UNITED STATES OF AMERICA
SECURITIES EXCHANGE ACT OF 1934
ACCOUNTING AND AUDITING ENFORCEMENT
The Securities and Exchange Commission ("Commission") deems it appropriate that public proceedings be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Microtest, Inc. ("Microtest" or "Respondent") violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20, 13a-1, and 13a-13 thereunder.
In anticipation of the institution of these proceedings, Microtest has submitted an Offer of Settlement ("Offer") that the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, Microtest, by its Offer, without admitting or denying the Commission's findings contained in this Order Instituting Public Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease-and-Desist Order (the "Order"), except that it admits to the Commission's jurisdiction over it and over the subject matter of this proceeding, consents to the entry of this Order.
The Commission's Order finds that:
Microtest is a Delaware corporation with its principal place of business in Phoenix, Arizona. Microtest develops, engineers and markets a variety of hardware and software tools for troubleshooting, managing and enhancing computer network performance. Microtest reported revenues of $52.5 million in its 1995 fiscal year and $50.4 million in its 1996 fiscal year.1 Microtest's stock is quoted on the NASDAQ and is registered with the Commission pursuant to Section 12(g) of the Exchange Act.
In order to meet revenue goals at the end of the third fiscal quarter of 1995, Microtest entered into sales agreements with five of its distributors that included liberal payment and return privileges that were different from the terms that Microtest previously had included in sales agreements with its distributors. Microtest violated generally accepted accounting principles ("GAAP") by improperly recognizing the revenue from these sales in its third quarter and year-end 1995 financial results because it could not reasonably estimate and provide a reserve for future returns of product. As a result of the improper recognition of revenue from these transactions, Microtest reported materially inaccurate financial results in periodic reports filed with the Commission for the third quarter of 1995 and for the 1995 fiscal year.
In 1996, Microtest instituted a direct sales program in which the buyers entered into the transactions with Microtest "at absolutely no risk with a 30 day money back guarantee." Microtest also represented to the buyer that it could "send no money now but agree to pay this amount in 30 days from the above date if [it] decided to keep the product." On these transactions, Microtest improperly recognized revenue at the time of shipment rather than at the end of the 30-day period. This improper accounting was discovered during the audit of Microtest's 1996 financial statements, and Microtest restated its net income for the second and third quarters of 1996 by 25% and 31%, respectively.
Finally, Microtest's reported net income and revenue for the first three quarters of 1998 were overstated by $926,000 and $380,000, respectively, due to inaccurate books and records and a failure of internal accounting controls. Microtest restated its financial statements for those three accounting periods.
B. 1995 Channel Sales to Distributors
The market for Microtest's products is characterized by rapidly changing technology, short product life cycles and evolving industry standards. Through the last several months of 1994 and into early 1995, the demand for certain Microtest products exceeded the supply and Microtest had no problem selling its available inventory. By mid-1995, however, additional competition and increased market saturation made it more difficult for Microtest to attain its targeted revenues. As a result, in order to attain the goals set by Microtest's operating plan, which were not materially different than the market estimates, Microtest made sales to certain customers during the third quarter of 1995 under abnormal terms. For example, Microtest was only able to obtain sales from two of its largest distributors, Anixter Bros., Inc. ("Anixter") and Graybar Electric Company, Inc. ("Graybar"), by granting extended payment periods and rights of return, which were characterized by Microtest as "stock rotation" rights.2
The end-of-quarter sales to Anixter and Graybar totaled $3,129,000, or 20.6 percent of third quarter revenue. The invoices for these sales included liberal payment terms and rights of return that were different from any terms that Microtest previously had in its agreements with these customers. For example, Microtest gave Anixter 150-day payment terms, in contrast to Anixter's standard 45-day payment terms. Microtest also granted to Anixter stock rotation rights up to $200,000 for the first quarter of 1996 and 10% of the remaining balance for the next three quarters of 1996; these rights were in addition to Anixter's normal 10% stock rotation rights. Anixter also was given the right to return less marketable or obsolete products, due to new or improved Microtest products, within 12 months of the date of purchase. Microtest granted Graybar extended payment terms of 120 days, plus an additional 90 days for inventory unsold at the end of the 120-day period, and Microtest agreed to accept the return of additional products that Graybar had purchased from Microtest in a previous accounting period. All of these terms were departures from Microtest's previous agreements with Anixter and Graybar.
