SCO Must Restate 2004 Earnings

The Unix company may prevent delisting by filing revised quarterly and annual reports, but with reclassification of shares in the works, financial questions remain.

SCO announced on Thursday that it would be restating three of its quarterly financial statements for 2004 because of accounting errors.

The SCO Group Inc. is facing delisting from the Nasdaq SmallCap Market stock market because of its failure to file its annual report, or Form 10-K, for the fiscal year ended Oct. 31, 2004, in a timely fashion.

Now we know some of the reasons why SCO was unable to file its report.

On Feb. 28, SCOs management, the Audit Committee of the Board of Directors, and KPMG LLP, SCOs auditors, agreed that, due to certain accounting errors, SCO could no longer rely on its financial statements for the 2004 quarters ending Jan. 31, April 30 and July 31, and would have to restate them.

Despite this, SCO, the embattled Unix company taking on IBM Corp. over Linux intellectual propery issues, announced that the restatement would not impact its previously reported net loss, its earnings per share, or its aggregate cash and available-for-sale securities balances for the fiscal year 2004.

/zimages/6/28571.gifClick here to read more about SCOs legal battle with IBM.

Specifically, Lindon, Utah-based SCO and its auditors found that the company must reclassify amounts related to certain shares of common stock that it may have issued under its equity compensation plans in the first, second and third quarters.

In a press release, SCO stated that "these shares may have been issued under SCOs equity compensation plans without complying with the registration requirements of federal and applicable state securities laws from permanent equity to temporary equity in the amounts of approximately $272,000, $231,000, and $557,000, respectively."

According to SCO sources, these amounts are not stock options. They are attributable to shares that were purchased through the employee stock purchase program.

Because of this, SCO may need to make a rescission offer to the employees who purchased these shares. A rescission is a legal remedy that erases an existing contract and restores everyone to their situation prior to entering into a contract. In this case, the stock would be repurchased from the employees by the company.

Therefore, if SCO makes a rescission offer for these shares, the amounts represent the cost to the company to repurchase them. These numbers, though, are only approximate ones. Thats because the price that SCO would have to pay would depend in part on the companys share prices when, and if, the rescission offer is made.

In the next problem area, SCO will need to reclassify accrued dividends related to its previously issued Series A and Series A-1 Convertible Preferred Stock from equity to current liabilities, in the amounts of about $879,000 and $1,619,000 for the first quarter and the second quarter respectively.

This is the stock that was issued in connection with SCOs $50-million private placement from BayStar Capital II LP and the Royal Bank of Canada. BayStar eventually assumed the Banks shares and then failed in an attempt to gain control of SCO.

After an acrimonious series of exchanges, BayStar agreed to sell its outstanding shares back to SCO in July 2004 for $13 million and 2.1 million shares of SCO common stock certificates for its shares.

Because of this, SCO no longer had to pay dividends on the BayStar shares. The accrued dividends were never paid and were recorded as equity when the BayStar repurchase transaction finally went through in August 2004.

It turned out that recording those dividends as equity was an error. So, SCO will be reclassifying these dividends as current liabilities instead of equity.

Finally, SCO expects that it will have to restate about $233,000 of stock-based compensation, aka stock options, an expense which was recorded in the second quarter but incurred in the first quarter. The net result will be that there will be no change to the total stock-based compensation expense for the fiscal year 2004.

Both the dividend and the stock option restatements, according to an offical SCO source, will result in a wash, with no net change to the companys bottom line.

SCO expects, as soon as SCO and KPMG LLP complete the analysis and audit review, to file amendments to its quarterly reports on Form 10-Q for the three quarters. After that, SCO will finally file its annual report on Form 10-K for fiscal year 2004.

In the meantime, SCO has already staved off delisting by obtaining a hearing with the Nasdaq Listing Qualifications Panel on March 17. Since the delisting process started because of SCOs failure to file its annual report, if the company is able to get its revised quarterly reports and annual report in before the hearing, this will go to SCOs credit.

Still, there are questions about SCOs finances.

/zimages/6/28571.gifTo read Steven J. Vaughan-Nichols opinion on SCOs potential downfall, click here.

"While SCO states that the pending restatement of financial statements to correct certain accounting errors will not impact the net loss or earnings for the fiscal year ended October 31, 2004," said Stacey Quandt, senior business analyst with the Robert Frances Group, "the question remains how this restatement will impact future earnings."

For example, because SCO expects to reclassify amounts related to its employee stock purchase shares and to reclassify dividends from equity to current liabilities, "a change from equity to liability may have a negative impact on SCOs future financial statements," said Quandt.

Quandt also raised the question of whether "SCOs agreement with its legal council to provide payment with SCO stock instead of cash has any relation to the restatement of earnings. For example, why does SCO need to restate approximately $233,000 of stock-based compensation expense which was recorded in the second quarter?"

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