Peregrine Systems Accounting Scandal

Peregrine Systems, Inc. was an enterprise software company that was founded in 1981 and sold enterprise asset management, change management, and ITIL-based IT service management software. Following an accounting scandal and bankruptcy in 2003, Peregrine was acquired by Hewlett-Packard in 2005.HP now markets the Peregrine products as part of its IT Service Management solutions, within the HP Software Division portfolio. Wall Street’s demand for high growth motivated Peregrine Systems’ executives, to fraudulently inflate revenues and stock prices. Peregrine apparently filed materially incorrect financial statements with the commission for 11 consecutive quarters. A member of Peregrine’s sales team admitted to meeting regularly with senior management near the end of the quarter to determine how much revenue was needed to exceed Wall Street’s expectations. The primary fraud committed by Peregrine was done by inflating revenue by booking revenue when sales never occurred. By recognizing revenue from sales that never occurred, the accounts receivable balance and net income were fraudulently overstated; the accounts receivable would never be collected, because the merchandise was never sold.

To cover up their high, outstanding, accounts receivable balance as a result of booking sales that did not occur, Peregrine fraudulently engaged in financial agreements with banks. Evidently, Peregrine Systems increased its revenues by pressuring distributors and resellers to build up their inventories. Through secret side or oral agreements Peregrine distributors and resellers were not obligated to pay Peregrine for their software inventories. This conduct obviously became a problem. If they could not sell Peregrine’s software, they would receive their money back. According to GAAP, revenue recognition on the sale of software requires evidence that an arrangement must exist, delivery must have occurred, vendor’s fees must be fixed or determinable, and collectability must be probable before recognizing revenue. Peregrine falsely recorded this transfer of inventory to distributors and resellers as revenue.

Peregrine officers, sales personnel, and channel partners knew through secret oral or written side agreements, that the channel partners were not obligated to pay Peregrine, but that Peregrine would later negotiate sales to end-users and arrange for the payment to `flow through’ them; the channel partners had 30 days or more to back out of the software license contracts; or if the channel partners were unable to resell Peregrine’s software licenses, they could invoice Peregrine for `services’ in a dollar amount equal to what they had not resold.” Peregrine falsely recorded as much as $225 million by falsely recognizing revenue in this way and recording it as a “non-substantial transaction,” which was in violation of GAAP revenue recognition criteria for software sales. By violating GAAP revenue recognition criteria, revenues and stockholders’ equity was overstated, and liabilities were understated. As a result of recognizing revenue without actually making a sale, Peregrine accumulated a large number of receivables on its balance sheet that would not or could not be paid. To remove the receivables from the balance sheet, to avoid suspicion, and to lower the days’ sales outstanding number, Peregrine assigned almost $141.6 million of its accounts receivable balance to a bank.

However, they reported the assigned receivables as a factoring agreement. In an assignment, the borrowing company (Peregrine) usually retains ownership of the assigned accounts, incurs any bad debts, collects the amounts due from customers, and uses these funds to repay the bank. In an assignment, the accounts receivable are not eliminated from the balance sheet; a liability is created, and the receivables are sold with recourse. This recourse means the bank can demand payment from the company if the receivables are not collected. This is what occurred with Peregrine. Peregrine sold the receivables, transferred title to the factor, who assumed all the risks of ownership. In this factoring agreement the accounts receivable were removed from the balance sheet, and the receivables were sold without recourse. This meant that if the receivables were not collected, the factor cannot demand payment. In my opinion, Peregrine recorded the “factoring” and assignment of their receivables as a factoring agreement and recorded the transaction as a sale of the receivables.

