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Cover Letter
ESCO TECHNOLOGIES INC
9900A Clayton Rd.
St. Louis, Mo. 63124-1186
March 1, 2006
Mr. Joseph Foti
Senior Assistant Chief Accountant
Division of Corporation Finance
Securities and Exchange Commission
100F Street, N.E.
Washington, D.C. 20549
RE: ESCO Technologies Inc.
File No. 1-10596
Form 10-K for the Fiscal Year Ended September 30, 2005
Dear Mr. Foti:
The attachment to this letter sets forth the response of ESCO Technologies Inc.
(the "Company") to the comment of the Division of Corporation Finance of the
Securities and Exchange Commission (the "Commission") dated February 2, 2006,
with respect to the above referenced filing. We have duplicated the comment set
forth in the comment letter in the attachment and have provided our response.
If you have any questions or if you require additional information, please do
not hesitate to contact me at 314-213-7246.
Sincerely,
/s/ Gary E. Muenster
Gary E. Muenster
Senior Vice President
and Chief Financial Officer
ESCO Technologies Inc.
9900A Clayton Road
St. Louis, MO 63124
Correspondence
COMMENT #1: CRITICAL ACCOUNTING POLICIES:
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We note that management is required to make estimates and use assumptions under
certain revenue models utilized by the Company (e.g., percentage of completion,
milestones, cost reimbursement contracts) and accordingly, you consider revenue
recognition as one of your critical accounting policies; however, such
disclosures should supplement, not duplicate, the description of the accounting
policies that are already disclosed in the notes to the financial statements.
The disclosure should provide greater insight into the quality and variability
of information in the financial condition and operating performance and address
why the Company's accounting estimates or assumptions bear the risk of change.
For example, with respect to your estimates and assumptions used in revenue
recognition you should consider discussing, to the extent material, factors such
as how you arrive at your estimates, how accurate the estimate/assumption has
been in the past, how much the estimate/assumption has changed in the past, and
whether the estimate/assumption is reasonably likely to change in the future.
Since critical accounting estimates and assumptions are based on matters that
are highly uncertain, you should analyze their specific sensitivity to change,
based on other outcomes that are reasonably likely to occur and would have a
material effect. In this regard, we believe you should consider revising your
disclosures in your critical accounting estimates to address the factors
discussed above, to the extent material, rather than duplicate your accounting
policy from the notes to the financial statements. Please refer to the guidance
in FR-72 (Release No. 33-8350).
Response
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As suggested by the Staff, Management will revise our critical accounting policy
disclosures in future filings to further clarify our estimates and assumptions
used in revenue recognition. Our proposed revision to be included in future
filings to our critical accounting estimates is presented below.
Filtration / Fluid Flow Operating Unit:
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Within the Filtration / Fluid Flow operating unit, approximately 75% of
operating unit revenues (30% of consolidated revenues) are recognized when
products are delivered (when title and risk of ownership transfers) or when
services are performed for unaffiliated customers.
Approximately 25% of operating unit revenues (10% of consolidated revenues) are
recorded under the percentage-of-completion provisions of SOP 81-1, "Accounting
for Performance of Construction-Type and Certain Production-Type Contracts"
because the Company manufactures complex products for aerospace and military
customers under production contracts. The percentage-of-completion method of
accounting involves the use of various estimating techniques to project costs at
completion. These estimates involve various assumptions and projections relative
to the outcome of future events over a period of several years, including future
labor productivity and availability, the nature and complexity of the work to be
performed, availability of materials, the impact of delayed performance, and the
timing of product deliveries. These estimates are based on Management's judgment
and the Company's substantial experience in developing these types of estimates.
Changes in underlying assumptions/estimates may adversely affect financial
performance if they increase estimated project costs at completion, or
positively affect financial performance if they decrease estimated project costs
at completion. Due to the nature of these contracts and the operating unit's
cost estimating process, the Company believes that these estimates generally
should not be subject to significant variation in the future. There have been no
material changes to these estimates for the financial statement periods
presented. The Company regularly reviews its estimates to assess revisions in
contract values and estimated costs at completion.