Microtest also signed distributor agreements with three new parties late in the third quarter of 1995. The initial sales to these three customers, Globelle, MicroAge, and GBC Technologies, Inc. ("GBC"), totaled $885,000 or 5.8 percent of third quarter revenue. The terms of these agreements also were unusually liberal, and allowed for payment terms of 90 to 210 days and the right to return up to 100% of the initial orders in exchange for other products within either 180 days or for an unlimited period of time depending upon the customer. Microtest's chief financial officer approved all of the terms of sale to Anixter, Graybar, and the three new distributors that included these extensive return privileges and other non-standard sales incentives. Both the company's chief financial officer and its controller approved the recognition of revenue from these sales for the third quarter of 1995 despite these terms, and despite the company's inability to reasonably estimate and create a reserve for future returns of product.
At the time of these sales, both Anixter and Graybar already had sufficient inventory of Microtest products to cover their needs for a significant period of time. Anixter and Graybar's incentive to take the Microtest product in the third quarter of 1995 was simple: Microtest granted them liberal rights of return and unusual payment terms. As a result of taking the additional inventory at the end of the third quarter, both Anixter and Graybar had sufficient inventory for many months and did not place another order for Microtest products until the second quarter of 1996.
Microtest's sales to these five customers at the end of the third quarter in 1995 totaled $4,014,000, or 26.5 percent of $15,174,000 third quarter revenues. For all five distributors, Microtest lacked the ability to estimate and reserve for returns. As to Anixter and Graybar, it could not estimate returns because it had changed the terms upon which it did business with these two companies. Due to Microtest's lack of experience with the new terms granted to these two distributors, it was unable to estimate and reserve for potential returns both at the end of the third quarter of 1995 and at year-end. Similarly, Microtest could not estimate the amount of returns on sales to the three new distributors because it lacked any historical sales experience with those customers and the sales to them included extended payment terms and rights of return. Because of the inability to estimate and reserve for potential returns, Microtest improperly recognized revenue on the sales that the company made pursuant to those terms in the third quarter of 1995 and at Microtest's 1995 fiscal year-end.
C. 1996 Direct Sales
In 1996, Microtest created a direct sales program, which used a telephone sales force to market certain products. The terms listed on the sales order form indicated that these sales were made "at absolutely no risk with a 30 day money back guarantee." Microtest also represented to the buyer that it could "send no money now but agree to pay this amount in 30 days from the above date when [it decides] to keep the product." Despite these terms, during the second and third quarters of 1996 Microtest improperly recognized revenue when the product was shipped rather than at the end of the 30-day period. Microtest's controller approved the recognition of revenue at the date of shipment. This improper accounting was discovered during the audit of Microtest's 1996 financial statements. As a result, Microtest restated its net income for the second quarter of 1996 from $1.316 million to $982,000, a difference of 25 percent, and its net income for the third quarter of 1996 from $1.435 million to $991,000, a 31 percent reduction. Microtest restated its revenue for the second quarter of 1996 from $13.32 million to $12.666 million, a difference of 5 percent, and its revenue for the third quarter of 1996 from $13.007 million to $12.136 million, a 7 percent reduction.
D. 1998 Accounting Errors
During Microtest's 1998 fiscal year end audit, Deloitte & Touche LLP, the company's independent accounting firm, identified a variety of books and records and internal control problems at the company. These problems included erroneous journal entry postings, lack of timely reconciliations of certain account balances, and accounting system interface problems. In order to correct these errors, Microtest restated its earnings for the first three quarters of 1998. Among other items, the restatement adjustments resulted in an increase in the sales return reserve and also an increase in research and development expenses to correct for costs which had been erroneously capitalized. The restatement reduced reported revenue for the first three quarters by $380,000 and reduced net income by $926,000, or 84 percent.
A. Violations of Section 13(a) and Rules 12b-20, 13a-1, and 13a-13
Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission factually accurate annual and quarterly reports. SEC v. Savoy Indus., 587 F.2d 1149, 1165 (D.C. Cir. 1978). Rule 12b-20 requires that periodic reports filed with the Commission contain all such further material information as is necessary to make the required statements not misleading. Financial statements incorporated in Commission filings must comply with Regulation S-X, which in turn requires conformity with GAAP. The filing of a periodic report containing inaccurate information constitutes a violation of these regulations. See Savoy Indus., 587 F.2d at 1165.
Microtest filed materially inaccurate reports for the third quarter and fiscal year 1995. In the third quarter report, it overstated revenue by $4,014,000, or 26.5 percent of the quarter's total stated revenue. It was improper to recognize this revenue at that time and at year-end 1995 because the amount of future returns on certain sales transactions could not be reasonably estimated due to the extended return privileges and other non-standard sales incentives Microtest granted to its vendors. The revenue recognition for these transactions was not in accordance with the GAAP requirements set out in the Statement of Financial Accounting Standards ("SFAS") No. 48, "Revenue Recognition When the Right of Return Exists."
