OracleSystems 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 articulatedby 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 ofaccounts receivable, many analysts argued that Oracle’s stock was a risky buy. As aresult, the company’s stock price had plummeted from a high of $56in March toaround $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, andsecond that the low price made it expensive for the firm to raise new equity capitalto finance its future growth.’
ORACLE’S BUSINESS AND PERFORMANCE________________
Since its formation in California in June 1977, Oracle Systems Corporation hasgrown 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 distributesa 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 offersextensive maintenance, consulting, training, and systems integration services to support its products.
Oracle’s leadership in developing software for database management hasenabled it to achieve impressive financial growth. As reported in Exhibit 1, thecompany’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.
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<": Theprimary 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 thefirst database management system to run on mainframes, minicomputers, andPCs. In 1986, ORACLE was the first database management system with distributed capability, making access to data on a network of computers as easy asaccess 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 softwarethat 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 onPCs. 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 offerextended 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 inearnings (see Exhibit 2 for quarterly results for 1989 and 1990). Managementexplained that several factors contributed to this poor performance. First, the company had recently redrawn its sales territories and, as a result, for several monthssalespeople had become unsure of their new responsibilities, leaving some customersdissatisfied. 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 stockprice 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 over50%, though the net bottom line did not doso well, because Oracle's running more cash than it should be as a result offinancial 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, andfrom sublicensing agreements with original equipment manufacturers (OEMs) andsoftware value-added relicensors (VARs). Initial license fees for the ORACLE database management system range from $199 to over $5,500 on micro- and personalcomputers, and from $5,100 to approximately $342,000 on mini- and mainframecomputers. 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 numberof copies distributed. Under VAR agreements the company charges a developmentlicense fee on top of the initial nonrefundable fee, and it receives sublicense fees basedon the number of copies distributed. Sublicense fees are usually a percentage ofOracle'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 andproblem 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 7.5percent to 22 percent of the current list price ofthe appropriate license. These fees are recorded as unearned revenue when the maintenance contract is signed and are reflected as revenue ratably over the contractperiod. The major questions about Oracle's revenue recognition concern the way the firm recognizes revenues on license fees. There is no currently accepted standard foraccounting for these types of revenues.2 However, Oracle tends to be one of the moreaggressive reporters. The firm's days receivable exceeds 160 days, substantially higherthan the average of 62 days receivable for other software developers (see Exhibit 3for a summary of days receivable for other major software developers in 989 and1990). 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 theaccounting treatment for the sale of products. In addition, the collectibility of license fees is considered questionable by some analysts, who have urged the firm torecognize 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 inthe firm's stock. The company had lost credibility with investors and customers dueto 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 wouldbe influential. As he saw it, the company had three alternatives. One was to modifythe 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 Boardwos consideringtne issue of revenue recognition for software developers atthistime. It was widely expectedthat 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 lineand 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 currentaccounting method. Ellison carefully considered which alternative made the mostsense 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 CorporationConsolidated Financial Statements CONSOLIDATED BALANCE SHEETS As of May31,1990 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 1 ,236 $9,747 Current maturities of long-term debt i 1 ,265 1 3,587 Accounts payable 64,922 51,582 Income taxes payable 18,254 14,836 