Where There’s Thunder, There’s Lightning: SEC’s Investigation Of IBM’s Cloud Computing Accounting May Be A Harbinger Of A New Enforcement Focus

by Orrick - Securities Litigation and Regulatory Enforcement Group
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Cloud computing may be the next shoe to drop. On the heels of Mary Jo White’s recent appointment as Chairman of the SEC and predictions that it may refocus enforcement on accounting fraud came word last week that the Commission is investigating IBM’s cloud-computing accounting. In an SEC filing, IBM defended its revenue accounting for cloud-based services, stating “[w]e are confident that the information we have provided has been consistently accurate.”

This may just be the tip of the iceberg for an industry estimated by some analysts to generate global revenues of $131 billion this year, 60% of which originate in the United States.

Cloud computing has no single definition but one basic expression would be the practice of storing and accessing information on servers accessed through the Internet. There are many cloud-computing business models, including Infrastructure as a Service (“IaaS”), in which customers access computing power, such as servers, through physical equipment owned by the provider; Platform as a Service (“PaaS”), in which customers use a provider’s computing environment—including operating systems, programming languages, and databases—to create applications remotely; and Software as a Service (“SaaS”), services that allows users to operate software remotely. Google Documents and the e-Discovery platform Relativity are just two cloud-based services that readers may be familiar with.

Cloud computing gives rise to two overarching accounting considerations. First, with respect to revenues, how does one appropriately recognize revenue and expenses on service contracts that have “multiple elements,” such as platform development, data migration and hosting, training, and support services? These principles are generally covered by Emerging Issues Task Force (EITF) 08-01, among others. Important for potential accounting fraud, the effect of premature recognition could be to record revenue before it is earned or realized, artificially inflating revenues in current periods. One area of revenue accounting that is especially tricky and subject to significant judgment is determining the “Best Estimate of Selling Price” or BESP. That occurs when one element of a multiple-element transaction cannot be objectively verified based on internal or external evidence of value and must be estimated using management’s “best judgment.”

Second, with respect to costs, which costs should be capitalized and amortized over the life of the service and which costs should be expensed in the year incurred? These principles are generally covered by FASB Accounting Standards Codification (ASC) 350-40, 350-50, 360, and 985-20, among others. Were costs improperly capitalized, the effect could be to reduce costs and increase income in a given period, although the offsetting capitalization may lower return on assets.

Depending on the size of the accounting adjustment, the effect on a line item like revenue and costs of services could be important—i.e., material—to an investor’s perception of a company’s value.

IBM’s disclosure gave little information on the exact scope of the SEC’s investigation, which began as early as May of this year. The footnotes to IBM’s most recent annual financial statements lay out in detail its accounting policies for multiple-deliverable arrangements—see IBM’s 2012 Annual Report at p. 77—and indicate that “[t]hese arrangements may include any combination of services, software, hardware and/or financing” whereby “the hardware and software [may be] delivered in one reporting period and the software support and hardware maintenance services delivered across multiple reporting periods.” It does note that the company employs BESP in “certain limited circumstances” when the company is “unable to estimate selling price” using other means. This could be one area the SEC is investigating, including whether the company has employed consistent methodology in estimating BESP across financial periods and customer accounts.

How and when to account for these bundled services is often tricky under the accounting rules. The significant amount of judgment required, varied facts and circumstances, and lack of clear guidance in certain cases may make it difficult for the SEC to successfully prove up claims founded on fraudulent intent. But, emboldened by its recent trial successes and a new sense of purpose under Chairman White, this is unlikely to deter the Commission from trying. The SEC has recently announced the creation of a Financial Reporting and Audit Task Force within the Division of Enforcement. According to the announcement, the Task Force is “dedicated to detecting fraudulent or improper financial reporting,” and anecdotal reports suggest that multiple element transactions are one focus of the Task Force’s early efforts.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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