Article Chosen: http://money.cnn.com/2007/07/19/technology/microsoft/

Articles Referenced: http://www.forbes.com/2007/07/05/msft-xbox-charge-tech-media-cx_rr_0705techmsft.html

http://www.microsoft.com/en-us/news/press/2007/jul07/07-05warrantyextentionpr.aspx

I chose this article for my blog entry because it deals directly with a major issue that Microsoft faced in 2007.  One of the company’s top selling products, the Xbox 360 underwent severe malfunctions which caused frustration and complaint amongst millions of users of the popular game console. The malfunctions also lead to a billion dollar expense for the company during its 2007 fiscal year.

In July 2007, Microsoft announced that it will be incurring a $1.06 expense as a result of several components that make up the Xbox 360 charge. Microsoft initially had hoped to repair many of the defective consoles that were returned to the company by users for repairs, after their initial one year warranty had expired.  The defect on the consoles became known as the “Red Ring of Death” due to a flashing ring on the Xbox console that signaled the malfunction. The damage to the consoles was so severe in most cases that Microsoft was not able to return these consoles to users. They were also not able to repair and resell them. The company had to revalue the defective consoles (for a much lower value than their original) and wrote down this inventory on its balance sheet. The inventory write down of the X-box consoles represented about 35% of the $1.06 billion charge.

The larger component of the Xbox charge was an improvement in Microsoft’s warranty for existing users of the console, as well as for new users. Microsoft’s original warranty for the Xbox console was one year. However, after all of the complaints and malfunctions that occurred, the company extended the warranty to a 3 year policy which included replacement of the consoles. This warranty charge cost Microsoft over $70 million.

During its July 2007 conference call with analysts, Microsoft’s CFO at the time, Chris Liddell alerted investors of the Xbox charge, and also pointed out how earnings and revenue for the fourth fiscal quarter would have looked if the charge didn’t occur. Liddell informed investors that the charge was a one-time only occurrence that was not indicative of the company’s past or future performance. Without the Xbox charge in 2007,  diluted earnings per share for Microsoft would have been $0.39 for the quarter as opposed to $0.31 with the charge. Additionally, operating income for the quarter would have been $5 billion as opposed to $4 billion.

It is definitely wise to investigate the financial and accounting implications that occur when a company undergoes a major, unusual charge. It is also helpful to understand that companies often incur “one-time only” charges that do not indicate their true earning potential. The Xbox Charge in 2007 was  an example of this type of charge.

Articles Used:

http://www.ft.com/intl/cms/s/0/001291ca-fa94-11e2-a7aa-00144feabdc0.html?siteedition=intl&siteedition=intl#axzz2fOkVKFjw

Referenced Material:

 http://www.fasb.org/revenue_recognition.shtml

This past week my group and I presented to our classmates a tutorial on revenue recognition by looking at Priceline.com. I kicked off the discussion by asking the class a question, “Should Priceline report revenues gross (what it sells the ticket, hotel room, etc.…  for), or net (what it keeps after paying the third party)?” The class gazed back at me as if I was Napoleon about to lead them out of a great accounting war with a definitive answer; that mood quickly shifted as I muttered the words, “It depends.” Suddenly I had found myself as a Benedict Arnold, pleading for a chance to explain myself. Similarly Priceline had to defend itself from an SEC inquiry regarding its revenue recognition practices over a decade ago. While better guidelines have and continue to be written since the SEC inquiry, IBM has also found itself in some hot water lately.

This past August the SEC officially opened up another inquiry into revenue recognition – this time at IBM. IBM is interesting because it was always know for its conservatism when booking revenues, usually when shipping the product to a dealer. In a recent article in the Financial Times, reporter Henry Mance mentions that while many companies in the IT space are raging about growing cloud revenues, very few actually report the figures. The debate over how and when these revenues should be recognized has long been an issue for companies. The article goes on to mention how aggressive accounting methods are now being investigated at Autonomy, which was acquired by HP in 2011. The fact that companies have flexibility when it comes to revenue recognition has resulted in the need for a better set of guidelines.

