In the last two weeks, Broadcom, a maker of semiconductors used for high-speed Internet devices, has come under an unusual degree of scrutiny, stemming from questions about how the firm recognized stock warrants issued to customers of acquired companies. The company had been in the habit of recognizing the value of the warrants as goodwill and amortizing them over a five-year period.
But ever since The Wall Street Journal first reported the story in late February, accounting experts and analysts have called the method unusual and argued that the firm should instead deduct the value of the warrants from its revenue.
For its part, the company maintains its practices were appropriate, although a spokeswoman said Broadcom CFO William Ruehle was not available for comment. At an investor conference last week sponsored by Morgan Stanley both Ruehle and Broadcom CEO Henry Nicholas said the accounting treatment had been cleared with the firm’s auditors at Ernst & Young.
Still, the company also put out a statement last week that said it would alter the practice, although it has not settled on the precise treatment it will use. The company said one option it is considering, based on E&Y’s advice, is “a variable accounting model,” under which the warrants would only be recorded if the customers hit their revenue targets. The Broadcom statement also said its auditors are “still inconclusive on the appropriate accounting for these contracts.”
An E&Y spokesman said the company doesn’t “discuss confidential client issues.”
It’s also unclear what long-term impact the issue will have on Wall Street’s view of the company. Firms that get tarred with a reputation for manipulating their results can spend an eternity trying to regain the Street’s approval.
“Anytime you’re associated with any kind of questionable accounting , even if it’s a good faith dispute, some people will label you an earnings manager,” says Bob Willens, an analyst at Lehman Brothers who specializes in tax and accounting issues. “Hopefully that doesn’t happen to them.”
The other outstanding question is exactly when Broadcom will adjust its accounting treatment. The firm is barely two weeks away from the end of the current quarter, and it’s unlikely that it has the time to switch its financial statements to the new method. It may not take place until the firm reports its June results. A company spokeswoman said she did not know when the company plans to adopt its new treatment.
Taking its time and getting it right might be the best course for Broadcom. Willens says it makes sense that the company move slowly. “They don’t want to make a mistake and have to change it again.”
But in the meantime, there’s certainly a cloud hanging over the company.
One analyst says that the practice of issuing warrants to clients, while not common, is hardly unheard of.
The problem is that in issuing the warrants, Broadcom appears to have given its customers a price discount. Normally, such a discount would reduce a company’s total revenue. But in this case, the value of the warrants was merely rolled into the goodwill for the acquisition target, and it was only a small fraction of the total.
At last week’s Morgan Stanley conference, CFO Ruehle said the total revenue of the acquired companies that issued warrants was no more than $20 million. But at the same time that Broadcom explained its decision to change its accounting for the warrants, the company warned that its first quarter revenue would fall about $100 million shy of previous estimates from Wall Street.
Broadcom blamed the weakening economy for its revenue shortfall, and it also said economic factors were leading some clients to cancel sales contracts tied to the warrants, and one such customer was 3Com, the “major customer” to Altima, which Broadcom acquired in September 2000.
Some analysts question the extent to which the warrants acted as a price discount and persuaded customers to buy products they wouldn’t have otherwise purchased. Now that the warrants are being treated differently, will customers still be eager to buy the firm’s offerings?
This is no small issue for a firm whose sales doubled to $1.1 billion in 2000 and, until the warrant controversy flared up, enjoyed a reputation as one of the few remaining high fliers left in the battered tech sector. To what extent was the stellar revenue growth driven by customers lured in by warrants and price discounts?
Joe Carcello, an associate professor of accounting at the University of Tennessee in Knoxville, says if a large portion of the revenue shortfall is traced to the accounting revision, it can persuade Wall Street that its business prospects have not significantly worsened. On the other hand, the larger the proportion of the revenue shortfall tied to the warrants, the more weight will be lent to the barrage of shareholder suits that have been filed against the firm in the past week.
“It’s hard to know how much that haircut is due to changes in economic conditions and how much to changes in accounting,” Carcello says. “The chip industry is slowing dramatically.”