TERAYON COMMUNICATION SYSTEMS - 10-Q - 20070110 - CONTROL_AND_PROCEDURES
Item 4.
Controls
and Procedures
Evaluation
of Disclosure Controls and Procedures
The Company is required to maintain disclosure controls and
procedures that are designed to ensure that information required
to be disclosed in its reports under the Securities Exchange Act
of 1934, as amended (Exchange Act) is recorded, processed,
summarized and reported within the time periods specified in the
Commission’s rules and forms, and that such information is
accumulated and communicated to management, including the
Company’s Chief Executive Officer (CEO) and Chief Financial
Officer (CFO) as appropriate, to allow timely decisions
regarding required disclosure.
In connection with the preparation of this
Form 10-Q
for the quarter ended September 30, 2006, management, under
the supervision of the CEO and CFO, conducted an evaluation of
disclosure controls and procedures. A control system, no matter
how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control
system are met. Based on that evaluation, the CEO and
CFO concluded that the Company’s disclosure controls and
procedures were not effective at a reasonable assurance level as
of September 30, 2006 because of the material weaknesses in
the Company’s management report on internal controls over
financial reporting included in Item 9A to its Annual
Report on
Form 10-K
for the year ended December 31, 2005 (2005
Form 10-K)
and outlined below. As of September 30, 2006, none of the
material weaknesses identified in the 2005
Form 10-K
have been fully remediated, and each remains ongoing as of the
filing date of this Form 10-Q. Because the material
weaknesses described below have not been fully remediated as of
the filing date of this
Form 10-Q,
the CEO and CFO continue to conclude that the Company’s
disclosure controls and procedures are not effective as of the
filing date of this
Form 10-Q.
As previously disclosed in the 2005
Form 10-K,
management identified the following material weaknesses as of
December 31, 2005 and during the restatement process
relating to the Company’s internal control over financial
reporting:
•
insufficient controls related to the identification, capture and
timely communication of financially significant information
between certain parts of the organization and the accounting and
finance department to enable these departments to account for
transactions in a complete and timely manner;
•
lack of sufficient personnel with technical accounting expertise
in the accounting and finance department and inadequate review
and approval procedures to prepare external financial statements
in accordance with GAAP;
•
failure in identifying the proper recognition of revenue in
accordance with GAAP, including revenue recognized in accordance
with Statement of Position (SOP)
97-2,
“Software Revenue Recognition”
(SOP 97-2),
Staff Accounting Bulletin (SAB) No. 101, “Revenue
Recognition” (SAB 101), as amended by
SAB No. 104 (SAB 104),
SOP 81-1,
“Accounting for Performance of Construction-Type and
Certain Production-Type Contracts”
(SOP 81-1),
Financial Accounting Standards Board, Emerging Issues Task Force
(EITF)
00-21,
“Accounting for Revenue Arrangements with Multiple
Deliverables” (EITF
00-21);
•
the use of estimates, including monitoring and adjusting
balances related to certain accruals and reserves, including
allowance for doubtful accounts, legal charges, license fees,
restructuring charges, taxes, warranty obligations and fixed
assets;
•
lack of sufficient analysis and documentation of the application
of GAAP; and
•
ineffective controls over the documentation, authorization and
review of manual journal entries and ineffective controls to
ensure the accuracy and completeness of certain general ledger
account reconciliations conducted in connection with period end
financial reporting.
Because of the material weaknesses, the CEO and CFO concluded
that the Company did not maintain effective internal control
over financial reporting at a reasonable assurance level as of
September 30, 2006 or at the filing date of this
Form 10-Q.
Changes
in Internal Control over Financial Reporting
As disclosed in the Quarterly Report on
Form 10-Q
for the quarter ended June 30, 2005, in connection with the
preparation of that report and in consultation with
Ernst & Young LLP, the Company’s former
independent registered public accountants, the Company
determined that, due to deficiencies in communication of
financially significant information between certain parts of the
Company’s organization and the finance and accounting
organization (in particular the sales organization and the
accounting and finance department), its disclosure controls and
procedures and internal control over financial reporting were
not effective. As previously disclosed, under the direction of
the Company’s Audit Committee and with the participation of
senior management, the Company took steps designed to ensure
that organizations within it would communicate with one another
to further strengthen the Company’s internal controls.
