DIGITAL FUSION, INC.
4940-A Corporate Drive
Huntsville, AL 35805
July 26, 2005
BY ELECTRONIC TRANSMISSION
Securities and Exchange Commission
Division of Corporation Finance
450 Fifth Avenue, N.W.
Washington, DC 20549-0303
Attn: Brad Skinner, Accounting Branch Chief
Re: Digital Fusion, Inc.
Form 10-KSB for the Fiscal Year Ended December 31, 2004
Forms 10-QSB for the Fiscal Quarter Ended March 31, 2005
File No. 0-24073
Dear Mr. Skinner:
This letter provides our responses to your comment letter dated July 12,
2005 with respect to the above referenced filings of Digital Fusion, Inc. (the
"Company"). For convenience of reference, we have included in this response
letter the same captions and paragraph numbers, as well as the text of the
comments, from your letter of July 12, 2005, followed by our responses.
Form 10-KSB For Fiscal Year Ended December 31, 2004
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Note 2. Significant Accounting Policies
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(b) Revenue Recognition, page F-7
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Comment:
1. We note that you design and develop customized software applications and
implement third party solutions to fulfill your customers' needs. Please
tell us whether you are recognizing this revenue in accordance with SOP
97-2. If so, explain how your revenue policies comply with this
literature. If you are not following SOP 97-2, explain how you considered
paragraph 2 of the SOP.
Response:
The Company is recognizing revenue in accordance with SOP 97-2. The
Company's software product sales are a separate element that is contractually
independent from any software consulting work. The software products the Company
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July 26, 2005
Page 2
sells are commercial off-the-shelf products and the customer may or may not need
our consulting services. The Company recognizes software product revenue when:
o Persuasive evidence of an arrangement exists.
o Delivery has occurred.
o The vendor's fee is fixed or determinable.
o Collectibility is probable.
The design, development, and customization of software applications and
implementation of third party solutions are done on a time and material basis.
There is no right of return, no upgrades or any other post sale liability, and
these sales contracts do not have multiple elements.
Comment:
2. Please describe to us your revenue recognition policies in cases where
there are "significant performance obligations yet to be fulfilled" and
revenue is deferred. Provide us with a typical example of such an
arrangement and explain how you recognize revenue. Identify the
accounting literature that you follow in recognizing this revenue and
explain how your polices comply with that literature.
Response:
The Company's revenue recognition policy is based on SAB 101 guidance and
follows the proportional performance concept. Revenue is recognized as time is
expended and or materials are delivered. The Company's deferred revenue relates
to payments we have received in advance of services (hours worked). The majority
of the Company's current contracts are with Federal Government Departments or
Agencies, or subcontracts to companies whose prime contracts are with the
Federal Government. Most of these contracts are Time and Material (T&M) or Firm
Fixed Price Level of Effort (FFP LOE). The FFP LOE contract is generally used
for studying a specific research and development area with a report as the final
product. The LOE clause requires the Company to have a certain number of labor
hours and that these hours are worked by personnel qualified to perform under
certain labor categories. The price is based on effort expended, not results
achieved. The revenue on these contracts is recognized by hours worked which
serves as a proxy for output. All of our contracts or subcontracts in support of
the Federal Government are subject to audit by various Government Agencies such
as Defense Contract Audit Agency or GSA Audit
Comment
3. Please tell us the amount of fixed-fee service revenue that you
recognized using the percentage of completion method during 2004 and the
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July 26, 2005
Page 3
subsequent interim period. In addition, explain how you considered the
guidance in footnote 1 to SOP 81-1 that prohibits the use of contract
accounting for service transactions.
Response:
We assume you are referring to "fixed price" versus fixed fee contracts
as defined in the Federal Acquisition Regulations (FAR). In 2004 the Company had
no fixed price service revenue and in the first fiscal quarter of 2005 the
Company had $178,000 of fixed price service revenue. Generally, the deliverable
in these types of contracts is a report or study and the period of performance
is usually less than one year. Typically, these types of contracts have no
interim deliverables or milestones (except program cost reports). The Company's
revenue recognition policy for fixed price contracts is based on SAB 101
guidance and follows the proportional performance concept. The revenue on these
contracts is recognized by hours worked. In future filings the Company will
revise our revenue recognition policy footnote and critical accounting policy to
fully address our revenue recognition policies.
Note 6. Borrowings, page F-12
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Comment:
4. We note that you have modified the terms of several significant debt
agreements over the past two years. Please explain to us how you
accounted for each of the significant modifications made to the Digital
Shareholders' and Laurus notes. As part of your response, explain how you
considered the guidance in EITF 96-19.
