Ronna Abramson

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PeopleSoft's Accounting Draws Critics

Ronna Abramson

Allegations by Oracle(ORCL - Cramer's Take - Stockpickr) that a controversial anti-takeover strategy being employed PeopleSoft(PSFT - Cramer's Take - Stockpickr) is causing PeopleSoft to book revenue improperly might have some teeth, two accounting experts say.

The independent accounting experts think the issue might even warrant a look from the Securities and Exchange Commission. Oracle is trying to acquire PeopleSoft in a $7.3 billion hostile takeover bid.

"It's a prominent public company that's involved in an acquisition that is in an industry that has had problems with revenue recognition in the past," said Charles Mulford, director of the DuPree Financial Analysis Lab and an accounting professor at the Georgia Institute of Technology. "At the minimum, they [SEC officials] have to look at the transaction."

Jim Brendel, author of "Software Industry Accounting" and a partner at the accounting firm Hein & Associates, agreed. "I would think the SEC would be looking at it," he said. It's conceivable, in a worst-case scenario, that the SEC could require PeopleSoft to restate results, he said. But the matter is not clear-cut, so the agency also could conclude there's no problem, he noted.

At issue is a change in PeopleSoft's so-called "customer assurance program," in which customers are promised refunds of two to five times their license fees if PeopleSoft is acquired. Under a change made in the third quarter, PeopleSoft said the refunds would also kick in if a majority of its directors changed, according to an SEC filing. PeopleSoft stated that $155.9 million in revenue was collected with that change in place.

That means the refunds could be triggered even if PeopleSoft is not acquired, putting PeopleSoft -- and not an acquirer -- on the hook for the refunds.

Oracle CFO Jeff Henley charged in a conference call at the beginning of the week that accounting rules dictate that PeopleSoft should not have recognized the $155.9 million in revenue since it might have to be refunded by PeopleSoft. (It should be noted that anything that lowers the perceived value of PeopleSoft arguably redounds to Oracle's favor.)

PeopleSoft subsequently sent customers a letter clarifying that the company meant the refunds would be triggered only if there was both a change in the board majority and an acquisition. But Oracle executives suggested that letter would not be legally binding.

PeopleSoft spokeswoman Dee Anna McPherson declined to comment on whether the SEC has contacted the company regarding the matter. "We are not really going to comment on this whole issue other than to say we're absolutely confident that the revenue was recognized appropriately," McPherson said Wednesday.

McPherson said the change in question was never included in any customer contracts but rather was put in an SEC filing by mistake and quickly corrected. However, a review of PeopleSoft's SEC filings indicated that some contracts signed before the end of the quarter did include the condition that only a change in the board majority could trigger the refunds. After the end of the third quarter, PeopleSoft inserted clarifying language into subsequent contracts so that refunds could only be triggered if the board changed and PeopleSoft were acquired, according to SEC filings.

The intent was always that only a change in the board triggered by an acquisition would require refunds to companies, McPherson said. "Under no circumstances could the liability ever be PeopleSoft's," she added.

SEC spokesman John Nestor said the agency does not comment on whether it is investigating a company.

Even if the SEC does look into PeopleSoft's revenue recognition, it's hardly a clear-cut question because PeopleSoft's refund program is unprecedented, accounting experts say.

Brendel said there are two ways to look at the accounting surrounding the refund program. PeopleSoft appears to be treating the potential refund as a "contingent liability," which must only be booked if it's probable the company will have to pay it. In its SEC filings, PeopleSoft said it believes execution of the refund program to be improbable.

On the other hand, the program raises questions about revenue recognition because one standard for when revenue can be booked is that the seller is certain it can collect, Brendel added. If a customer has rights to a refund, such collectability is not reasonably assured, he said.

Either way, "anything that creates uncertainty creates some risk," Brendel said.

Mulford, meanwhile, argued that at a minimum, PeopleSoft should have included an offsetting expense for part of the revenue to account for the probability of it having to be paid back. He called it a "fairly large leap" to say the probability of being acquired is zero.

The revenue recognition surrounding PeopleSoft's refund program is just the latest in a series of questions that have been raised about the company's accounting practices, which some have called aggressive. Some analysts also have criticized the way the company arrived at its latest pro forma revenue and earnings results. In particular, they have questioned whether PeopleSoft should have included deferred revenue from recently acquired J.D. Edwards and excluded a capitalized software expense tied to the J.D. Edwards acquisition, noting such changes are not typical of either PeopleSoft's prior acquisitions or other acquisitions in the software sector.

Although he has raised flags about the way PeopleSoft treated capitalized software, Sanford C. Bernstein analyst Charlie Di Bona said he was not so concerned about how the company recognized revenue under the refund program. Rather, the bigger issue raised by the refunds is how they affect the price Oracle is willing to pay for PeopleSoft. Di Bona has an underperform rating on PeopleSoft and his firm doesn't do banking business.

While others have said Oracle will have to raise its $19.50-a-share hostile takeover bid for PeopleSoft, Di Bona wondered if the value of PeopleSoft actually will go down because the refund program restricts Oracle's actions in an acquisition.