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Accounting Loophole Closing

Photonics Spectra
Jan 2001
FauxTon Co. officials order the manufacturing department to hurry up and ship one more truckload of widgets before the end of the day on Dec. 31. Manufacturing says the widgets aren't ready. Sales says, "Ship them anyway. The customer can return them later, but we need to get that revenue on the books in December."

The US Securities and Exchange Commission has adopted new accounting rules that make this sort of scenario less likely for public companies that have been somewhat liberal about defining when revenues are revenues.

The rules, which go into effect this year, say that companies can't account for revenues on sales of goods until:
  • The buyer and seller have a purchase agreement with a fixed price.
  • The seller has delivered the product.
  • The buyer has accepted the product with no side agreement that he or she can return it later or force the seller to buy it back.
  • The seller is reasonably sure that he or she can collect the debt.
Will the rules affect photonics companies? History suggests that they might.

In October 2000, Lucent Technologies of Murray Hill, N.J., announced fourth-quarter revenues of $9.4 billion. A month later, the new CEO revealed a "revenue recognition" issue: Roughly $125 million of that figure might not really be revenue yet. Lucent stock tumbled -- pulling down most other communications stocks as well.

Lucent's public records don't specify the accounting problem, and officials are withholding comment until auditors and lawyers review the numbers. But one typical revenue recognition issue involves accounting for all of the expected revenues from a long-term contract in a short financial period.

'Revised' Revenues

For example, in the first year of a five-year contract, the company accounts for all of the expected revenue and only part (or none) of the expense. Profits appear to be excellent. In the second through fifth years, however, the deal suddenly becomes all expense and no revenue.

Furthermore, the revenue never arrives if the seller can't deliver -- as in the case of photonics companies that have had trouble obtaining raw materials this year. The same problem arises if the seller cancels the contract -- as in the case of communications firms that double-booked orders this year as insurance against suppliers' raw materials shortages.

Ultimately, the accounting rule's effect on photonics companies in 2001 depends on how conservative their accountants have been until now. But the year's first round of quarterly results reports, due out in mid- to late April, could be interesting.

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