On September 25, the SEC brought an administrative enforcement action alleging that a software company misstated its revenue because its internal controls were inadequate to permit the company to generate the information necessary to comply with the accounting standards. The misstated revenues related to consulting services sold in conjunction with software licenses and to service agreements linked to the sale of software licenses. The respondent, JDA Software Group, Inc., agreed, without admitting or denying the Commission’s charges, to cease and desist from violating the periodic reporting, books and records, and internal control requirements of the Securities Exchange Act and to pay a $750,000 civil money penalty.
During the years in question, the accounting standards applicable to revenue recognition for the sale of software and software-related products required a seller of software licenses bundled with related services and sold as a single contract to have vendor specific objective evidence (VSOE) of the fair
value of each undelivered element in order to recognize revenue from the sale of the license in the quarter in which the sale occurred. A similar requirement applied to sales of software licenses and related services in separate contracts, but linked, contracts. If the seller was unable to establish VSOE for any undelivered element, it had to recognize revenue
from the software license sale ratably over the term of the services agreement.
According to the SEC’s order, JDA failed to comply with these requirements because it lacked adequate revenue recognition policies and procedures to determine the fair value of certain services and failed to identify all service-related contracts needed for VSOE testing. As a result, revenue was misstated during the period 2008 to 2011; the highest overstatement was 3.95 percent ($23.5 million) in 2010, and the greatest understatement was 2.82 percent ($19.5 million) in 2011. The impact of these revenue misstatements on net income was substantial. Net income was overstated by 909 percent ($3.5 million) in 2008 and by 728 percent ($24.7 million) in 2010. On August 6, 2012, JDA restated its financial statements for fiscal years 2008, 2009, 2010 and the first three quarters of fiscal year 2011.
Comment: From an audit committee perspective, this case illustrates three points that have been discussed in prior Updates. First, it once again highlights the SEC’s renewed enforcement focus on financial reporting cases, including those that do not involve fraud or intentional misstatements. See July 2013 Update. The risk that financial reporting errors (including those the company identifies and corrects via a restatement) will result in an SEC enforcement inquiry is significantly higher than it has been during most of the past decade.
Second, the SEC’s allegations that internal control failures caused the financial reporting failures dovetails with the PCAOB’s scrutiny of ICFR auditing. Both the SEC and the PCAOB seem to be going out of their way to signal the importance they place on controls and the consequences of weaknesses or audit lapses in that area. See August 2014 Update.
Finally, revenue is a significant financial statement account for virtually all companies and often involves significant risk. As noted in the September 2014 Update, the PCAOB recently issued a Practice Alert on revenue recognition audit challenges and urged audit committees to discuss the issues with their auditor. Audit committees might want to consider following this advice.