Bausch & Lomb, Inc (B&L) – a New-York based leading manufacturer of optical and health care products – changed its distribution and sales strategy at the end of 1993. The new strategy placed a significant amount of conventional contact lens inventories in the hands of distributors. As such, B&L sold and delivered directly to large retail customers whilst using the help of distributors to service its many smaller retail customers. In other words, the entire conventional lens sales and servicing for the company were handled by distributors. This translated that BBL regarded the product shipments linked with the new strategy as revenues. From the face value the new strategy proved straightforward and caused relatively little confusion. At that stage, however, it was unclear if the new strategy would serve to free up resources and provide a chance to focus on new items, how the larger retail clients would react to the need to do business with distributors on that single item, and whether the distributors themselves had the necessary operational knowledge together with business acumen to effectively manage the rather large block of inventory.
Shortly thereafter, the optical market experienced an unprecedented downward surge forcing the company to recall almost its entire distributor inventory despite no such formal right of return having been agreed upon initially. In this regard, distributors were made to take in huge inventories in the then negative optical market. The excess inventory had to be returned to Bausch without terms to that effect, something that triggered a public scandal for the company. A couple of years later, B&L made a public revelation that the U.S. Securities and Exchange Commission had launched an inquiry into its accounting practices. The inquiry was inspired by a number of aspects such as the manner in which B&L recognized revenues relating to its unsuccessful strategy.
Materiality and Audit
In 1993, B&L posted net sales of approximately $22 million higher following the adoption of the new distribution and sales strategy. Furthermore, the company’s ratio of cost of goods sold to its net sales was 45%. The company thus deducted an allowance for bad debts from sales evidenced by the fact that it reported only its net sales (Simons et al, 1999). Assuming that there was non-payment for a certain percentage of all sales, there would be need to create a contra asset account falling under accounts receivable which would be offset by a similar reduction in revenues.
In the same year, B&L’s ratio of SG&A expenses to net sales was recorded as 33%. This is the figure used to allocate SG&A expenditures to the new sales strategy. The materiality of this figure may vary among interpreters. The general consensus is that the an aspect is material if it holds the ability to change the perspective of a relatively informed user of the company’s financial statements such as equity holders, debt holders, board members as well as the employees. On the one hand, some interpreters would compare the $22 million to $1.8 billion of sales and find it immaterial (Simons et al, 1999). On the other hand, however, other interpreters the impact of the $12.1 to the $156.6 in net income, as well as the impact on trends in the company’s earning and find it significantly material. Generally, materiality depends on the question at hand, making management to strive to expect all the different ways that the information will be utilized prior to determining its materiality.
A key area of debate is whether B&L transaction qualified to be regarded as revenue in its 1993 financial statements. Supporters of B&L accounting choice point to the common practice among companies to acclaim revenues at the point of product shipment in addition to B%L’s lack of formal return policy. Further, the new sales strategy is defended on the fact that it did not entail venturing into a different geographic area or line of business. This would rule out the issue of realizability because of no evidence of B&L’s problems of paying the distributors. Given that conventional lenses still claimed the bulk of the 1993 U.S. contact lens market, B&L distributors should have gained more business increasing their profitability of paying for the inventories compared to before. More knowledgeable sympathizers defend B&L’s decision by pointing to the ability of companies to engage in factoring – selling accounts receivable for cash. Factoring affords a company the ability to satisfy rather stringent realizability procedure for recognizing revenue (Simons et al, 1999).
However, opponents argue the significant increase in the supplier inventories which would result in insolvency. Opponents further hold that B&L was obliged to offer significant sales and marketing support to maintain the viability of the brand though revenue was recognized at the point of product shipment. Other critics would argue that B&L was unjustified in recognizing revenues in light of the concerns over realizability claim arguing that the sudden year-end timing of the new sales strategy was highly suspicious. In addition, the strategy can be termed as very aggressive considering the declining percentage of U.S. soft contact lens customers using the conventional lenses during the period of 1992-93 (Simons et al, 1999). Given the previous good record in performance, it can be further argued that B&L adopted the new sales strategy in the effort to maintain the positive show. While these critics would agree on the strategic significance of the timing of the strategy, it is argued the timing issues alone would not impact the ultimate settlement of the amounts owed. The feeling is that a disclosure of the change is sales policy along with its impact on the company’s sales would be sufficient.
The role of the Securities and Exchange Commission (SEC) as an enforcement agency was evident in this case. It was held that B&L violated SEC Rule 10b-5, which considers unlawful to commit fraud; to make an untrue statement of any material fact or to leave out a material fact of the statement; or to engage in any practice, act, or business practice that would be fraudulent or deceitful to any person. SEC found that B&L’s division controller and director of distributor sales had concluded in fraud by signing side agreements allowing return of products, renting their warehouse space distributors for the excess inventory, and entering post-1993 shipments in the 1993 financial results (Simons et al, 1999). SEC reached a decision that top management was accountable for poor oversight because they were not aware of the fraudulent actions. SEC did not challenge the top management’s decision to recognize revenue and censured the CEO for poor oversight and control environment though he was absolved of fraud. SEC imposed charges on B&L of approximately $13 million though did not demand the company to admit wrongdoing.
Exit of all B&L executives
The SEC probe had a significant impact to the top management of B&L. The president of the Contact Lens Division (CLD), the CLD controller and vice-president of finance, and the director of distributor sales of the CLD agreed to a cease-and-desist order. Further, there was a release and issuance of an injunction against the company’s former regional sales director of the CLD.
Conclusion
The Bausch and Lomb case is a good case that teaches the management of their top responsibility in the decisions of a company. It reminds them to put in place all requisite internal controls and be functional to ensure all transaction accounting are not only transparent but also truly reflective of the situation of the company at the given time.