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CASE 2-1 Revenue and Expense RecognitionOrthodontic Centers of America

CASE OBJECTIVES
The objective of this case is to evaluate the revenue and expense recognition methods used by the company.

INTRODUCTION
The following information was extracted from the 1999 and 2000 annual reports of Orthodontic Centers of America [OCA]. The company provides practice management services to orthodontic practices in the United States. OCA acquires and develops orthodontic centers and manages the business operations and marketing aspects of afliated orthodontic practices. At December 31, 2000, there were 592 orthodontic centers, of which the company developed 306 and acquired 361 (75 were consolidated into another center). The afliated orthodontists control the orthodontic practices, determine which personnel, including orthodontic assistants, to hire or terminate, and set their own standards of practice in order to promote quality orthodontic care. A typical patient receives an initial consultation and preliminary procedures (teeth impressions, x-rays, and the placing of spacers between the teeth for braces) in advance of the next appointment. The patient signs a contract for treatment in the event the orthodontist recommends orthodontic treatment. Generally, braces are applied two weeks later and subsequent adjustments to the braces are made every four to eight weeks. The contract species the terms and the length of the treatment as well as the total fees. The average contract length is 26 months. No initial down payment is required; the patient makes equal monthly payments followed by a nal payment on completion of the treatment. OCA provides the following services to its afliates: 1. Stafng 2. Supplies and inventory 3. Computer and management information services 4. Scheduling, billing, and accounting services An unrelated nancial institution nances operating losses and capital improvements for newly developed orthodontic centers; OCA guarantees the related debt.

1999 REVENUE RECOGNITION


The Company earns its revenue from long-term service or consulting agreements with afliated orthodontists. Through December 31, 1999 OCA recognized monthly fees equal to approximately: 24% of the aggregate amount of all new patient contracts entered into during that particular month, plus The balance of contract amounts allocated equally over the remaining term of the contract. Gross amounts are reduced by the portion of contract amounts expected to be retained by the orthodontist. OCA recognizes operating expenses as incurred. Required: 1. OCA believes that at least 24% of its services relate to the rst month of the patient contracts. Given the services provide by OCA and the terms of the service and consulting agreements: Evaluate the revenue recognition method used by OCA. Propose and justify a more appropriate revenue recognition method.

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2. Estimate OCAs average contract balance for new patients in 1999, using the operating data in Exhibit 2C-1. 3. Estimate the rst year revenue that OCA recognizes from a new patient contract, assuming that OCAs share of the contract amount is $3,000, the contract length is 26 months, and the contract is signed on (i) January 1 of the rst year (ii) July 1 of the rst year (iii) December 1 of the rst year 4. Estimate the second year revenue that OCA recognizes from a new patient contract, under the same assumptions as Question 3, for each of the three signing dates. 5. Explain why, using your answers to Questions 3 and 4, OCA must expand its operations rapidly to maintain revenue growth. 2000 Revenue Recognition Effective January 1, 2000, OCA changed its revenue recognition method citing SEC Staff Accounting Bulletin No. 101 (see page 45 of text). OCA now recognizes net revenue using a straight-line allocation of patient contract revenue over the duration of the patient contract (typically 26 months). The company reported that
The cumulative effect of this accounting change, calculated as of January 1, 2000, was $50.6 million, net of income tax benet of $30.6 million. The effect of this accounting change in 2000 was to reduce revenue by $26.3 million. In 2000, the Company recognized revenue of $57.3 million that was included in the cumulative effect adjustment.1

The company also reported the pro forma effect of the accounting change on net income, assuming it had been in effect in prior years. Results for those years were not, however, restated. Exhibit 2C-1 contains operating and income statement data for OCA for the years 1997 through 2000. The exhibit also shows reported balance sheet data for 1998 through 2000, and restated data for 1999 (see Question 15). Use the exhibit to answer the questions that follow. Required: 6. Redo Questions 3 and 4, using the revenue recognition method that OCA adopted in 2000. 7. Compare the rst and second year revenue recognized under the 2000 and 1999 methods. Note: use an average of the three signing assumptions. 8. The accounting change had two effects on year 2000 revenue: Revenue recognized from new patients was reduced. Revenue from patients signed in prior years, included in the cumulative effect adjustment, was recognized in 2000. (i) From the companys disclosure of the effect of the accounting change, compute each of these effects. (ii) Use your answer to Question 7 to estimate the second of these effects. 9. Compute OCAs 2000 revenue and net income assuming that it had not changed its revenue recognition policy. 10. Explain why OCAs revenue recognition policy has a disproportionate effect on net income. 11. Discuss the effect of the accounting change on your answer to Question 5. 12. Compute the annual percent changes in each of the following statistics for 1997 to 2000, and discuss their trend and their implications for future revenue growth: Number of orthodontic centers Total case starts Number of patients under treatment 13. Describe the effect of the accounting change on OCAs receivables.