These steps include increasing the scope of executive staff
meetings held on a weekly basis, quarterly disclosure committee
meetings, which include the heads of operational groups
(including sales, finance and accounting), the completion of
disclosure committee procedures by each member of the disclosure
committee, training provided to employees on the procedures
followed for reporting transactions to finance and emphasizing
the importance of promptly
communicating with the accounting and finance organization, and
additional training provided to the sales organization on prompt
communication and appropriate documentation.
In addition, in connection with the Company’s review of
disclosure controls and procedures as of December 31, 2004,
the Company determined that procedures related to controls over
the preparation and review of the 2004 Annual Report on Form
10-K were not effective. The insufficient controls included a
lack of sufficient personnel with technical accounting expertise
in the accounting and finance department and inadequate review
and approval procedures to prepare external financial statements
in accordance with GAAP.
In connection with the review of disclosure controls and
procedures as of December 31, 2005, the Company determined
that its revised communication procedures lacked sufficient
documentation to permit verification of the operation of this
control. Since the Company was not reporting its financial
information, this lack of documentation resulted from the
suspension of regular meetings of the disclosure committee.
Additionally, the Company did not complete the disclosure
procedures required by disclosure committee members on a
quarterly basis during the period that the Company was preparing
the restatement of its financials, as well as a lack of
documentation related to the training of the sales organization.
In addition, the Company has been relying on experienced
accounting consultants to provide the technical accounting
expertise and has not yet hired permanent personnel with this
expertise. As a result, the Company concluded that it failed to
remediate the previously identified material weaknesses, which
constitute ongoing material weaknesses in internal control over
financial reporting as of September 30, 2006 and at the
filing date of this
Form 10-Q:
•
insufficient controls related to the identification, capture and
timely communication of financially significant information
between certain parts of the organization and the accounting and
finance department to enable these departments to account for
transactions in a complete and timely manner; and
•
lack of sufficient personnel with technical accounting expertise
in the accounting and finance department and inadequate review
and approval procedures to prepare external financial statements
in accordance with GAAP.
Detailed
Discussion of Material Weaknesses
In addition to the two ongoing material weaknesses described
above, management identified four additional material weaknesses
as of December 31, 2005 and during the restatement process
and continuing through September 30, 2006 and through the
filing date of this
Form 10-Q.
Revenue Recognition.
The Company did
not properly recognize revenue on its video products in
accordance with GAAP, specifically
SOP 97-2,
SAB 104 and EITF
00-21.
The
Company also did not properly account for a product development
project in accordance with
SOP 81-1
and did not properly account for deferred revenue and related
cost of goods sold.
•
The Company acquired its video products as part of acquisitions
completed by the Company in 1999 and 2000, and at that time
determined that the products would be accounted for under
SAB 101, as amended by SAB 104. The Company did not
sufficiently evaluate its video products and continued to
account for its video products in accordance with SAB 104 when
revenue on the video products should have been accounted for in
accordance with the software revenue recognition principles
under
SOP 97-2.
Additionally, the Company sold maintenance support contracts
that included software upgrades with its video products and did
not establish vendor specific objective evidence (VSOE) of fair
value on the pricing of such maintenance contracts in accordance
with
SOP 97-2,
SAB 104 and EITF
00-21.
Because the Company continued to account for the video products
and maintenance sold with the video products under SAB 104,
the Company did not take the steps necessary to establish VSOE
of fair value on the pricing of its maintenance products and
revenue was recognized during incorrect periods.
•
The Company did not properly account for a significant
transaction whereby it developed a broadcast platform based on
its DM 6400 product to sell to its customer Thomson
Broadcast (Thomson) in accordance with project accounting under
SOP 81-1,
SAB 104 and EITF
00-21.
The
Company entered into an agreement with Thomson in December 2003
where it agreed to develop a statistical
remultiplexing product that would include certain features and
functionality (BP 5100) agreed upon by the parties, as well
as maintenance of the products purchased by Thomson for a period
of one year. In September 2004, Thomson accepted the
BP 5100 and the Company recognized revenue on the products
sold through September 2004 and the maintenance provided through
September 2004. In December 2004, the Company recognized revenue
on the BP 5100s sold to Thomson and the maintenance
provided to Thomson in the quarter ended December 31, 2004.
In December 2004, the Company extended its agreement with
Thomson by agreeing to develop an additional software release
containing additional features and functionality that were not
developed under the original agreement and providing product
maintenance for an additional period of one year. The Company
should have accounted for the transaction as a multiple element
arrangement under
SOP 97-2
and adopted the completed contract recognition criteria under
SOP 81-1,
which would have required the Company to delay recognizing
revenue under its agreement with Thomson until December 2005
when the Company completed its deliverables under the agreement.
