Electronic Data Systems [EDS] has revealed just how badly it was wrong-footed by a change in accounting rules on services contracts, when it revealed a $2.24 billion non-cash charge for the first quarter of this year.
The figures mean that EDS’ first quarter reported loss ballooned from $0.26 per share to $2.95 per share. EDS warned of the upcoming revision back in July. At the time it said the revision was likely to be in the region of $1 to $2 billion.
Companies have a choice of either applying the rule change, EITF 00-21, to contracts signed after June 30 2003, or applying it retroactively, and adjusting previous figures accordingly.
EDS said it had chosen the latter option because it results in more consistency when accounting for both existing and future contracts.
This consistency comes at a price, however. For example, $3 billion in unbilled revenue carried as an asset on EDS’ balance sheet has been slashed by $2.9 billion, while $1.1 billion of costs are deferred.
The upshot is a non-cash $2.24 billion cumulative accounting adjustment. This translates into an after tax earnings impact of $1.42 billion, or $2.92 per share, applied against EDS’ first-quarter results.
Under the previous percentage of completion (POC) system, EDS’ first quarter pro forma earnings were $0.30 per share, or a $0.26 loss per share on a GAAP basis.
Under the new system, EDS’s adjusted pro forma first earnings are now $0.07, which on a GAAP basis, equates to a loss of $2.95 per share.
The adoption of the new rules has an ongoing impact, with subsequent quarters’ earnings having to be adjusted accordingly. EDS’ second quarter earnings were originally $0.34 pro forma and $0.28 under GAAP. Yesterday’s restatement reduced those figures to $0.24 and $0.18 respectively.
However, the company said it expected to recoup the cumulative adjustment in future quarters as it delivers services under existing contracts.
EITF 00-21 applies to the way companies in a variety of industries record revenue on long-term service contracts with multiple deliverables. Its effects are particularly felt in contracts that involve high start-up costs, such as complex IT deals.
The upshot of the rule change is that EDS will generally report lower amounts of revenue and income in the early stages of a contract, with higher amounts of revenue and income in later stages.
Previously, revenues would have been recorded on a percentage of completion basis. Under this system, revenue was recognized according to the percentage of work completed. EDS said that based on initial costs incurred at the beginning of a contract, it would record a portion of amounts not yet billed to the customer as revenue. Revenue in excess of billed amounts was posted on the balance sheet as unbilled revenue while operating costs were expensed as incurred.
Under the new rules, contracts are split into components, with, for example, the costs of building a system accounted for separately from operating costs. EDS said this means that it will generally only recognize revenue when it is billed. At the same time, development costs will generally be deferred and amortized over the life of the contract.
The company was adopting the rule change going forward and did not anticipate any material affect from the change, as it had not used POC accounting on commercial outsourcing
This article was based on material originally published by ComputerWire.