Accrued compensation and related benefits 61,164 39,063 Customer advances and unearned revenues 42,121 15,403 Other accrued liabilities 32,417 23,400 Sales tax payable 22,193 8,608 Deferred income taxes 2,107 Total current liabilities 283,572 178,333 LONG-TERM DEBT 89,129 33,506 OTHER LONG-TERM LIABILITIES 4,936 5,702 DEFERRED INCOME TAXES 22,025 12,114 STOCKHOLDERS' EQUITY: Common stock, $.0 1 par value-authorized, 200,000,000 shares; outstanding: 131,1 38,302 shares in 1 990 and 126,933,288 shares in 1989 388 346 Additional paid-in capital 118,715 84,931 Retained earnings 267,475 150,065 Accumulated foreign currency translation adjustments 1,007 (4,788) Total stockholders' equity 387,585 230,554 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $787,247 $460,209 292 Part 4 Additional Cases . . 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CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended May 31,1990 to 1988 (in $000, except per share data)
1990
1989
1988
REVENUES
Licenses
$689,898
$417,825
$205,435
Services
280,946
165,848
76,678
Total revenues
970,844
583,673
282,113
OPERATING EXPENSES
Sales and marketing
465,074
272,812
124,148
Cost of services
1 60,426
100,987
51,241
Research and development
88,291
52,570
25,708
General and administrative
67,258
34,344
17,121
Total operating expenses
781,049
460,713
218,218
OPERATING INCOME
189,795
122,960
63,895
OTHER INCOME (EXPENSE):
Interest income
3,772
2,724
2,472
Interest expense
(12,096)
(4,318)
(1,540)
Other income (expense)
(8,811)
(1,121)
152
Total other income (expense)
(17,135)
(2,715)
1,084
INCOME BEFORE PROVISION FOR INCOME
TAXES
172,660
120,245
64,979
PROVISION FOR INCOME TAXES
55,250
38,479
22,093
NET INCOME
$117,410
$81,766
$42,886
EARNINGS PER SHARE
$.86
$.61
$.32
NUMBER OF COMMON AND COMMON
EQUIVALENT SHARES OUTSTANDING
136,826
135,066
132,950
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CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended Hay 31,1990 to 1988 (in $000)
1990
1989
1988
CASH FLOWS FROM OPERATING ACTIVITIES
Net income
$117,410
$81,766
$42,886
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization
44,078
23,156
12,973
Provision for doubtful accounts
16,625
9,211
4,839
Increase in receivables
(227,046)
(149,900)
(74,777)
Increase in prepaid expenses & supplies
(12,834)
(5,684)
(1,458)
Increase in accounts payable
12,491
25,236
12,854
Increase income taxes payable
3,002
6,821
7,940
Increase in other accrued liabilities
42,166
38,057
21,420
Increase in customer advances
and unearned revenues
25,786
6,496
5,682
Increase (decrease) in deferred taxes
7,728
(10,857)
8,170
increase (decrease) in other non-current liabilities
(766)
1,938
Net cash provided by operating activities
28,640
26,240
40,529
CASH FLOWS FROM INVESTING ACTIVITIES
Increase in short-term investments
(480)
2,998
(7,498)
Capital expenditures
(89,275)
(68,428)
(30,959)
Capitalization of computer software development costs
(27,639)
(10,526)
(4,447)
increase in other assets
(1,116)
(2,084)
(481)
Purchase of a business
(6,650)
Net cash used for investing activities
(118,510)
(84,690)
(43,385)
CASH FLOWS FROM FINANCING ACTIVITIES
Notes payable to banks
21,156
10,305
(169)
Proceeds from issuance of long-term debt
68,530
37,539
1,445
Payments of long-term debt
(34,239)
(6,205)
(3,638)
Proceeds from common stock issued
18,460
11,060
4,712
Tax benefits from stock options
15,366
10,593
3,992
Net cash provided by financing activities
89,273
63,292
6,342
EFFECT OF EXCHANGE RATE CHANGES ON CASH
552
(1,061)
69
NET INCREASE (DECREASE) IN CASH
(45)
3,781
3,555
CASH: BEGINNING OF YEAR
44,893
41,112
37,557
Cash: end of year
$44,848
$44,893
$41,112
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EXCERPTS FROM NOTES TO CONSOLIDATED FINANCIALSTATEMENTS
/. Organization and Significant Accounting Policies Organization
Oracle Systems Corporation (the Company) develops and markets computer software productsused for database management, applications development, decision support, programmer tools, computer network communication, end user applications, and office automation. The Company offersmaintenance, consulting, and training services in support of its clients’ use of its software products.
Basis of Financial Statements
The consolidated financial statements include the Company and its subsidiaries.AII transactions and balances between the companies are eliminated.
Business Combination
In November 1988, the Company’s subsidiary, Oracle Complex Systems Corporation, acquired all ofthe outstanding shares of Falcon Systems, Inc., a systems integrator, for $13,714,000 in cash and $4,600,000 in notes which become due November I, 1991.The acquisition was accounted for as apurchase and the excess of the cost over the fair value of assets acquired was $5,648,000, which isbeing amortized over 5 years on a straight-line method. Pro forma results of operations, assuming the acquisition had taken place June I, 1987, would not differ materially from the Company’s actualresults of operations.
