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Case 2-1 - Solution

Estimated time to complete this case is two hours.


1.

In a typical contract, the patient receives an initial


consultation and preliminary procedures (teeth impressions,
x-rays, and the placing of spacers between the teeth for
braces). Generally, braces are applied two weeks later and
subsequent adjustments to the braces are made every four to
eight weeks.
Because the orthodontists provide orthodontic services,
most, if not all, of the initial services are provided by
the orthodontist rather than OCA. The company is responsible
for business operations and marketing; OCA states that
revenue is earned from long-term service or consulting
agreements with the orthodontists. OCA provides staffing,
supplies and inventory, computer and management information
services, and scheduling, billing, and accounting services.
It is not clear why any of these services would be clustered
upfront to the extent necessary to justify recognition of
24% of the revenues during the first month of patient
contracts.
To the extent that OCA supplies equipment, supplies, and
administrative
support
needed
for
teeth
impressions,
spacers, and x-rays, the company may be able to justify the
recognition of more revenue in the first month of the
contract. However, recognition of 24% appears excessive and
not supported by the description of the typical arrangement
provided in the financial reports.
The services provided by OCA appear to be those needed
throughout the contract with the patient. Absent any
compelling argument regarding the amount and timing of their
delivery, OCA should recognize revenue on a straight-line
basis as time passes.

2.

The company reported $369.1 million in initial new patient


contract balances and it initiated 126,307 treatments for an
average
new
treatment
balance
of
$2,922.25
($369.1
million/126,307).

2C-1

3. and 4.Revenue per contract


Assumptions: initial contract balance
average length of contract (months)
3. Revenue recognized
Initial month (24% of $3,000)
Each remaining month [($3,000 - $720)/25]
First year revenue assuming contract
(i) Signed January 1 [720 + (11 x $91.20)]
(ii) Signed July 1 [720 + (5 x $91.20)]
(iii)Signed December 1
Average of three cases

$3,000.00
26
$

720.00
91.20

$1,723.20
1,176.00
720.00
1,206.40

4. Second year revenue (all cases) (12 x $91.20)


1,094.40
% change from first year revenue assuming contract
Signed January 1 of 1st year
-36%
Signed July 1 of 1st year
- 7%
Signed December 1 of 1st year
52%
Average of three cases
- 9%
Note: we have computed the average for all three cases as these
data are needed in question 7.

5.

The calculations for questions 3 and 4 show that when


patients are signed during the first half of the year or
evenly throughout the year (average of all cases), OCAs
revenue per contract declines in the second year. Thus, to
report revenue growth, the company needs to continuously add
more patients and/or centers (by starting new centers or
purchasing existing orthodontic practices).

2C-2

6. and 7. Revenue per contract after accounting change

6.

7.

8.

Assumptions: initial contract balance


average length of contract (months)
Revenue recognized
Initial month
Each remaining month
First year revenue assuming contract
(i) Signed January 1 (12 x $115.38)
(ii) Signed July 1 (6 x $115.38)
(iii)Signed December 1
Average of three cases
Second year revenue (all cases)
% change from first year revenue assuming contract
Signed January 1 of 1st year
Signed July 1 of 1st year
Signed December 1 of 1st year
Average of three cases

(i)

3,000
26
2000
115.38
115.38

$1,384.62
692.31
115.38
730.77
1,384.62
0%
100%
1,100%
89%

The company reported that 2000 revenues were reduced by


$26.3 million although the company recognized revenue
of $57.3 million that was included in the cumulative
effect adjustment. Thus,
1.
The
accounting
change
reduced
2000
revenue
recognized from new patients by $83.6 million
($57.3 + $26.3).
2.
Revenue of $57.3 million was recognized in 2000
from patients signed in prior years (as stated).

2C-3

(ii) To estimate the second effect, we must estimate the


revenue effects in the second and third year of patient
contracts. Comparing the second year revenues under
both accounting methods estimated in questions 4 and 6:
Revenue recognition method
Second year revenue (all cases)
Difference

Pre-2000
2000
$1,094.40 $1,384.62
290.22

We must make a similar calculation for third year


revenue:
Revenue recognition method
Pre-2000
2000
Third year revenue
Signed January 1 of 1st year1
$ 182.40 $ 230.77
2
Signed July 1 of 1st year
729.60
923.08
Signed December 1 of 1st year3
1,094.40 1,384.62
Average of three cases
$668.80
$846.15
Difference
177.35
1
2
3

Two months at $91.20 and $115.38 respectively


Eight months at $91.20 and $115.38 respectively
Twelve months at $91.20 and $115.38 respectively

The amount of prior year revenue recognized in 2000 is


equal to the sum of the third year effect on 1998 net
patients and the second year effect on 1999 patients
(amounts in $thousands):
New patients
1998
1999
Total
Number of new patients
95,377
126,307
1
Second year effect
$36,656.23
Third year effect2
$16,915.48
Total effect
$16,915.48 $36,656.23 $53,571.71
Percentage error
6.5%
1
2

126,307 X 290.22
95,377 X 177.35

The estimated total effect differs by 6.5% from the


$57.3 amount provided by the company. The difference
most likely relates to the timing of new contracts.