When rights of return become part of a sales transaction, certain criteria must be met for a company to properly recognize revenue pursuant to GAAP. SFAS No. 48 requires that in order to recognize revenue at the point of sale when the buyer has a return privilege, the amount of future returns must be reasonably estimable by the seller company. A company's ability to estimate the amount of future returns depends on many factors. As stated in SFAS 48, paragraph 8:
Microtest's products were facing increasing competition and were subject to technological obsolescence. Microtest also granted these distributors payment terms of 90 to 210 days, well in excess of Microtest's standard 30-day or 45-day payment terms. Moreover, for sales to the three new distributors, Microtest did not have any historical experience or sales experience relating to product returns. These circumstances were factors that rendered Microtest unable to reasonably estimate and reserve for returns and, therefore, Microtest improperly recognized revenue from these transactions in the third quarter of 1995. As for Graybar and Anixter, given the abnormal payment terms and extensive return rights that Microtest granted to these existing distributors, Microtest could not apply its historical sales experience with these distributors to reasonably estimate for likely returns and to provide an appropriate reserve.
Moreover, and specifically with respect to the sales made to Graybar, SFAS 48 also provides that revenue should not be recognized until the buyer is obligated to pay the seller, and the obligation must not be contingent on resale of the product. Although Graybar was ultimately obligated to pay for the products, payment was deferred to allow Graybar time to resell the product. Considering the circumstances surrounding the sale, including the timing of the sale, negotiations between Microtest and Graybar, and Graybar's high level of Microtest inventory at the time of the transaction, this transaction was, in effect, a quasi-consignment sale, and, on this basis as well, Microtest should not have recognized revenue from these sales in the third quarter of 1995.
Finally, the "stock rotation" rights that Microtest granted to all five distributors in 1995 constituted rights of return. Therefore, Microtest had to meet all the requirements of SFAS 48 in order to recognize revenue on these sales. Only "exchanges by ultimate customers of one item for another of the same kind, quality and price" do not constitute a return within the meaning of SFAS 48 [emphasis added]. Microtest's arrangements with its distributors in 1995 did not qualify as that type of exchange because the distributors in this case were not the ultimate customers and there were no restrictions on the kind, quality, or price of the products that the distributors had to purchase in any offsetting order.
By recognizing the revenue from sales to these five distributors in its 1995 Form 10-Q, Microtest violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder. Microtest was still not in a position to reasonably estimate future returns or recognize the revenue for these same five customers when it filed with the Commission its annual report on Form 10-K for fiscal year 1995. By recognizing this revenue in its annual report, Microtest filed a materially inaccurate annual report and violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder.
In addition, Microtest improperly recognized revenue during 1996 from its direct sales program. Under this program, until 30 days had expired from the date of shipment, the customer had the right to return the product, bore no risk of loss, was not obligated to pay for the product, and Microtest received no payment from the transaction. In such circumstances, the recognition of revenue on the date of shipment violated GAAP. Thus, by recognizing such revenue based on the shipping date in its 1996 second and third quarter reports, Microtest violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder.
Finally, Microtest violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder in connection with its first, second, and third quarter 1998 earnings. At year-end 1998, it restated its earnings for the first three quarters of 1998 to correct for errors identified during the 1998 year-end audit process. These material errors arose largely as a result of improper entries made to Microtest's general ledger. The restatement reduced reported revenue for the first three quarters by $380,000 and reduced net income by $926,000, or 84 percent.
B. Violations of Section 13(b)(2)(A) and (B)
Section 13(b)(2)(A) of the Exchange Act requires issuers that are registered with the Commission to make and keep books, records and accounts that accurately reflect the transactions and disposition of their assets. Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurance that, among other things, transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP and to maintain accountability of assets. Microtest failed to make and keep books and records that accurately reflected its transactions and failed to maintain a system of internal accounting controls sufficient to provide assurances that transactions, such as purchase orders, were recorded as necessary to permit the proper preparation of financial statements in conformity with GAAP. Specifically, Microtest: (1) improperly recorded as revenue over four million dollars in sales transactions in the third quarter of 1995 and at year-end 1995; (2) improperly recorded revenue for sales made through its direct sales department in the second and third quarters of 1996; and (3) materially misstated its financial statements in the first three quarters of 1998. Therefore, Microtest committed violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act.
Based on the foregoing, the Commission finds that Microtest violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20, 13a-1, and 13a-13 thereunder.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that:
Microtest CEASE AND DESIST from committing or causing any violation and any future violation of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20, 13a-1, and 13a-13 thereunder.
By the Commission.
1 Microtest's fiscal year ends on December 31.
2 Microtest's revenue recognition policy defines stock rotation as "the contractual obligation by Microtest to accept a contractual percentage of the prior quarter's product in return for the equivalent dollar amount of new orders placed." In other words, customers could return product to Microtest in exchange for another order of the same dollar amount.