Communications Segment:
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Within the Communications segment, approximately 90% of the segment's revenue
arrangements (30% of consolidated revenues) contain software components. Revenue
under these arrangements is recognized in accordance with Statement of Position
97-2 (SOP 97-2), "Software Revenue Recognition," as amended by SOP 98-9,
"Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain
Transactions." The application of software revenue recognition requires
judgment, including the determination of whether a software arrangement includes
multiple elements and estimates of the fair value of the elements, or
vendor-specific objective evidence of fair value ("VSOE"). Changes to the
elements in a software arrangement, and the ability to identify VSOE for those
elements could materially impact the amount of earned and/or deferred revenue.
There have been no material changes to these estimates for the financial
statement periods presented and the Company believes that these estimates
generally should not be subject to significant variation in the future. The
remaining 10% of the segment's revenues represent products sold under a single
element arrangement and are recognized when products are delivered to
unaffiliated customers.
Test Segment:
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Within the Test segment, approximately 65% of revenues (18% of consolidated
revenues) are recognized when products are delivered (when title and risk of
ownership transfers) or when services are performed for unaffiliated customers.
Certain arrangements contain multiple elements which are accounted for under the
provisions of EITF 00-21, "Revenue Arrangements with Multiple Deliverables." The
application of EITF 00-21 requires judgment as to whether the deliverables can
be divided into more than one unit of accounting and whether the separate units
of accounting have value to the customer on a stand-alone basis. Changes to
these elements could affect the timing of revenue recognition. There have been
no material changes to these elements for the financial statement periods
presented.
Approximately 35% of the Test segment revenues (10% of consolidated revenues)
are recorded under the percentage-of-completion provisions of SOP 81-1,
"Accounting for the Performance of Construction-Type and Certain Production-Type
Contracts" due to the complex nature of the enclosures that are designed and
produced under these contracts. As discussed above, this method of accounting
involves the use of various estimating techniques to project costs at
completion, which are based on Management's judgment and the Company's
substantial experience in developing these types of estimates. Changes in
underlying assumptions/estimates may adversely or positively affect financial
performance. Due to the nature of these contracts and the operating unit's cost
estimating process, the Company believes that these estimates generally should
not be subject to significant variation in the future. There have been no
material changes to these estimates for the financial statement periods
presented. The Company regularly reviews its contract estimates to assess
revisions in contract values and estimated costs at completion.
COMMENT #2: NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (e) REVENUE
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RECOGNITION
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Based on your current revenue recognition accounting policies you indicate that
the majority of your revenues are recognized upon product shipment or when
services are performed, and that other revenue recognition methods are also used
depending on the terms of the contract or arrangement. However, your disclosures
appear only to provide general descriptions of your broad number of revenue
recognition methods and do not elaborate on how such methods relate to your
specific product and service offerings. That is, the information included in
your current revenue recognition footnote is insufficient to provide a reader
with a clear understanding of how each of the revenue methods employed by the
Company and its respective criteria for recognition applies to your product and
service offerings, and, furthermore, the context necessary to assess the
significance of each type of revenue stream relative to your consolidated
financial statements. For example, you state revenue recognition under long-term
contracts, for which delivery is an inappropriate measure of performance, the
percentage of completion method is used; however, there is no explanation as to
why delivery is an inappropriate measure of performance, or alternatively, why
percentage of completion is appropriate rather than other methods used by the
Company such as milestone-based or when specific contract terms are fulfilled.
Another example includes your disclosure with respect to cost reimbursement
contracts in which case revenue is recognized as costs are incurred plus a fixed
fee, but it is unclear which of the Company's products and/or service
offering(s) that this method of recognition is relevant and why. Furthermore, it
is unknown whether there are circumstances that exist where the Company may be
liable for or obligated to repay any of the funds and if so, how such funds are
accounted for within the financial statements. In this regard, we believe you
should revise future filings to clarify your revenue recognition policy to
provide in clear and complete detail of the information necessary for a reader
to understand the application of the Company's revenue recognition methods
relative to its various product and service offerings. For each method, please
discuss the products and services involved and why such method is appropriate
for recognition. This will provide enhanced clarity and transparency within your
current disclosures. Note that for revenue methods that do not generally
represents a material portion of the company's revenue, you may quantify or
specifically discuss in the footnote why you do not consider it to be material.
Please provide us with your proposed revisions.