2C-4

9.
Income Statement
Amounts in $ thousands
Net revenue (actual + $26,300
Net income (actual + $16,569)

Pro forma 2000


Amount % Change
$ 295,136
64,291

30%
38%

OCA reported that the accounting change reduced reported


revenue by $26.3 million in 2000 (net of the effect of prior
year amounts). Applying a 37% tax rate to that amount
produces an estimated effect on net income of $16,569.
Adding these amounts to reported 2000 data results in the
pro forma data in the table above.
Therefore, if OCA had made no accounting change, reported
revenues and net income would have increased by 30% and 38%
respectively from the amounts originally reported for 1999.
These increases are similar to the percentage increases
originally reported for 1999 (compared with 1998) but below
the increases in the pro forma net income assuming the
accounting change. The change in revenue recognition policy
effectively shifted prior year growth into the year 2000.
10. OCAs revenue recognition policy has a disproportionate
effect on net income because its 1999 revenue recognition
method permitted it to recognize revenues earlier and faster
than expenses that occurred evenly throughout the year.
10.

OCAs revenue recognition policy has a disproportionate


effect on net income because its 1999 revenue recognition
method permitted it to recognize revenues earlier and faster
than expenses that occurred evenly throughout the year.

11.

The accounting change results in revenue being recognized


evenly over the life of the contract. Consequently, new
patients (case starts) have less of an immediate effect on
revenue growth. As a result there is less short-term
pressure to add new patients. Longer-term, however, revenue
growth will continue to depend on new patients, whether
acquired at existing centers or from newly established or
acquired centers.

2C-5

12.
Years ended December 31
Operating Data
Number of orthodontic centers
Total case starts
Number of patients under treatment

1997

1998

1999

2000

360

469

30%

537

14%

592

10%

70,611

95,377

35%

126,307

32%

160,639

27%

130,000

195,000

50%

267,965

37%

343,373

28%

All three operating criteria show marked declines in growth


rates over the 1997 to 2000 period. These declines forecast
declines in OCAs revenue and income growth rates Income
will still grow but at a slower pace. The company may face
limits on its ability to expand because of competition or
the lack of orthodontic centers with adequate number of
patients needed to be profitable. It is also possible that
generating a sufficient number of incremental case starts
may be costly.
13.

The accounting change should decrease OCAs accounts


receivable because revenue is now recognized evenly over the
life of the contract; previously 24% of the fee was
recognized upfront. Note that there is no change in the
timing of actual payments as the contracts have not been
changed. However, expected payments are recognized later in
the operating cycle, thereby reducing receivables.

14.
($thousands)
Years ended December 31
Per patient under
contract
1997 1998 %
1999 % 2000
Revenue
$903 $878 - 3% $844 -4% $783
Expense
626
600 - 4%
557 -7% 550
Operating profit
277
278
1%
287
3% 233
Per center
Revenue
326
365
12%
421 15% 454
Expense
226
249
10%
278 11% 319
Operating profit
100
116
16%
143 24% 135

%
- 7%
- 1%
-19%
8%
15%
- 6%

Trends in Per Patient Profitability


Revenues per patient declined over the 1997 to 2000 period
with the most significant decline occurring in 2000. The
1998 and 1999 declines may have resulted from OCA entering
into lower income areas where it could not charge as much or
its clinics facing competition, keeping prices lower.
However, the greater 2000 decline was largely due to the
change in revenue recognition method.
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Expenses per patient declined 7% in 1999 compared to 4% in