That need is currently being worked on jointly by the FASB and IASB, which intend to have companies conform to the new standards by 2016. The new guidelines will be broad, and will give managers more leeway when deciding what is appropriate for their business. Regardless of the industry, managers will now have to think about the process of how a good or service they are selling is being transferred to the customer and match that with the appropriate amount of revenue. Allowing management a greater amount of flexibility, to me almost seems counterintuitive.

So while we persevered in convincing many of our classmates what Priceline was doing was acceptable, I am not sure we could have made the same argument about the new literature. Giving management more power to decide how revenues should be booked, could lead to greater discrepancies between reality and fact. So while the intent of the new regulations is to make things less ambiguous, in my opinion they are doing just the opposite and will cause more stress amongst managers, and investors. This might not be a bad thing for Priceline though as people will be looking for ways to unwind their anxiety.

Working on the case of priceline.com got me wondering as to whether there was an e-commerce company that had to change its method of revenue recognition from Gross to Net and the impact it had on the financial statements and the reputation of the company.

Enter Groupon.com.

Groupon.com is a website that provides daily discount deals usable at local or national companies. For example, a $100 jacket could be purchased by the consumer for $60 through Groupon. The $60 would then be shared by the retailer and Groupon on the basis of the decided ratio usually 50:50. Groupon followed the gross method of revenue reporting until the company filed for its Initial Public Offering (IPO). This means that the company showed the entire receipt from the customers as its revenue. In this example it reflected $60 as its revenue instead of $30.

However, the Securities and Exchange Commission pressured the company to change how it accounted for its revenue from the gross method to the net method. Analyzing the impact this had on the reported revenues of the company:

The reported revenues of the company fell by more than 50% after the restatement. Another interesting aspect to analyze is the marketing cost to revenue ratio after the restatement.

After restating the revenues using the net method, the marketing cost to total revenue ratio goes up to 90.86%. This means that to earn $100 as revenue the company spent $90.86 as marketing cost. This is basically the amount the company would have to spend on marketing to acquire new customers leaving them with really low margins to recover other costs, let alone earn profits (the company had started focusing on new customers in the year 2010). This represents dim future prospects for the company. Now this ratio becomes extremely evident on reporting the revenues by the net method but that’s not the case when using the gross method as it just comes to 36.89%.

This restatement did raise questions on the management of Groupon just before the opening of its IPO. Yet the IPO was oversubscribed and the stock opened above its IPO price, which was $20. However within a period of 3 weeks, the stock price fell below the price at which the IPO was offered ($16.96 as on November 23, 2011) and as on September 20, 2013 the stock is trading at $12.64. I don’t attribute the fall in the stock price of Groupon to the revenue restatement, however the reported revenue figures post restatement were definitely an indication of the future prospects of the company.

So finally gross or net or a combination of both, I am sure this question will continue to trouble companies and analysts for many more years to come.

Article:

http://online.wsj.com/article/SB10001424053111903791504576589211214409214.html

http://www.businessweek.com/news/2011-09-23/groupon-operating-chief-leaves-as-company-restates-revenue.html

Reference Material:

http://dealbook.nytimes.com/2011/09/23/groupon-changes-its-revenue-accounting/?_r=0

http://www.cfoworld.com/accounting/36127/groupons-material-weakness-restated-revenue-raise-questions-about-both-it-and-ey

http://finance.yahoo.com/q/hp?s=GRPN&a=10&b=4&c=2011&d=10&e=23&f=2011&g=d

http://www.theverge.com/2013/3/1/4043566/andrew-masons-deal-with-the-devil

“Imagine this, if you had invested $10,000 in Priceline on October 9, 2002, and held on through the 2008 decline, you’d have about $1.47 million today.”

“The general course goal is to use accounting information in various economic decision-making contexts.  Financial accounting produces financial statements that primarily serve external decision-makers, such as investors, financial analysts, creditors and government agencies.”

One of the two above quotes is from the article I chose (see link below) and the other is from the course syllabus. The case of whether or not Priceline is reporting their revenues correctly enabled my group and I to dig deep into Priceline’s financial statements while gaining a better understanding of how their accounting principles can influence potential investors. In the case of Priceline, it is evident that understanding accounting principles is an important factor for determining whether or not a company has the potential to generate profits.