Software Development Costs
Effective June 1, 1986, the Company began capitalizing internally generated software developmentcosts in compliance with Statement of Financial Accounting Standards No. 86,”Accounting for theCosts of Computer Software to be Sold, Leased or Otherwise Marketed.” Capitalization of computersoftware development costs begins upon the establishment of technological feasibility for the product. Capitalized software development costs amounted to $27,639,000, $ 10,526,000, and $4,447,000 in fiscal 1990,1989, and 1988, respectively.
Amortization of capitalized computer software development costs begins when the products are available for general release to customers, and is computed product by product as the greaterof: (a) the ratio of current gross revenues for a product to the total of current and anticipatedfuture gross revenues for the product, or (b) the straight-line method over the remaining estimated economic life of the product. Currently, estimated economic lives of 24 months are used inthe calculation of amortization of these capitalized costs. Amortization amounted to $8,185,000,$3,504,000, and $2,345,000 for fiscal years ended May31,1990, 1989, and 1988,respectively, andis included in sales and marketing expenses.
Statements of Cash Flows
The Company paid income taxes in the amount of $33,731,000, $29,006,000, and $711,000 andinterest expense of $8,026,000, $4,274,000 and $ 1,540,000 during the fiscal years ended 1990,1989, and 1988, respectively. The Company purchased equipment under capital lease obligations in theamount of $ 17,616,000, $4,692,000, and $4,108,000 in fiscal 1990, 1989, and 1988, respectively.
Revenue Recognition
The Company generates several types of revenue including the following:
License andSublicense fees. The Company licenses ORACLE products to end users under licenseagreements. The Company also has entered into agreements whereby the Company licenses Oracle
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products and receives license and sublicense fees from original equipment manufacturers (OEMs) andsoftware value-added relicensors (VARs). The minimum amount of license and sublicense fees specified in the agreements is recognized either upon shipment of the product or at the time such agreements are effective (which in most instances is the date of the agreement) if the customer iscreditworthy and the terms of the agreement are such that the amounts are due within one year and are nonrefundable.and the agreements are noncancellable.The Company recognizes revenue at suchtime as it has substantially performed all of its contractual obligations. Additional sublicense fees aresubsequently recognized as revenue at the time such fees are reported to the Company by the OEMsand VARs.
Maintenance Agreements.Maintenance agreements generally call for the Company to providetechnical support and certain systems updates to customers. Revenue related to providing technical support is recognized proportionately over the maintenance period, which in most instances is oneyear, while the revenue related to systems updates is recognized at the beginning of each maintenanceperiod.
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Consulting, Training, and Other Services.The Company provides consulting services to itscustomers; revenue from such services is generally recognized under the percentage of completionmethod.
2. Short-Term Debt
Short term debt (in $000) consists of:
Year Ended May 31
1990 1989
Unsecured revolving lines of credit $ 18,198 $5,955
Other 13,038 3,792
Total $31,236 $9,747
At May 31,1990, the Company had short-term unsecured revolving lines of credit with two banksproviding for borrowings aggregating $42,000,000, of which $ 18,198,000 was outstanding. These linesexpire in September 1990 ($2,000,000), November 1990 ($10,000,000), and January 1991($30,000,000). Interest on these borrowings is based on varying rates pegged to the banks’ prime rate, cost of funds, or LIBOR. The Company also had other unsecured short-term indebtedness tobanks of $13,038,000 at May 31, 1990, payable upon demand. The average interest rate on short-term borrowings was 9.4% at May 31,1990.
The Company is required to maintain certain financial ratios under the line of credit agreements. The Company was in compliance with these financial covenants at May31,1990.
3. Long-Term Debt
At May31,1990, the Company had long-term unsecured revolving lines of credit with four banks providing for borrowings aggregating $135,000,000, of which $61,460,000 was outstanding. Of the$61,460,000 outstanding, $58,210,000 was classified as long-term debt and $3,250,000 was classifiedas current maturities of long-term debt-These lines of credit expire in December 1991 ($60,000,000), March 1992 ($ 15,000,000), July 1992 ($20,000,000), January 1991 ($20,000,000), and March 1991 ($20,000,000).The Company has the option to convert $20,000,000 of its line expiring in January of1991 and $8,000,000 of that expiring in March of 1991 into two term loans which would mature in1993. Interest on these borrowings vary based on the banks’ cost of funds rates.At May 31,1990 the interest rate on outstanding domestic and foreign currency borrowings ranged from 8.6% to 15.6%. The aggregate amount available under these lines of credit at May31,1990 was $73,540,000.