Response
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As suggested by the Staff, Management will revise future filings to clarify our
revenue recognition policy to provide in clear and complete detail the
information necessary for a reader to understand the application of the
Company's revenue recognition methods relative to its various product and
service offerings. Our proposed revision to our Summary of Significant
Accounting Policies in future filings is provided below.
Filtration / Fluid Flow Operating Unit:
- ------------------------------------------
Within the Filtration / Fluid Flow operating unit, approximately 75% of
operating unit revenues (30% of consolidated revenues) are recognized when
products are delivered (when title and risk of ownership transfers) or when
services are performed for unaffiliated customers.
Approximately 25% of operating unit revenues (10% of consolidated revenues) are
recorded under the percentage-of-completion provisions of SOP 81-1, "Accounting
for Performance of Construction-Type and Certain Production-Type Contracts."
Products accounted for under SOP 81-1 include the design, development and
manufacture of complex fluid control products, quiet valves, manifolds and
systems primarily for the aerospace and military markets. For arrangements that
are accounted for under SOP 81-1, the Company estimates profit as the difference
between total estimated revenue and total estimated cost of a contract and
recognizes these revenues and costs based on units delivered. The
percentage-of-completion method of accounting involves the use of various
estimating techniques of expected costs at completion.
Communications Segment:
- ------------------------
Within the Communications segment, approximately 90% of the segment's revenue
arrangements (30% of consolidated revenues) contain software components. Revenue
under these arrangements is recognized in accordance with Statement of Position
97-2 (SOP 97-2), "Software Revenue Recognition," as amended by SOP 98-9,
"Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain
Transactions." The segment's software revenue arrangements generally include
multiple products and services, or "elements" consisting of meter and substation
hardware, meter reading system software, software support (post-contract
customer support "PCS") and program management support. These arrangements
typically require the Company to deliver software at the inception of the
arrangement while the hardware, software support and program management support
are delivered over the contractual deployment period. These revenue arrangements
are divided into separate units of accounting if the delivered item(s) has value
to the customer on a stand-alone basis, there is objective and reliable evidence
of the fair value of the undelivered item(s) and delivery/performance of the
undelivered item(s) is probable. For multiple element arrangements, revenue is
allocated to the individual elements based on vendor-specific objective evidence
of fair value ("VSOE") of the individual elements.
The application of these principles requires judgment, including the
determination of whether a software arrangement includes multiple elements and
estimates of the fair value of the elements. The VSOE of the undelivered
elements is determined based on the historical evidence of stand-alone sales of
these elements to customers. Hardware revenues are generally recognized at the
time of shipment or receipt by customer depending upon contract terms. VSOE
generally does not exist for the software element, therefore, the Company uses
the residual method to recognize revenue when VSOE exists for all other
undelivered elements. Under the residual method, the fair value of the
undelivered elements is deferred and the remaining portion of the arrangement
fee is recognized as revenue.
SOP 97-2 requires the seller of software that includes post-contract customer
support (PCS) to establish VSOE of the undelivered element of the contract in
order to account separately for the PCS revenue. The Company determines VSOE by
a consistent pricing of PCS and PCS renewals as a percentage of the software
license fees and by reference to contractual renewals, when the renewal terms
are substantive. Revenues for PCS are recognized ratably over the maintenance
term specified in the contract (generally in 12 monthly increments). Revenues
for program management support are recognized when services have been provided.
The Company determines VSOE for program management support based on hourly rates
when services are performed separately.
Deferred revenue is recorded for products or services that have not been
provided but have been invoiced under contractual agreements or paid for by a
customer, or when products or services have been provided but the criteria for
revenue recognition have not been met. If there is a customer acceptance
provision or there is uncertainty about customer acceptance, revenue is deferred
until the customer has accepted the product or service.
Approximately 10% of segment revenues (4% of consolidated revenues) are
recognized when products are delivered (when title and risk of ownership
transfers) or when services are performed for unaffiliated customers. Products
include the SecurVision digital video surveillance systems.
Test Segment:
- --------------
Within the Test segment, approximately 65% of revenues (18% of consolidated
revenues) are recognized when products are delivered (when title and risk of
ownership transfers) or when services are performed for unaffiliated customers.