The article summarizes how Priceline’s stock initially soared during the dot-com bubble and plummeted during the burst. Like most internet travel companies, the effects of 9/11 took its toll on Priceline and by October 9, 2002, its stock price fell to $6.60; pretty significant since it was trading at nearly $1,000 a share in April of 1999.

Since 2002 Priceline has been steadily turning itself around. They have climbed back from $6.60 a share over ten years ago and recently surpassed $1,000 a share. Many things factored into this turn around, but it could not have been done without people confidently investing in Priceline.

Our presentation discussed if it was correct for Priceline to report their revenue utilizing the “gross” or “net” method and why they would want to use one method instead of the other. Net income will remain the same in both, so why use the “gross” method? For dot-com companies it is important to show significant increases in revenues to express that they are indeed attracting more customers. Utilizing the “gross” method will yield higher numbers and give a clearer picture to potential investors on how much business is actually done through their company; a continuous growth in revenue can help predict future success and profits within their industry. According to the article, the reason Priceline was able to turn itself around was because they did still produce revenues:

“But Priceline had a couple of things most dot comers didn’t have — revenue and a small profit.”

I believe the steady increase in profits and the fact that investors and analysts could see Priceline’s revenues continually growing is what allowed them to invest confidently and ultimately turn the company into the powerhouse that it is today.

Article:

http://www.cbsnews.com/8301-505123_162-57597763/the-rise-and-fall-and-rise-of-priceline.com/

Referenced:

http://www.bloomberg.com/news/2013-09-19/priceline-tops-1-000-on-growing-demand-for-web-bookings.html

http://topics.nytimes.com/top/news/business/companies/pricelinecom-inc/index.html

This week, our group presented on Priceline.com regarding the company’s decision to report revenues as gross and net on its financial statements.   We came to the conclusion that Priceline should continue to report a mix of gross and net, as it has done since inception, as long as it can justify the decisions through the indicators on FASB’s EITF 99-19.  One of the major reasons Priceline and other tech companies reported earnings as gross during their early years was because they wanted potential investors to see the value of their customer base.  Once Priceline reaches sufficient economies of scale in the long term, this becomes less relevant.

Presently, Priceline.com is one of the most expansive companies in the online booking industry.  After its acquisition of the European Booking.com in 2005, its market share and profits increased significantly.  Priceline’s stock price recently hit record highs of over $1,000 per share.  It has been flexing its economic muscle in the past few years and has been catching some flak over a few questionable business tactics.  One practice, common to the big players in the online booking industry, which has been causing a backlash from some hotels and government agencies in Europe recently, is rate parity.  Financial Times has written two articles in the past two months regarding investigations by both the French and British government’s inquiries into this and other anti-competitive practices.

Rate Parity is commonly written into contracts between the online agencies and hotels.  It dictates that hotels only offer their lowest rates on the particular agencies’ portals.  While being listed on the online agency websites such as Priceline and Expedia is vital to the survival of most hotels, signing a contract with rate parity limits the hoteliers ability to give the best price to customers it finds on its own accord.  This catch 22 has caused several French hoteliers to submit a complaint to France’s antitrust regulation agency.  Their goal is not to part from the online booking companies, just to have some negotiating power on their pricing abilities.

The UK’s Office of Fair Trading investigated Priceline and Expedia after a smaller online booking company, Skoosh.com, claimed that their rate parity contract clauses were causing hotels to make Skoosh list higher prices or remove them completely from their website.  Skoosh claimed it lost 30 percent of its hotels in the past few years.  In 2012, the Office of Fair Trading ruled that they had broken the competition law.  Priceline and Expedia agreed to make concessions on the rate parity constrictions, but did not admit to any wrongdoing.

Article

http://online.wsj.com/article/SB10001424127887323342404579079402009561162.html

http://www.ft.com/intl/cms/s/0/a79e9384-00c1-11e3-8918-00144feab7de.html

Article:

http://online.wsj.com/article/SB10001424127887323420604578652484201833550.html#articleTabs_comments

This article provided insights into Virgin America’s performance and financial results of the second quarter of 2013. The newly released income statement showed that Virgin America made a net income of $8.8 million in that quarter. This was an exciting news for the company because this is the only second profitable quarter since its 6 years (24 quarters) operation.  The article led us to take a closer look at the Income Statement to see where this black number on the net income came from.