Source: footnote 2 to 2000 nancial statements.

1999 REVENUE RECOGNITION

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EXHIBIT 2C-1. ORTHODONTIC CENTERS OF AMERICA Reported Operating and Financial Data Years Ended December 31 Operating Data Number of orthodontic centers Total case starts Number of patients under treatment New patient contract balances ($ millions) Income Statement (Amounts in $ Thousands, Except Per Share Data) Net revenue Operating expense Operating prot Net interest income (expense) Pretax income Income tax expense Net income*
*Before cumulative effect of accounting changes

1997 360 70,611 130,000

1998 469 95,377 195,000

1999 537 126,307 267,965 $ 369.1

2000 592 160,639 343,373 $ 494.1

Years Ended December 31 1997 $117,326 $(81,368) $ 35,958 $331,143 $ 37,101 $ (14,469) $ 22,632 1998 $171,298 (117,012) $ 54,286 $444,280 $ 54,566 $ (20,753) $ 33,813 1999 $226,290 (149,366) $ 76,924 $1 (2,204) $ 74,720 $ (28,206) $ 46,514 2000 $268,836 (188,834) $80,002 $8 (3,731) $ 76,271 $ (28,549) $ 47,722

Diluted earnings per share Provision for bad debt expense Pro Forma for 2000 Accounting Change Net income Diluted earnings per share Balance Sheet Data (Amounts in $ Thousands) Patient receivables1 Unbilled patient receivables2 Service fees receivable3 Total assets Patient prepayments Deferred revenue Total debt Total liabilities Stockholders equity
1 2

$ $

0.50 1,851

$ $

0.70 2,295

$ $

0.96 2,079

$ $

0.96 373

$ 12,013 $ 0.26

$ 22,276 $ 0.46

$ 32,326 $ 0.66

n/a n/a

December 31 1998 Reported $ 20,163 46,314 296,798 4,326 20,055 65,639 231,159 $ 25,976 65,793 367,022 4,206 50,632 88,495 278,527 $ 87,563 362,816 50,632 84,289 278,527 $ 35,350 367,947 2,516 58,575 80,751 287,196 1999 Restated 2000

Net of allowance for uncollectibles of $5,356 in 1998 and $6,403 in 1999 Net of allowance for uncollectibles of $2,209 in 1998 and $3,241 in 1999 3 Net of allowance for uncollectibles of $9,644 in 1999 and $2,598 in 2000

14. Compute each of the following statistics for 1997 to 2000. Discuss their trend, their impact on reported income, and their implications for future revenue and income growth. Discuss the effect of the accounting change on the 2000 statistics. (i) Revenue, expense, and operating prot per patient under contract (ii) Revenue, expense, and operating prot per center 15. In 2000, OCA restated its 1999 balance sheet to aggregate billed and unbilled patient receivables (as service fee receivables). It also reduced that amount by patient prepayments,

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previously shown as a current liability. Compute the ratio of the allowance for uncollectible amounts to gross receivables for: Billed and unbilled patient receivables for 1998 and 1999 Service fees receivable for 1999 (restated) and 2000. (i) Discuss whether the differences between the ratios for billed and unbilled receivables accord with the nature of the receivables. (ii) Discuss the trend in the allowance ratios over the 1998 to 2000 period. (iii) Explain why the aggregation is a loss of information useful for nancial analysis. 16. Compare the trend of earnings per share for 1997 to 2000 using the pro forma data with the trend as originally reported. Explain which time series better represents the operating results over that time period. 17. Discuss two reasons why the time series that is your answer to question 16 may not be a reliable basis for forecasting future results.

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