1998. The decline is most likely due to economies of scale
as more centers and more patients are added, OCA reaps those
benefits. However, in 2000, the declining growth rate in
number of centers and new cases appears to have caught up
with OCA as expenses per patient declined only 1%.
The 1998 and 1999 changes in revenues and expenses explain
the trend in operating income for those years. However, the
decline in revenue per patient, the change in accounting
method and the falloff in expenses per patient all combined
to result in a 19% decline in operating profit in 2000.
Trends in Profitability per Center
The 1998 and 1999 increases in revenues per center likely
reflect increases in the number of new cases per center,
given that 24% of new contract revenue was recognized in the
first month). Note that the growth rate of revenue per
center was below the growth rate of patient under treatment
per center. This may reflect lower pricing. The 2000 decline
in revenues per center mainly reflects the impact of the
change in the revenue recognition method.
Expenses per center rose each year with the greatest
percentage increase in 2000. The increase reflects the
higher costs incurred at the beginning, higher amortization
costs from acquisitions, and higher cost of newer purchases.
Note that expense per center grew more slowly than patients
under treatment per center from 1997 to 1999, but almost as
rapidly in 2000.
Although operating profits per center rose in 1998 and 1999
(as high upfront revenue recognition resulted in faster
growth in per center revenue than expense), the 2000 decline
in per center revenue (due in large part to the accounting
change) and increase in expense reduced operating profit per
center.

2C-7

15.
1998
Amounts in $thousands
Gross patient receivables:

$25,519

1999
Reporte Restate
d
d
$32,379

Allowance for uncollectibles


Net patient receivables
Allowance as % of gross receivables

(5,356)
$20,163
21.0%

(6,403)
$25,976
19.8%

Gross unbilled patient receivables:

$48,523

$69,034

Allowance for uncollectibles


Net unbilled patient receivables

(2,209)
$46,314

(3,241)
$65,793

4.6%

4.7%

Allowance as % of gross receivables


Gross service fee receivables

$97,207
(9,644
)
$87,563
9.9%

Allowance for uncollectibles


Net service fee receivables
Allowance as % of gross receivables

(i)

2000

$37,948
(2,598)
$35,350
6.8%

The allowance for billed versus unbilled receivables


suggests that patients are less likely to pay for
treatment
already
received
than
for
future
treatments.
The
higher
allowance
for
billed
receivables appears illogical as we would expect that
some proportion of patients do not return for
treatment after the initial consultation despite
signing a contract. On the other hand, many patients
may pay as they visit and the billed receivables may
be those with significant collection problems. It is
also
possible
that
the
reserve
for
unbilled
receivables is too low. Discussion with management
would be required to resolve these questions.

2C-8

(ii)

OCA lowered the allowance for billed receivables in


1999 relative to 1998, while raising it slightly for
unbilled receivables. Absent disclosures about writeoffs, it is difficult to evaluate the change.
However, the larger decrease in the allowance for
billed receivables helped the company report higher
net revenues and gross margins. The decrease in the
2000 ratio is difficult to understand without knowing
the underlying payment and write-off trends. It is
especially hard to justify as the 2000 decrease in
gross service fee receivables reflects lower unbilled
receivables, where the loss ratio has historically
been lower. The mix change alone would be expected to
increase the allowance.

(iii) The aggregation combined with an absence of data on


write-offs for the two categories of receivables
makes it more difficult to evaluate the quality of
earnings. As there should be different loss patterns
on billed versus unbilled receivables, the loss of
separate data is meaningful. In addition, patient
prepayments presumably result in revenue virtually
all of the time while receivables are not always
collected. Netting them together obscures trends in
each component.
16. Diluted earnings per share
1997
1998
As reported
$0.50
$0.70
Pro forma
0.26
0.46

%
40%
77%

1999
$0.96
0.66

%
37%
43%

2000
$0.96
0.96

%
0%
45%

The level and trend of originally reported earnings per


share through 1999 was a function of OCAs front-end loaded
revenue recognition method and its rapid expansion through
the development and acquisition of new centers. Earnings per
share for 2000 are not comparable to the 1999 level due to
the change in revenue recognition method.
The pro forma data report earnings per share assuming that
OCA had used the 2000 accounting method for all years
presented. Therefore the amounts are comparable and this
time series better represents operating results over that
time period.

2C-9

17.

While the pro forma time series better represents past


operating results, it may not be a reliable basis for
forecasting future results.
One reason is that it incorporates growth rates in the
number of centers and new patients that may not be
sustainable. As discussed in the solutions to questions 12
and 14, underlying trends show that growth is slowing.
The second reason why pro forma data must be used with
caution is that it implicitly assumes that management
behavior is not affected by accounting methods. As discussed
in chapter 5 and elsewhere in the text, accounting often
affects management due to incentives such as profit sharing
and stock options.
As the solutions to questions 5 and 11 state, the change in
revenue recognition method reduced the incentive to obtain
new patients. Thus we cannot assume that the pro forma data
report what OCAs actual earnings per share would have been
if it had used the 2000 revenue recognition method in prior
years.

2C-10