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SEC Cracks Down on Book Cooking

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News Analysis
Light Reading
11/22/2000
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What do George W. Bush, Al Gore, and Lucent Technologies Inc. (NYSE: LU) all have in common? Fuzzy math.

Yesterday, Lucent reported a $125 million snafu in its revenue recognition for the last quarter, and it changed its guidance going forward as a result (see Lucent Shares Hammered by $125M Goof).

While Lucent isn’t giving any details regarding how this mistake came about, some experts think that it could have stemmed from Lucent’s practice of counting revenue before products had been shipped and installed in customer networks (see Lucent's Poor ATM Numbers Confirmed).

But a new standard accounting bulletin from the Securities and Exchange Commission, SAB 101, could put an end to some of this creative arithmetic. The new rules, which were adopted last year and will finally go into effect starting in 2001, will require that “revenue should not be recognized until it is realized or realizable and earned.”

What does this mean? In brief, the SEC says there must be persuasive evidence that a purchase agreement actually exists. Delivery must also have occurred, the seller’s price to the buyer must be fixed and determinable, and collectibility must be reasonably assured.

The way companies account for revenue has been an issue for networking equipment vendors for some time, say analysts.

“The big box business is lumpy by nature,” says Max Schuetz, optical networking analyst at Thomas Weisel Partners. “A company could ship a couple million-dollar boxes one quarter and then not ship any to that same customer the next quarter.”

This up-and-down purchasing cycle can be a nightmare for public equipment vendors. “Investors want smooth growth, so companies play with the numbers,” says Schuetz. “ If they are short one quarter they might borrow from the next quarter. But it gets dicey when they don’t have the advanced booking. That means the deficit builds until it blows up in their face. That is pretty much what happened to Lucent.”

Under the new guidelines companies could be more restricted in how they handle revenue. For example, the days of vendors shipping boxes without line cards and recognizing that as revenue on their quarterly statement could be over. Also, vendors won’t be allowed to recognize revenue on products that are still being tested by a customer.

“I think what the SEC was trying to do is just give some guidance on what is acceptable,” says Jim Kroeker, a fellow at the Financial Accounting Standards Board (FASB), a private organization for establishing standards of financial accounting and reporting, recognized by the SEC. “There hasn’t been a lot of formal written guidance for revenue recognition. This should help.” But analysts and industry experts caution that there may still be some wiggle room left in the rules. In fact, the new rules are open to interpretation.

“Someone might look at one piece of the rule and say that makes perfect sense, and another part might be a little less clear,” says Kroeker. “But it is up to the SEC to decide.”

One type of situation that might not be covered under the accounting bulletin has to do with vendor financing. There are still no clear boundaries regarding when revenue can be recognized from products that haven’t been completely paid for. This could be a problem as more vendors begin to offer vendor financing, especially if these vendors are backing unstable service providers that could default on their agreements.

“The problem is that even when carriers deploy a product or promise to deploy it, customers can still have it without paying for it,” says Schuetz. “There are still ways of getting around it.

“The most draconian approach would be to report revenue when you get cash payment from customers. That eliminates a lot of this debate. But if you did that, there would have to be a lot of re-education for investors. Telecom sales come in lumps, and that freaks out investors.”

For the most part, vendors seem to be taking the new rules in stride. During Nortel Networks Corp.’s Webcast yesterday, CFO Frank Dunn, responding to a question, told analysts that the company wasn’t worried about SAB 101.

“We reviewed the SEC proposal in detail in January,” said Dunn. “Going forward, this isn’t an issue; we’ve built it into our plans.”

Lucent said it would not comment directly but had this to say: “We are aware of the staff accounting bulletin and we’re currently evaluating the impact of it on our business,” said a spokesperson. “We will adopt the rules in 2001 as required by the SEC."

-- Marguerite Reardon, senior editor, Light Reading, http://www.lightreading.com

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