•
The Company incorrectly recorded deferred revenue and cost of
goods sold on the balance sheet for certain transactions. As a
result of the Company’s focus on revenue recognition more
generally as described above, the Company identified specific
invoices for which deferred revenue for these sales had been
recognized but the criteria for revenue recognition had not been
met, including the criteria that delivery or performance had
occurred, the fees were fixed or determinable or that
collectibility was reasonably assured. Accordingly, the Company
corrected these errors in deferred revenue, deferred cost of
goods sold, inventory and accounts receivable accounts and
recognized revenue when title transferred or customer payments
were reasonably assured and all criteria for revenue recognition
were met.
The Use of Estimates.
The Company
lacked policies and procedures for determining estimates and
monitoring and adjusting balances related to certain accruals
and provisions, and also lacked support for its conclusions on
those estimates.
•
The Company did not effectively monitor and adjust reserves
related to its restructuring charges. In 2001, the Company
restructured a portion of its leased facilities in Israel. The
Company did not sufficiently review its restructuring charges to
account for its rental of the restructured facilities such that
at one point, the restructuring reserve exceeded the amount of
rent due under the lease.
•
The Company over accrued reserves related to the payment of
legal fees, taxes and other liabilities owed to third party
vendors. The Company did not have controls in place to
accurately estimate the accruals.
•
The Company used the wrong methodology to account for a prepaid
license fee associated with the research and development of one
of its product lines. The Company prepaid a license fee of
$2.0 million to license technology to incorporate into the
semiconductor chip used in its cable modem and eMTA products.
Additionally, as part of the license agreement, the Company was
required to pay a royalty of $1.00 per semiconductor chip
sold to a third party. When the Company selected the method of
amortization to be applied to the $2.0 million license fee,
the Company opted to amortize $1.00 per chip for each chip
utilized in the modem and eMTA products based on the third party
rate established in the license agreement. However, the Company
amortized the $2.0 million over the production of the
semiconductor chips and not the sale of the modem and eMTA
products containing the semiconductor chips. In hindsight, the
Company should have used the useful life method, which resulted
in quarterly adjustments as the royalty of $1.00 was overstated.
•
The Company did not properly account for warranty obligations
related to the sale of certain assets. In July 2003, the Company
sold certain assets related to one of its products to a third
party. Under the terms of the sale, the Company agreed to assume
up to $1.0 million warranty obligation on the product
related to the complaint of one customer. The Company recorded
the $1.0 million as an accrued warranty liability. The
Company amortized $0.8 million of the $1.0 million
obligation during 2004. However, during the course of the
restatement, the Company determined that the obligation should
not have been relieved unless either there was other actual
expenses incurred in connection with the obligation or upon the
actual expiration of the warranty. Since the Company did not
incur any expenses in connection with
this obligation, the Company corrected this error by increasing
the accrual $0.2 million in each quarter of 2004. Accordingly,
the warranty obligation of $1.0 million was relieved at
March 31, 2005 at the expiration of the warranty term.
Qualified Accounting Personnel.
The
Company did not have adequate personnel in its accounting and
finance department, and additionally lacked sufficient qualified
accounting and finance personnel to identify and resolve complex
accounting issues in accordance with GAAP.
Inadequate
Controls over Documentation and Record Keeping.
•
The Company did not have sufficient controls to address the
amendment of sales orders with its customers. Sales orders could
be amended through the amendment of the sales orders, purchase
orders, and agreements. When sales were amended through sales or
purchase orders, the person processing the amendments would
exercise discretion in inputting the revised terms and
conditions, and there was no consistent policy requiring the
accounting and finance department to approve such amendments or
even informing the accounting and finance department of such
amendments.
•
The Company did not retain certain corporate records in
conjunction with the sale of certain subsidiaries to third
parties.
•
The Company did not have sufficient controls in place to ensure
the proper authorization and review of manual journal entries
and the associated support documentation. Additionally, the
Company did not keep adequate documentation related to the
reconciliation of certain general ledger accounts.
Remediation
Steps to Address Material Weaknesses
In an effort to remediate the identified material weaknesses,
management is in the process of implementing the following
steps. As of the filing date of this
Form 10-Q,
the material weaknesses identified by management (and discussed
above) have not been remediated. Management does not anticipate
that the material weaknesses will be remediated until the second
half of the year ended December 31, 2007.
Communication
of Financial Information.
•
During the quarter ended June 30, 2005, the Company established
procedures to document the review of press releases to account
for transactions in a complete and timely manner.