Link to the Second Quarter of 2013 Financial Result :

http://www.virginamerica.com/press-release/2013/virgin-america-reports-second-quarter-2013-financial-results.html

As we can see, Virgin America operating revenue was $376 million, an increase of 8 percent from the second quarter of 2012. At the same time, it reduced its operating expenses for 1 percent from 351 million to 348 million. As a result, the operating income was revised to a positive 27 million from negative 4 million.

We can learn from the article that Virgin America has put many efforts, such as adding new route on profitable market, relocating capacity from existing markets, and increasing capacity of each airplane,  to increase the operating revenue. On the other hand, comparing to the same period of last year, Virgin Airline operated 5% more flights while the cost of fuel dropped by 6%,  thanks to the decrease in the fuel price. Meanwhile, Virgin America slowed down its growth rate and suspended buying more airplanes to until 2015 to reduce the operating expense. This strategy helped the company to improve the operating  income.   Considering Virgin America already has hundreds of millions of losses  (Accumulated Deficit) since it started in 2006,  it is crucial for the company to improve its financial performance. Otherwise, it may be dangerous for both the creditors and the shareholders.

Virgin America has a $800 million of debt,  thus the account “Other expense” had included interest expense of $30 million per quarter.  In this May, Virgin Airline reduced the interest obligation by restructuring its debt. It converted $290 million of the debt (one third of the total) into equity  to the investors once the company goes public.   As a result, the company reduced “Other expense” from 27 million to 19 million, a 31% decrease.  And in the end, this all added up to a 8.8 million net income compared to a year-ago loss of $31.8 million.

By walking through this article and Virgin America’s income statement, we can have a deeper understand about the airline industry and where the net income comes from. As we have learnt from the Northwest Case, Flight Equipments usually are the most expensive assets of the airline company. During the past years, Virgin Airlines expanded quickly by purchasing many airplanes (now it has a fleet of 53). However, this fast growth rate incurred large operating expense  and a huge debt. In order to improve the financial performance, Virgin Airline began  to control its growth rate while improving the profitability.  At the same time, it also reduced its financial expense through debt restructuring.  We think Virgin Airline is doing the right thing – airline company shall pay close attention to its financial situation while planning its business strategy. Business growth is good only if the company survives.

In addition, only good financial result can attract investors to fuel the company. In Virgin America’s case, if it wants an IPO, one single profitable quarter is not enough, it has to produce consistent good performance.

Other resources:

http://www.bloomberg.com/news/2012-11-16/virgin-america-trims-flights-labor-cost-on-slower-winter.html

http://www.cntraveler.com/daily-traveler/2013/07/virgin-america-airline-not-seeing-profit

The Article Used:

http://www.usnews.com/news/blogs/rick-newman/2013/02/14/how-airline-mergers-saved-an-industryand-may-even-benefit-fliers

Article Referenced:

http://freakonomics.com/2011/06/24/why-do-airlines-always-lose-money-hint-its-not-due-to-taxes-or-fuel-costs/

Yeah it happened again, another airline declared bankruptcy but this time it was American Airlines and not Northwest Airlines. This time the bankruptcy wasn’t precipitated by some kind of cataclysmic event. This time was the seventh time it happened in the airline industry since 2000. This time, the proposed solution to the problem was once again a merger. I took a closer look to see why the airline industry was such loser and why mergers were so common.

Did you know that at the end of 2009 the book value of domestic carrier assets totaled $169 billion and the book value of shareholders equity totaled only $10 billion? Yeah… me either. This is bad.

To put this in perspective a little bit, lets apply what we’ve learned thus far in our Financial Reporting class; If Assets = Liabilities + Shareholder Equity this would mean that the domestic carriers collectively have a $159 billion of liabilities on their books.  From this we can further deduce that a disproportionate amount of the industries assets have been financed through debt. With just one more leap of faith we can get closer to the heart of the issue; assuming that most of that debt carries interest and most of those assets (airplanes and equipment) are depreciating we can now begin to see the picture a bit clearer but we are still missing one key ingredient.