Certain arrangements contain multiple elements which are accounted for under the
provisions of EITF 00-21, "Revenue Arrangements with Multiple Deliverables." The
multiple elements generally consist of materials and installation services used
in the construction and installation of standard shielded enclosures to measure
and contain magnetic and electromagnetic energy. The installation process does
not involve changes to the features or capabilities of the equipment and does
not require proprietary information about the equipment in order for the
installed equipment to perform to specifications. There is objective and
reliable evidence of fair value for each of the units of accounting, as a
result, the arrangement revenue is allocated to the separate units of accounting
based on their relative fair values. Typically, fair value is the price of the
deliverable when it is regularly sold on a stand-alone basis.
Approximately 35% of the segment's revenues (10% of consolidated revenues) are
recorded under the percentage-of-completion provisions of SOP 81-1, "Accounting
for the Performance of Construction-Type and Certain Production-Type Contracts"
due to the complex nature of the enclosures that are designed and produced under
these contracts. Products accounted for under SOP 81-1 include the construction
and installation of complex test chambers to a buyer's specifications that
provide its customers with the ability to measure and contain magnetic,
electromagnetic and acoustic energy. As discussed above, for arrangements that
are accounted for under SOP 81-1, the Company estimates profit as the difference
between total estimated revenue and total estimated cost of a contract and
recognizes these revenues and costs based on either (a) units delivered or (b)
contract milestones.
If a reliable measure of output cannot be established, (which applies in less
than 8% of Test segment revenues or 2% of consolidated revenues) input measures
(e.g., costs incurred) are used to recognize revenue. Given the nature of the
Company's operations related to these contracts, costs incurred represent an
appropriate measure of progress towards completion.
The percentage-of-completion method of accounting involves the use of various
estimating techniques of expected costs at completion. These estimates are based
on Management's judgment and the Company's extensive experience in developing
these types of estimates.
COMMENT #3: NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (e) REVENUE
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RECOGNITION
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Further, we also note that you enter into multiple element arrangements for
which you account for such arrangements in accordance with EITF No. 00-21 and
SOP No. 81-1. Please explain to us and revise future filings to describe the
multiple elements typically involved in such arrangements and, for elements
where fair value has been determined by the Company, disclose the objective
evidence used specifically in determining its respective fair value and its
impact on the timing of revenue recognition.
Response
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As suggested by the Staff, Management will revise future filings to describe the
multiple element arrangements in accordance with EITF 00-21 and SOP 81-1. Our
proposed revision to our future filings is included in response to comment #2
above.
COMMENT #4: NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (e) REVENUE
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RECOGNITION
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We note your disclosure on page 3 of Form 10-K indicates that your two-way
communication systems (i.e. TWACS systems) for the electric utility industry are
comprised of software in addition to equipment and support services, and
according to your revenue footnote you follow the guidance outlined in SOP No.
97-2 for arrangements which involve software. We also note that revenue
generated from the sales of TWACS systems represented a significant portion of
total revenues in fiscal years 2005, 2004 and 2003 or 28%, 31% and 34%,
respectively. In this regard, we would expect your accounting policy to discuss
the nature and accounting recognition for such software revenue arrangements at
length in light of the complexities relative to the recognition of software
revenue and significance of such software revenues to your consolidated
financial statements. However, we note your disclosure provides only a brief
description of your policy in generic terms and, therefore, does not supply a
reader with meaningful information or the insight necessary to obtain an
understanding of how the guidance prescribed in SOP 97-2 and its application
affects the timing of the Company's recognition of software revenue. In this
regard, we believe you should significantly expand your footnote in future
filings to discuss your accounting for software revenue arrangements relative to
your product and service offerings and how your accounting recognition complies
with SOP 97-2. In addition to the items mentioned above, your revised disclosure
should consider: (1) The types of products and services involved in transactions
(2) Whether vendor specific objective evidence of fair value (VSOE) has been
established for any of the multiple elements and if so, identifying such
elements and the method for which VSOE was established in accordance with SOP
97-2 and; (3) How the establishment of VSOE for any of the multiple element
arrangements noted in (2) above affected the timing of your revenue recognition.
Please revise future filings accordingly and provide us with your revised
disclosures.
Response
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As suggested by the Staff, Management will revise future filings to discuss the
nature and accounting recognition for software revenue arrangements as outlined
in the guidance provided in SOP 97-2. Our proposed revision to our future
filings is included in response to comment #2 above.