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SEC Settles Revenue Recognition Allegations And Charges Two Executives
02/14/2017On February 3, 2017, California-based technology company Ixia and its former CEO, Victor Alston, settled claims brought by the United States Securities and Exchange Commission (the “SEC”) for failing to properly defer recognition of certain revenue in violation of the books and records and internal controls provisions of the Securities Exchange Act of 1934 (the “Exchange Act”). In the settlement document, Ixia and Alston neither admitted nor denied the SEC’s findings. In the Matter of Ixia and Victor Alston, Admin. Proc. No. 3-17825 (Feb. 3, 2017). The Commission also filed suit in the United States District Court for the Central District of California against two other former Ixia employees in connection with these same claims, and this suit is still pending. Complaint, SEC v. Miller, et al., 17-cv-00897 (C.D. Cal. Feb. 3, 2017), ECF No. 1.
Under section 13(b)(2)(A) of the Exchange Act, reporting companies must keep books and records that accurately reflect their transactions in reasonable detail. Section 13(b)(2)(B), in turn, requires reporting companies to maintain a sufficient system of internal accounting controls to give reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements in conformity with Generally Accepted Accounting Principles (“GAAP”). Of relevance to this settlement, GAAP is instructive on how to recognize revenue from a software transaction that involves separate products or services (typically labeled “elements”). Specifically, GAAP provides that revenue must be allocated to each separate element, based on that element’s fair value; the latter is established through vendor-specific, objective evidence (i.e., consistent prices paid by customers for the same or similar elements). GAAP further directs that if fair value cannot be established for any element of a software transaction, then recognition of revenue relating to the entire transaction must be deferred until either all products or services have been delivered, or until fair value for each of the elements can be established. Ixia’s internal revenue recognition policy was consistent with these GAAP provisions.
According to the SEC, Ixia violated the above provisions of the Exchange Act and GAAP by splitting purchase orders in an effort to improperly accelerate the recognition of revenue. Specifically, Ixia provided purchase orders to customers for the sale of software and professional services related thereto. Because there was no “fair value” for the professional services contained in the purchase orders, Ixia was required to defer recognition of revenue for these purchase orders until the services were provided. Alston nonetheless directed Ixia employees to “split” the purchase orders into separate orders for the sale of software and the professional services, which gave the false appearance that the services were stand-alone sales. This split, in turn, allowed Ixia to recognize revenue from software sales immediately, and also enabled it to create a record of stand-alone sales for its professional services, which could later support a “fair value” determination of such services in subsequent transactions. The SEC concluded that this “splitting” violated both GAAP and Ixia’s internal revenue recognition policies and was a deliberate circumvention of Ixia’s internal accounting controls. As a result, the split purchase orders triggered multiple, separate violations under sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, among other things.
The settlement and lawsuit highlight the SEC’s interest in revenue recognition issues that can significantly impact reporting companies’ financial disclosures. Indeed, both the complaint and the settlement document emphasized the impact that Ixia’s allegedly improper revenue recognition had on its financial statements. By cooperating with the SEC and agreeing to a number of undertakings related to these violations, Ixia was able to settle the case by agreeing to a monetary penalty of $750,000. Alston, however, was fined $100,000 and prohibited from serving as an officer or director of any issuer for five years. As referenced above, the case against the other two Ixia employees is pending in the United States District Court for the Central District of California.
