablet for packing space and a wholesale acquisition price of $2.33 per tablet, which included an assumed 400% markoup for the Distributor as well as a 35% wholesaler margin. The interior dimensions of a typical 18-wheeler trailer were 17m rt 4.5m x 2.5m.\" LP. Morgan added that its analysts had never argued with earlier claims that Biovail's accounting might have been aggrtssive. However, its analyst report concluded that Biovail's current accounting did not seem egregious and that the earnings impact of Wellbutrin XL was completely transparent. History of Analyst Coverage and the Relationship with Banc of America Securities In October 2000, January 2002, and April 2002, lerry Treppel, Maria's predecessor at HAS, had downgraded his stock recommendation for Biovail. On each occasion, this resulted in substantial declines in Biovail's stock valuemore than 20% in the days following the April downgrade.12 1n the April 2002 report that contained a Sell recommendation, Treppel suggested that the company's revenue and earnings performance over the prior 18 months had. not been of high quality. Although stating that the information was unclear, Treppel was concerned about the sustainability of the rapid sales growth that Biovail was reporting. In particular, he highlighted sales of Cardizemtt CD, which represented 40% of product sales at Biovail. The reported sales of Cardizem CD for the previous quarter were $52 millionat least $10 million more than was reported in the previous quarter.13 Shortly after Biovail executives were unable to persuade HAS to retract the April 20m. report, Biovail made a number of public statements regarding Treppel's coverage, which led to an investigation of Treppel by the New York state attorney general's office. the Securities and Exchange Commission {SEC} and the National Association of Securities Dealers into his personal trading activities. In May 2002 Treppel was placed on leave by BAS and ultimately resigned his position. In response, Treppel sued Biovail some of its executives. and also its public relalions firm claiming defamation. It looked like it would take a long time for the litigation to be resolved. The Research Findings at 31115 Following the truck accident, Maris.r who had taken over the account from Treppel, and his team started to do some digging. They called the state trooper handling the crash investigation, got a copy of the accident report.r and talked to someone at the impound lot where the truck was towed. According to the rst trooper on the scene, who had obtained information directly from the bill of lading, the truck contained 8 pallets of product with a total weight of 11,690 poundsall of it Wellbutrin XL, since the truck had no other cargo. The trooper estimated that the truck was about one-quarter full and that even 25 pallets would not have lled up a tractor-trailer of the size involved in the accident." Maris and his team also talked to the towing company and to a local TV reporteri'cameraperson who'd shot the scene. Maris also watched the report on the TV station's web site. The investigation suggested that Biovail might have signicantly overestimated the amount of 'lt'lnlellbutl'intlI XL on the truck. If there had been $20 million worth of lr'lc'ellbutr'intEI XL pills on that truck, it would have been full, or nearly full, thought Maris. Maris looked back at Treppel's previous comments on Biovail from the file and remembered some of the comments that had been made during the conference call. Melnyk had stated: \"This accident will have a negative nancial impact on Biovail's third quarter revenues." He had then repeated "It is a third quarter item." Maris wasn't sure what to make of the comments and went back to check on some of the accounting rules, wondering if Treppel's concerns about aggressive accounting might have been correct. First there were the general disclosure requirements laid out by the SEC. Its Financial Reporting Release (FER) 35 required that a company's Management Discussion and Analysis (MUM) should "give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant's nancial condition and results of operations, with a particular emphasis on the registrant's prospects for the future." In the SEC's staff accounting bulletin concerning revenue recognition (SAB 101), the SEC reiterated that the MDrA should include an analysis of the reasons and factors contributing to the increase or decrease (in revenueset income).'5 However, in spite of these rules, according to SEC complaints and allegations, many companies artificially inated their reported revenues by deliberately sending retailers along the distribution channel more products than they were able to sell [a process referred to as \"charmel stuir'tg\").16 In such settings, the SEC did require some disclosure regarding such actions in the MDM, using \"shipments of product at the end of a reporting period that significantly reduce customer backlog and that reasonably might be expected to result in lower shipments and revenue in the next period\" as a specic example.\" In spite of these requirements, a cursory analysis of the MDM sections of Ill-K filings revealed only rare disclosures of this type. Most of those that could be found blamed seasonal customer buying patterns. Then there were the revenue recognition requirements which were taught in almost any financial accounting class. Since Biovail's stock was listed on the New York Stock Exchange, it filed its annual and interim financial statements with the SEC in accordance with US. GAAP. US. (3MP required that revenue must be earned and realized or realizable in order for it to be recognized. More precisely, SAB ll stated that these conditions would generally be satisfied when the following four criteria were met: i) Persuasive evidence of an arrangement mists; ii) Delivery has occurred or services have been rendered; iii} The seller's price to thebuyer is xed or determulable; and iv) Collectability is reasonably assured.\" Maris felt that Biovail should not be able to record revenue from the sale of the drugs in the truck in the third quarter. It just didn't feel right. However, he wanted to make sure that he really understood the effects of the accident on the rmbefore he signed offon his Sell recommendation