Did you know that from 1979 to 2009 the airline industry lost a whopping $59 billion dollars? No, I didn’t either, but now I am beginning to understand why bankruptcies and consolidations have been such a staple of the industry. If you are loaded with debt and your assets are not making money ten out of ten times the creditors are going to be coming after your assets. This makes sense right? Now let’s consider why the consolidation makes business sense as well.

On the operating income is a function of two things: revenue and expenses. Both of these factors play an equally important role in determining the ability of a company to sustain in a competitive market place. Unlike many other industries, the airline industry is a slave to price. When price becomes the leading differentiator, the game changes from of who can create the best product to who can be best at reducing cost. To compound this problem, the airlines operate in a space where their greatest cost is largely uncontrollable (oil). So now they are forced to not only compete among themselves, but with a slew of new low cost carriers, who are more lean, nimble, and  better prepared to operate under this framework.

So what do you do when you are bleeding cash, you are being priced out on your best routes, are overextended and competing with other companies who are also overextended, in markets that don’t have enough demand to satisfy the supply? You consolidate and reduce competition, because competition is an implicit cost of participation and by joining you are not only improving synergies but also winning on the reduced price competition.

While I can certainly understand the anti-trust concern of the DOJ in their decision to file a law suit to stop the American Airline and U.S. Airway merger I don’t necessarily agree with it. In their current form, I can’t see how American Airlines can continue to operate without paring down their operation. And if they are forced to exit markets, wouldn’t their absence in those markets be just as detrimental to those consumers? I guess only time will tell.

Article 1

Summary:

The Justice Department unexpectedly moved to block the merger of American Airlines parent AMR Corp. and US Airways Group Inc., threatening to upend what was viewed as the final step in the consolidation that has helped return U.S. airlines to profit after years of heavy losses.

Citation:

Carey, S., Kendall, B., & Nicas, J. (2013, Aug 13). U.S. moves to block US airways-american airlines merger; antitrust regulators say deal would hurt consumers. Wall Street Journal (Online). Retrieved from http://search.proquest.com/docview/1419793400?accountid=8500

Link: http://search.proquest.com.remote.baruch.cuny.edu/docview/1419793400/fulltext/1407F0241325E6D1616/1?accountid=8500

Article 2

Summary:

NEW YORK–A federal judge on Thursday confirmed AMR Corp.’s plan to exit bankruptcy-court protection through a merger with US Airways Group Inc., leaving a U.S. antitrust lawsuit as the deal’s final, if formidable, barrier.

Citation:

Checkler, J. (2013, Sep 12). Bankruptcy judge gives nod to AMR-US airways merger; deal still faces justice department’s antitrust lawsuit. Wall Street Journal (Online). Retrieved from http://search.proquest.com/docview/1432028014?accountid=8500

Link: http://search.proquest.com.remote.baruch.cuny.edu/docview/1432028014/1407E227038105D9A63/7?accountid=8500

The reason I chose this article is because it falls in the same industry as the one in our presentation (Northwest Airlines) and is related quite a bit to our case.

Background:

AMR Corporation, the parent company of American Airlines is in the same situation as many of its competitors were at different point of times. It struggled with higher wages, fuel and pension costs because of which they eventually filed for Bankruptcy protection under Chapter 11 in November 2011. The company posted a mammoth loss of $1,979[1] million for the year ended 2011, majorly effected by a combined expense of $15,357 million of Wages and Fuel Costs (roughly 64% of the revenues). American Airlines was not the only airline facing difficulties related to their pensions — United, Delta Air Lines Inc. and US Airways Group Inc all left their pensions in recent years when filing for bankruptcy, costing more than $11 billion.[2] On filing for bankruptcy, AMR would no longer have its defined benefit pension plan, helping absorb nearly $7 billion in debt.[3]

Over the past 2 years it has maintained normal operations even after the bankruptcy filing. It took advantage of Chapter 11 and cut major costs relating to pension and other expenses. Throughout 2012, it negotiated with various unions after which it expects to reduce approximately 10,500 positions in the near future; thereby saving a lot of labor costs. Another form of cost saving they adopted was that they resorted to fuel hedging agreements in order to reduce the hit taken by it due to fuel price fluctuations.