•
During the quarter ended June 30, 2005, the Company also
improved the internal process of drafting and reviewing periodic
reports by implementing additional management and external legal
counsel review prior to their submission to the Company’s
independent registered public accounting firm.
•
Continue to monitor the communication channels between our
senior management and our finance department and take prompt
action, as necessary, to further strengthen these communication
channels;
•
Increase staffing in the finance department;
•
Re-allocate duties to persons within the finance organization to
maximize their skills and experience;
•
Implement training procedures for new employees and/or
consultants in the finance department on our disclosure
procedures and controls, our Company and our actions in previous
reporting periods; and
•
Take steps to ensure that our senior management has timely
access to all material financial and non-financial information
concerning our business.
Revenue
Recognition.
•
During the first three quarters of 2006, the Company’s
finance and accounting department, with the assistance of
outside consultants, implemented procedures to recognize sales
of its video products under the software accounting rules under
SOP 97-2
in accordance with GAAP.
In 2006, the Company established pricing guidelines and internal
procedures to ensure consistent pricing to allow for the
establishment of VSOE of fair value for sales made with multiple
element arrangements.
•
During the second and third quarters of 2005, the accounting and
finance department established procedures surrounding the
month-end close process to ensure that the information and
estimates necessary for recognizing revenue in accordance with
SOP 97-2
were available.
•
The Company will provide its accounting staff with training on
revenue recognition, including software accounting and project
accounting, and GAAP, including attending seminars and
conferences. Additional training will be provided on a regular
and periodic basis and updated as considered necessary.
•
During the quarter ended March 31, 2006, the Company hired
an experienced revenue accountant to review all revenue
transactions and to ensure that revenues, cost of goods sold,
deferred revenue, and deferred cost of goods sold are properly
accounted for in accordance with GAAP and the Company’s
policies.
Use of
Estimates.
•
The Company has engaged the services of experienced accounting
consultants to review the Company’s books and close
procedures on a monthly basis to assist management in ensuring
that the Company’s financial statements are being recorded
in accordance with GAAP.
•
The Company continues to engage the services of an outside tax
accounting firm to assist with the calculation of the
Company’s tax liabilities.
•
During the quarter ended September 30, 2006, the Company
established a process where all significant accruals must be
reviewed and approved by the Corporate Controller.
•
During the quarter ended June 30, 2006, the Company
implemented a process to obtain and assess accruals for legal
costs and expenses owed to third party vendors whereby the
Company’s legal department obtains monthly estimates from
the third party vendors and reviews the amount reported by third
party vendors for accuracy.
Accounting
Personnel.
•
During the quarter ended June 30, 2006, the Company engaged
experienced accounting consultants to act as the
VP Finance, Corporate Controller, and Revenue Recognition
Accountant.
•
During the second, third and fourth quarters of 2006, the
Company engaged expert accounting consultants to assist the
Company’s accounting and finance department with the
management and implementation of controls surrounding revenue
recognition, the administration of existing controls and
procedures, the preparation of the Company’s periodic
reports, and the documentation of complex accounting
transactions.
•
The Company continues to take steps to recruit additional
qualified senior accounting personnel, including certified
public accountants personnel with recent public accounting firm
experience.
Record
Keeping and Documentation.
•
During the quarter ended March 31, 2007, the Company’s
employees involved in order entry will receive training
regarding the controls and procedures surrounding the amendment
of sales orders. Additional training will be provided on a
regular and periodic basis and updated as necessary to reflect
any changes in the Company’s or its customers’
business practices or activities.
•
During the quarter ended June 30, 2006, the Company entered
into agreements with third parties that purchased assets from
the Company in Israel. These agreements provide the Company with
access to the corporate records and require the third parties to
retain documents in accordance with Israeli law.
The Company has adopted a policy requiring it to retain a copy
of all corporate records in connection with dispositions of
assets to third parties.
•
The Company has established policies and procedures for the
review and approvals of all manual journal entries.
•
Improving the review process that occurs prior to providing the
initial draft of the periodic report to our independent auditors
for review.
•
The Company has developed monthly close schedules which include
the timeline for completion and approval of reconciliations by
the Corporate Controller.
Subsequent
Changes in Internal Control over Financial Reporting
Except for the changes in connection with the remediation
subsequent to December 31, 2005 of the material weaknesses
described above, there were no changes in the Company’s
internal control over financial reporting that occurred during
the quarter ended September 30, 2006 that have materially
affected, or are reasonably likely to materially affect, its
internal control over financial reporting.
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