Cisco Alters Andiamo Accounting

Cisco Systems Inc. (Nasdaq: CSCO) today disclosed that it will take a non-cash charge in the next quarter of between $200 million and $500 million related to a change in the way it accounts for the expected value of stock options granted to Andiamo Systems Inc. employees.

The disclosure reveals that Cisco believes it has invested at least $339 million into Andiamo to date ($139 million in debt plus a minimum of $200 million in options expenses). That would easily make Andiamo one the most richly valued "startups" in the storage networking industry.

Andiamo is the Fibre Channel switch venture that, since its inception in early 2001, has been exclusively funded by Cisco. Last August, Cisco said it would acquire Andiamo in an all-stock deal worth as much as $2.5 billion (although the final price is expected to be less). Andiamo is housed on the Cisco campus in San Jose, Calif. (see Cisco's Creative Andiamo Options, Cisco Buys Andiamo, and Cisco Owns Up to Andiamo).

The company disclosed the accounting change today in its 10Q filing for the quarter ended April 26, 2003, with the Securities and Exchange Commission (SEC).

In its filing, Cisco cited the Financial Accounting Standards Board's rule No. 46, "Consolidation of Variable Interest Entities," issued in January 2003, which requires companies to report assets, liabilities, and results of a "variable-interest entity" as part of its consolidated financial statements. Cisco says "substantially all Andiamo employee stock and options" fall into the variable accounting category, because the final purchase price Cisco pays for Andiamo is primarily derived from a revenue-based formula.Basically, Cisco is having to account for the anticipated value of the options that have been given to Andiamo employees as operating expenses now, rather than at the time it completes the acquisition. Cisco expects the deal to close as early as the third quarter of fiscal 2004 (between February and April 2004) and no later than July 31, 2004.

Cisco previously has recorded its investment in Andiamo purely as an R&D expense. That has amounted to $139 million as of April 26, 2003: $84 million in the form of convertible debt, which will be convertible into about 44 percent of the equity in Andiamo; and $55 million of nonconvertible debt, out of a total of $100 million in additional funding Cisco has promised to Andiamo.

The other 56 percent ownership stake in the "startup" consists entirely of stock options granted to Andiamo's approximately 270 employees and 37 Cisco employees who have been "seconded" to Andiamo (which means they are technically employed by Cisco but work full-time for Andiamo). The estimated value of those options to date, then, would average out to between $650,000 and $1.63 million per employee.

As a result of the FASB rule, Cisco will account for Andiamo "as if it had consolidated it since the company's initial investment in April 2001." That means that on July 27, 2003 -- the first day of Cisco's fiscal year 2004 -- the company will be forced to take a non-cash cumulative charge in the range of $200 million to $500 million to account for the variable compensation from April 2001 through July 2003 of Andiamo employees. Cisco says it will report that charge as a separate line item in its consolidated statements of operations, net of tax.

The charge will be based on the value of the Andiamo employee stock and options and their expected vesting. However, Cisco said, the amount does not necessarily reflect the value of Andiamo as a whole or indicate the expected valuation of Andiamo upon acquisition.Until the Andiamo deal closes, Cisco will record charges based on the expected vesting value of the Andiamo employee stock and options as operating expenses. Cisco says Andiamo is the only such entity requiring the accounting change under FASB rule No. 46 that will have a material impact on its operating results or financial condition.

Todd Spangler, US Editor, Byte and Switch