Asia deal didn’t raise Enterasys auditor's eyebrow

An on-site auditor looking at the books of Enterasys Networks seemed unfazed when she learned that a deal was being negotiated a week after the quarter in which it would be included as revenue ended, according to an e-mail disclosed in court Wednesday.

Yet it was this deal with Ariel International by the company’s Asia Pacific division – reached in the crucial quarter in 2001 when Enterasys spun off from Cabletron Systems — that eventually led to an investigation into accounting fraud and resulted in the criminal prosecution of five former Enterasys executives in U.S. District Court in Concord.

Prosecutors charged that executives conspired with at least four other executives who have already pleaded guilty to inflate revenue in order to enrich themselves and secure their positions.

In the Ariel transaction, the government charged that the executives took out various terms of the agreements that would preclude it from being recognized as revenue after the fact, backdated the revised document, and then secretly put the terms in a separate side letter, hiding all of this from the auditors, KPMG.

On Wednesday, after much wrangling by the attorneys, James Boyer a partner of KPMG who headed the Enterasys auditing team, took the stand. While much of the time he spent instructing the jury in basic accounting principles, he did start talking about the Ariel deal, referring to working papers dated Sept. 1, 2001, which showed “no unusual terms” were noted in the company’s ongoing audit. The alleged back-dated documents were only discovered the following February, during the audit of the company’s annual statement.

But the auditors apparently got wind something was up with the Ariel deal in early September, according to an e-mail chain revealed under cross-examination of Tara Shawver – a former Enterasys accountant who was the liaison with KPMG. KPMG asked Shawver whether there was anything different from the standard terms in that agreement. An Enterasys employee from the Asia Pacific Division replied on Sept. 7 that “we are still in the process of negotiating the agreement”

Elaine Marks, KPMG’s on-site auditor simply said “thanks” and to “let us know what due diligence management was done to ensure collectability is reasonably insured,” according to the e-mail There seemed no indication of concern that the deal was still being negotiated after the quarter ended.

In addition to the auditors, the government questioned John Scarfidi, the former chief executive officer of Worldlink — one of the three firms involved in “three-corner deals” in shaky companies allegedly designed primarily to inflate revenue during the quarter in question. These deals, the government charges were done primarily to recycle cash.

Wordlink, which provided telephone service over a wireless Internet connection primarily for Third World countries, simply wanted to borrow money to purchase the company’s equipment, Scarfidi testified. The company only had $170,000 in the bank, and was seeking to buy some $6 million in equipment.

Defendant Robert Barker, who was part of Enterasys’ investment team, instead wanted to structure the loan as an investment (contingent on the company’s current financing coming through). On Barber’s instructions, Enterasys would wire some $6.8 money to World Link, which immediately used it to purchase $5.3 million in equipment from a distributor, two days before the quarter, Scarfidi said.

The following day, Enterasys wired almost $500,000 and the company immediately wrote a check that matched the investment to the penny to purchase the software that went with it. The government alleges that that revenue was improperly reported as revenue to the auditors.

Wordlink’s other financing never came through, so the investment did not pan out. As for the equipment, Scarfidi said, much of it “was being packed up and being shipped back to ETS (Enterasys)” when he left in 2003.

Barber’s attorney emphasized several points during his cross-examination of Scarfadi:

• Barber conducted due diligence on the other investors, and there appeared to be no problems with them at the time.
• While Worldlink didn’t have much cash, it did rake in some $7.6 million in revenue and made some $736,000 in pre-tax profits in the quarter ending on June 30 2001.
• There were legitimate reasons to invest in Worldlink aside from revenue recognition.
• The company ended up using a large portion of the product in Miami. – BOB SANDERS