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Under the line-of-credit agreements, the Company is required to maintain certain financial ratios. At May31,1990 the Company was in compliance with these financial covenants.
Subsequent to May31,1990, the Company obtained two additional unsecured revolving lines ofcredit, one which expires May 1992 ($20.000,000) and one which expires January 1991 ($20,000,000).
4. Stockholders’EquityStock Option Plan
The Company’s stock option plan provides for the issuance of incentives stock options to employees of the Company and nonqualified options to employees, directors, consultants, and independentcontractors of the Company. Under the terms of this plan, options to purchase up to 23,335,624shares of Common Stock may be granted at not less than fair market value, are immediately exer-cisable, become vested as established by the Board (generally ratably over four to five years), and generally expire ten years from the date of grant. The Company has the right to repurchase sharesissued upon the exercise of unvested options at the exercise price paid by the stockholder should the stockholder leave the Company prior to the scheduled vesting date. At May 31, 1990,271,300 shares of Common Stock outstanding were subject to such repurchase rights. Options to purchase 5,005,720 common shares were vested at May 31,1990.
Non-Plan Options
In addition to the above option plan, nonqualified stock options to purchase a total of 5,712,000 common shares have been granted to employees and directors of the Company. These options weregranted at the fair market value as determined by the Board of Directors, became exercisableimmediately, vest either immediately (for directors) or ratably over a period of up to five years (for individuals other than directors) and generally expire ten years from the date of grant. The Companyhas the right to repurchase shares issued upon the exercise of unvested options at the exercise price paid by the stockholder should the stockholder leave the Company prior to the scheduled vesting date. Options to purchase 160,000 common shares were vested as of May31,1990.
As of May31,1990, the Company had reserved 11,135,194 shares of Common Stock for exercise of options.
Stock Purchase Plan
In October 1987, the Company adopted an Employee Stock Purchase Plan and reserved 8,000,000shares of Common Stock for issuance there under. Under this plan, the Company’s employees may purchase shares of Common Stock at a price per share that is 85% of the lesser of the fair market value as of the beginning or the end of the semi-annual option period. Through May31,1990,2,326,772 shares have been issued and 5,673,228 shares are reserved for future issuances under this plan.
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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Oracle Systems Corporation:
We have audited the accompanying consolidated balance sheets of Oracle Systems Corporation(a Delaware corporation) and subsidiaries as of May31,1990 and 1989 and the related consolidatedstatements of income, stockholders’ equity, and cash flows for each of the three years in the periodended May 31, 1990. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects,the financial position of Oracle Systems Corporation and subsidiaries as of May 31,1990 and 1989 and the results of their operations and their cash flows for each of the three years in the period endedMay 31, 1990, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed under Item I4(a)2. are presented for purposes of complying with the Securities and Exchange Commissions rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of thebasic financial statements and, in our opinion, fairly state in all material respects the financial datarequired to be set forth therein in relation to the basic financial statements taken as a whole.
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EXHIBIT 2
Oracle Systems CorporationReview of Quarterly Results in Fiscal 1989 and 1990(in $000 except per share data)
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Fiscal 1 990 Quarter Ended
Aug. 31
Nov. 30
Feb. 28
May 31
(989
1989
1990
1990
Revenues
$175,490
$209,023
$236,165
$350,166
Net income
11,679
28,491
24,282
52.958
Earnings per share3
$.09
$.21
$.18
$.39
Fiscal 1989
Quarter Ended
Aug. 31
Nov. 30
Feb. 28
May 31
1988
1988
1989
1989
Revenues
$90,639
$123,745
$153,354
$215,935
Net income
7,067
17,189
23,964
33,546
Earnings per share*
$.05
.13
$.18
$.25
“Adjustedto reflect the two-for-one stock splits in the thirdquarter of fiscal 1988 andthe first quarter of fiscal 1990.
EXHIBIT 3
Days’ Receivable for Selected Companies in the SoftwareIndustry for 1989-1990
Company
Borland International Corp. Lotus Development Corp.Microsoft Corp. NovellCorp.
Average
1989
49 64
5185
62
1990
45 645681
62