Current status:

The Company recorded a consolidated net income of $220 million in the second quarter of 2013 compared to a net loss of $241 million in the same period last year. The Company’s consolidated net income reflects $124 million of charges to reorganization items. On June 30, 2013, the Company had $6.2 billion in unrestricted cash and short-term investments[4]

The company announced its merger with US Airways in February 2013. All was going well with the plan till the US Department of Justice recently decided to oppose and filed a lawsuit to block the merger. The company was making profits, it had cut costs, had filed a bankruptcy-exit plan with the bankruptcy court. The approval of the plan would enable both parties to close the merger deal by the 3^rd quarter of 2013 as planned. This exit plan even had the support of the creditors and unions.

• The contention of the antitrust regulators as mentioned in the lawsuit is that the merger would leave 4 airlines controlling more than 80% of the U.S. market which would not bode well for the passengers. It would mean higher airfares, higher fees and fewer choices.
• The airlines contend the combination would reduce costs, give fliers more choices and serve as a counter-weight to merger-enlarged rivals, United Continental Holdings Inc. and Delta Air Lines Inc.
• Investors are worried that if the merger does not go through, the company would face the risk of a return to bankruptcy.

As per the existing plan, AMR creditors and bondholders were to be repaid in full, with interest, and existing shareholders were to receive at least 3.5% ownership stake in the new airline. Such large recoveries are rarities in Chapter 11 cases. The merger would give 72% of the combined airline to AMR shareholders, unsecured creditors, labor unions and some employees. US Airways’ shareholders would get the rest.

On September 12, 2013, a federal judge approved the exit plan submitted by AMR Corp., subject to the outcome of the antitrust lawsuit. The financial implications of the deal either ways would be huge for the entire industry. If the deal does go through, the industry would return to being profitable after a long period of time. The result could also be that the apprehensions of the antitrust regulators come true and the passengers may suffer. On the other hand, if the deal does not go through, AMR Corp. might be facing a return to bankruptcy. The company would have to prepare a new reorganization and exit plan to emerge from court protection as an independent company, revise its financial projections and renegotiate with creditors and bondholders and unions – all of which would take considerable time and could prove to be an expensive process.

Article:

http://abclocal.go.com/wpvi/story?section=news/business&id=5319513

I chose this article because the question why NWA went bankrupt was not raised or mentioned in the presentation.  We can also see in this article how the process of merging with Delta started.

The company went bankrupt, essentially because of rising fuel costs, which was different from the crisis of 09/11, since it was based on increasing costs, not on demand losses. After 9/11 the government acted quickly and injected $10 billion in the airline market, providing loans to cover losses.

This plan was cited in our presentation and generally called the Air Stabilization Act, reducing the company’s losses by $249 million, caused by the 2001 crisis; we can affirm this based on information provided in NWA’s financial statements.

But the 2005 crisis was slightly different, namely a cost crisis. This time the government didn’t offer any financial support to companies that were already facing financial issues since 2001.

The reason of the airline fuel crises can be based on several reasons such as, structure supply industry capacity (supply times demand), Hurricane Katrina that hit several refineries, as well as international events that happened in previous years. We cite here the Ukraine-Russia gas crisis as well since the invasion of Iraq by the US contributed to the rising oil prices. While the Airline Stabilization Act helped the industry in the short term, it was part of the reason fuel costs increased down the road because demand increased.

As we can see in the article NWA emerged from bankruptcy some 20 months after it defaulted. Here we can see that the company was not facing operational problems, the majority of its problems were financial, which they reduced by $4.2 billion.

In 2008, a new cost crisis showed the market, this time the best solution was for companies to combine their operations to face the challenges and gain from operational synergies.

Additional sources:

http://usatoday30.usatoday.com/travel/flights/2005-08-10-gas-shortages_x.htm

http://money.cnn.com/2005/09/14/news/fortune500/bankruptcy_airlines/

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