VideoLast summer, when Irvine, California, semiconductor maker Broadcom Corp. was negotiating to buy Altima Communications Inc., its biggest concern was the company's relationships with its customers. As with any small company in the hypercompetitive technology sector, winning and keeping customers is everything. In an effort to strengthen its relationships, Broadcom urged Altima executives to strike product purchase agreements that gave customers like 3Com and Pace Micro Technology performance-based warrants in the company. The more products the customers bought from Altima, the more warrants they were eligible to receive.
Broadcom itself pursued a similar strategy prior to going public in 1998, and it encouraged four other private companies it acquired last year to offer such incentives to their customers. When the acquisitions were completed, the warrants were converted into Broadcom warrants. In addition, their cost, considered part of the price paid for the companies, was rolled into goodwill and amortized over a five-year period. "We and the acquisition candidates viewed these transactions as a way to promote and solidify relationships with key customers," explained CEO Henry T. Nicholas III in a March 6 press release.
But when the Wall Street Journal and the Securities and Exchange Commission regulators got wind of the transactions, the deals were suddenly viewed in a more sinister light. Existing accounting guidance directs that any performance-based grants of shares or warrants to customers be charged against the revenue they relate to--like a cash rebate--thereby reducing the amount of revenue recognized. Because Broadcom simply dumped the cost of the warrants into goodwill instead of matching it against the revenue earned from the contracts, accounting watchdog groups like the Center for Financial Research and Analysis say the company is inflating its revenues. Ashok Kumar, a technology analyst with US Bancorp Piper Jaffray, suggests that the accounting method may have overstated Broadcom's sales growth rate by as much as 50 percent.
Nonsense, say Broadcom executives. Only about $20 million in sales related to the agreements has been recognized by the company, and the initial accounting treatment--which the company announced it would change on March 21-- was cleared with the company's auditors, Ernst & Young. "I don't think there's anything to be concerned about," said Broadcom CFO Bill Ruehle to a Wall Street Journal reporter. "Last time I checked, aggressive marketing practices were OK."
But aggressive accounting--even the whiff of it--is another matter altogether. In a market sensitized by scores of share-price meltdowns resulting from aggressive accounting practices, Broadcom's unusual treatment of the transactions was bound to generate bad press and SEC inquiries, not to mention the shareholder lawsuits that have lately been filed against the company.
Broadcom's use of warrants in performance-based contracts, however, is by no means unusual. For years, New Economy companies have been testing the tolerance of generally accepted accounting principles (GAAP) in matters of income statement presentation, revenue recognition, and the capitalization of expenses. And while companies in other industries (notably the oil and gas exploration industry) have entered equity-based transactions to share risk and build relationships with customers, technology companies have taken the practice to new, ever more complicated lengths.
In the heyday of the bull market, dot-coms threw their equity around like drunken sailors--loading up employees with options, and paying vendors, lawyers, public relations firms--even landlords--with stock. The performance-based deals with other companies produced heady investment profits for the recipients, while cash-strapped issuing companies conserved working capital and got bragging rights to big-name customers. In hindsight, of course, many on the receiving end of the transactions now wish they'd asked for cash. But there were, and still are, good reasons for companies to enter these agreements.
The accounting for the deals, however, is now coming under intense scrutiny from the SEC. Many of the contracts are still in effect, and continue to play out in corporate earnings and disclosures. And absent hard and fast rules for the appropriate treatment of the transactions, companies have been finding innovative ways to measure and present information about equity-based transactions. To say the least, regulators have their hands full. "It's like one of those arcade games-- as soon as you knock one gopher back in its hole, another pops up somewhere else," says Lynn Turner, chief accountant at the SEC.
In October 1999, the SEC enlisted the help of the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board to ferret out those gophers, along with several others affecting the New Economy. The EITF issued guidance for companies receiving equity instruments, in EITF 00-8 (on equity-instrument receiver recognition), last year. Two other bulletins, EITF 00-18 (on accelerated vesting of equity instrument payments) and EITF 00-25 (on vendor payments and rebates), are still in the works. The SEC also asked the American Institute of Certified Public Accountants last November to include related issues on classification and valuation. The problem, says Barbara Carbone, a partner at KPMG LLP, is that no two agreements are exactly the same. "The accounting is driven by the specific terms of the contracts and the securities," she says. "It has become more complex."
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