One of the big news items yesterday was that Supermicro held their quarterly conference call and made a big disclosure: their ongoing accounting investigation was not yet complete. That is important as on Friday, August 24, 2018, the company has a deadline from the NASDAQ to file its delinquent SEC filings. Here is a link to the disclosure. At STH, we review a lot of Supermicro products, and more, we are a customer. If you are reading STH, there is a good chance some part of this page view was served by a Supermicro server. Since I spent well over eight years doing management consulting at a Big 4 firm after finishing my JD/MBA, I tuned into the conference call and wanted to provide some context.

The accounting issue at Supermicro has already claimed numerous executives. Kevin Bauer the current CFO shed some light on what is going on at the company. Here is what he had to say, (apologies for typos as I am trying to transcribe portions of the quarterly conference call):

“[O]ur cash flows have not been impacted by our findings and no transaction reviewed by the company as part of this processes has involved revenue that could not ultimately be recognized nor have we concluded that a restatement to financial results is necessary.“

Breaking that down, it means that the accounting issue is most likely a revenue timing issue.

“The question you must be asking is why is this matter taking so long. The answer is that in order to be thorough, we are reviewing transactions near the end of each quarter for similar issues found in the earlier testing, but particularly as it relates to the matching of PO and shipping terms to the timing of revenue. As we’re a high-volume business, this entails locating documentation that is on-site, archived or at third parties and reviewing thousands of revenue transactions in detail using a structured approach.“

When accountants perform this type of investigation, they typically have to go back to source documents. Supermicro, unlike companies like larger companies like HPE and Dell EMC, has less formal systems. That gives the company agility, but it also means that documentation is spread all over. Although I cannot go into details of the project, when I was doing management consulting, I had a project at one of the largest computer/ server manufacturers where we had to disposition over 250K contracts spread in over 120 countries. That project took many months and the start involved simply finding the contracts in filing cabinets in offices in different companies.

“There are a number of issues, however, let me share an example of an issue that has arisen in our reviews. We have from time-to-time offered free shipping to customers, even though terms of our agreements with those customers provided that the customer would arrange for its own shipping company to pick the products up at our factory shipping dock. This practice had the unintended accounting consequences, converting the transaction from an ex-works transaction to a FOB transaction. If the end of quarter shipments are adjusted in this way, it can cause the appropriate date for recognizing the revenue for those shipments to slip from one quarter into the next…

The company believes the revenue recognized for reviewed transactions is valid revenue. The main issue is the quarter in which revenue must be recognized. We have not yet determined whether the magnitude of any timing adjustment will be material to any of our previously filed financial statements.“

This is a big deal. When doing management consulting I setup the pricing, discounting, and deal management systems of a then top 3 storage provider. One of the key points we had to watch was shipping terms on quotes as deals would come through. Revenue is often recognized when the company has fulfilled its obligations to a customer. Changing shipment terms to “free” instead of ex-works means that the company’s obligation can change from making the product available at their loading dock to when it is delivered to their customer. Further, depending on the terms, it can also mean that the company is required to carry the risk of loss all the way through the shipping process.

End of quarters at hardware companies are historically under what is called the “hockey stick” pressure. Sales are often slow in the early part of the quarter, but customers push for discounts at the end of a quarter and those discounts are often granted to make quarterly financial figures. In the last few hours of a quarter, deals, where one can fulfill obligations to customers by having the delivery point being the warehouse loading dock, are better than ones where the company has to guarantee delivery to a customer premises. Often sending an order air freight means it arrives the next day. From an accounting standpoint, that means the shipment arrives on the first day of the next quarter.

Looking Ahead

It seems that the company is bracing for delisting from the NASDAQ. That will hurt the company’s equity liquidity if it is instead traded over the counter (OTC.) Kevin Bauer stated on the call that the company is working with creditors on the matter:

“Finally, we’re also working closely with the agent of our bank group to inform on the testing process as well as our progress toward completing all the SEC filings. As a result, we expect to continue to have adequate lines of credit to fund the continued growth of the company. We’re not able today to project the date by which we will complete this review and file all our delinquent SEC reports, but we believe that date is not too far in the future. Thankfully, our business remains healthy and has grown during this time as a result of our fourth quarter reflect.“