They recorded the cash received and removed the related receivables from the accounts. By removing the receivables, they treated the receivables as if the risk of collection had passed to the bank without recourse. Peregrine concealed the revenue fraud by violating GAAP for financing arrangements. Because Peregrine had given the banks recourse, and frequently paid or repurchased unpaid receivables from them, Peregrine should have accounted for the financing arrangement as a liability and left the receivables on its balance sheet. Apparently, Peregrine had an agreement with the bank that they would collect the receivables from the customers and, subsequently, submit the payments to the bank. Obviously, when the customers did not pay Peregrine, Peregrine either repurchased the receivables or paid back the bank. $70 million of payments were recorded on the income statement as acquisition or investment related expenses. This action resulted in one-time expenses rather than operating expenses.

This action misled investors and was, again, in violation of GAAP. As a result Peregrine’s financial statements and books overstated cash flow from operations and understated accounts receivable and their liabilities to the bank. If the receivable was actually collected, it would have been reduced by the company twice; when it was sold to the bank and when it was received by the company (instead of increasing accounts payable for the liability that it did not record). This transaction overstated cash and understated receivables. When the amount was paid to the bank, the double dipped entries were reversed. Peregrine also understated compensating expenses. They picked the lowest stock price of the period for the compensating stock options, even though the decision to distribute these options had been made in the previous period. According to GAAP, any difference in the stock price between the exercise price and that on the date of measurement should be recorded as a compensating expense.

By not complying with the GAAP and fraudulently not recognizing these expenses, Peregrine’s expenses were falsely understated by nearly $100 million (judge rules). Peregrine also falsely recorded and falsely recognized revenue on nonmonetary transactions and of similar assets. Peregrine exchanged software with another software company, exchanged checks, and recognized revenue even though they were equal trades. Under GAAP, with the exchange of similar assets, a gain can only be recognized to the extent that boot or cash is received, unless the boot is less than 25% of the fair market value of the assets exchanged. By recognizing that revenue fraud was committed, boot should not have to be given when the assets have the same fair market value. Peregrine originally told investors and government regulators that its losses from April 1999 to December 2001 amounted to $1.54 billion. Their restatement showed these losses to be $4.09 billion. The shares of Peregrine trades were near eighty dollars a share in the year 2000. It was later delisted by the NASDAQ and traded at forty-one cents on an over- the-counter stock. Today, shares trade at nearly twenty dollars a share as an over-the-counter stock.

By issuing and approving financial statements that did not contain reliable information, Peregrine was doomed. Information did not faithfully represent the earnings and expenses of the company. Instead, it was biased to what Wall Street wanted-high growth. The information did not provide predictive or feedback value, as one cannot predict or change the future based on false reporting. Therefore, the information in the financial statements was not relevant. Because the information in the financial statements was not reliable nor contained relevant information, it was not acceptable under GAAP. Almost two-thirds of Peregrine’s licensing revenue never existed; it is not understood how the board could have approved Peregrine’s financial statements when Peregrine was so noticeably smaller. Now, the requirement for more signatures for the approval of financial statements and the annual report are becoming more prevalent.

I think that a good way to prevent management from even feeling tempted to falsely inflate earnings is to take away their personal gains, if the company’s stocks go up. I believe that when upper level management has too much incentive based on personal financial gain, which is directly based on the performance of the company; it compromises their judgments. I think that upper level management should not be allowed to receive stock options or to even own stock in the company as the financial statements would provide a neutral, bias-free report. Management would have no reason to “cook the books.” I also feel that any management who still decides to falsify documents needs to be held more accountable for their actions and receive tougher punishments. I think that these strict guidelines would help the people feel more confident in investing their money into the stock market.

References

Summary of Peregrine Scandal – http://www.freerepublic.com/focus/news/854680/posts Article relating to Peregrine’s Scandal – http://accounting.smartpros.com/x46099.xml LA Times Article regarding Peregrine –

http://articles.latimes.com/keyword/peregrine-systems-inc
FBI website press release regarding Peregrine –
http://www.fbi.gov/news/pressrel/press-releases/executives-and-auditor-of-peregrine-systems-inc.-indicted-on-securities-fraud-charges