Response:
The Company considered the guidance of FAS 15 which is for restructuring
of debt in a troubled debt restructuring. EITF 96-19 guidance is for how a
debtor should account for a substantial modification in the terms of an existing
debt agreement (other than a troubled debt restructuring); therefore the
guidance in FAS 15 was used instead of EITF 96-19.
In the current text D22.104 it states if the creditor for economic or
legal reasons related to the debtor's financial difficulties grants a concession
to the debtor that it would not otherwise consider, it constitutes a troubled
debt restructuring. The Digital Shareholder note and the Laurus note were both
restructured under these circumstances.
D22.104 further states that concessions either stem from an agreement
between the creditor and the debtor or is imposed by law/court. For example, a
creditor may restructure the terms of a debt to alleviate the burden of the
debtor's near-term cash requirements, and many troubled debt restructurings
involve modifying terms to reduce or defer cash payments required of the debtor
in the near future to help the debtor attempt to improve its financial condition
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July 26, 2005
Page 4
and eventually be able to pay the creditor. The lack of near term cash flow for
the Company was what caused the Digital Shareholder note holders and the Laurus
note holder to substantially modify the terms of their respective debt.
On March 2, 2003, the Digital Shareholder note extended its maturity from
March 1, 2003 to March 1, 2005. The interest rate increased from 6% to 8% as an
incentive to accomplish this extension. The Digital Shareholder note holders
preferred to be paid; however due to cash flow at the time of note maturity,
that was not possible. The Digital Shareholder note holders would not have
granted this extension of debt concession except for the near-term economic
condition of the Company.
The Company accounted for this modification in terms in accordance with
current text D22.112 which states a debtor in a troubled debt restructuring
involving only modification of terms of a payable that is not involving a
transfer of assets or grant of an equity interest-shall account for the effects
of the restructuring prospectively from the time of restructuring, and shall not
change the carrying amount of the payable at the time of the restructuring
unless the carrying amount exceeds the total future cash payments specified by
the new terms. That is, the effects of change in the amounts or timing (or both)
of future cash payments designated as either interest or face amount shall be
reflected in future periods. Interest expense shall be computed in a way that a
constant effective interest rate is applied to the carrying amount of the
payable at the beginning of each period between restructuring and maturity (in
substance the interest method). The new effective interest rate shall be the
discount rate that equates the present value of the future cash payments
specified by the new terms with the carrying amount of the payable. There were
no fees associated with this extension. The 8% of interest was recorded
prospectively from 3/1/05 to note payment.
If however, the total future cash payments specified by the new terms of
a payable, including both payments designated as interest and those designated
as face amount, are less than the carrying amount of the payable, the debtor
shall reduce the carrying amount to an amount equal to the total future cash
payments specified by the new terms and shall recognize a gain on restructuring
of payables equal to the amount of the reduction.
A debtor shall not recognize a gain on a restructured payable involving
indeterminate future cash payments as long as the maximum total future cash
payments may exceed the carrying amount of the payable.
The future cash flow to the Digital Shareholders note holders in
accordance with the modified note equaled the debt and interest payable that was
recorded, therefore no gain on a restructured payable was recorded.
The Laurus note was also a troubled debt restructuring resulting from a
near-term lack of cash flow during April 2003. The future cash flow to the
Laurus note holder equaled the debt and interest payable that was recorded,
therefore no gain on a restructured payable was recorded.
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July 26, 2005
Page 5
5. Please explain to us how you initially allocated the proceeds of the
Laurus Note in accordance with the paragraph 16 of APB 14 and how you
applied the guidance in EITF 98-5 and 00-27 to any beneficial conversion
feature at issuance or upon modification.
Response:
The initial Laurus debt of $800,000 had a warrant that had a FMV of
$12,000. The Company booked $12,000 of interest expense and equity associated
with the warrant. If it would have been allocated based upon the FMV, the amount
of interest expense would have been 11,823, not 12,000, an immaterial difference
of $177.
Present
Values % Allocation Diff
PV of Debt 800,000 99% 788,177 11,823
PV of Warrants 12,000 1% 11,823 177
----------------- -------------------------
812,000 800,000 12,000
================= =========================
At the time of issuance of this Laurus debt, the initial conversion
feature was at a price of $0.922 which was above the quoted market price of
$0.83; therefore, no portion of the proceeds from the issuance of convertible
debt was accounted for as attributable to the conversion feature in accordance
with APB14 P12.
On April 29, 2003, the conversion feature was reduced from $0.922 to
$0.4375. The FMV of the Company's stock was $0.365; therefore the conversion
feature was not "in the money" on April 29, 2003, and no value was associated
with the revised conversion feature.
On April 29, 2003, Laurus loaned the Company $266,667 which had a warrant
valued at $15,000. DFI booked $15,000 of interest expense and equity associated
with the warrant. If it would have been allocated based upon the FMV, the amount
of interest expense would have been 14,201, not 15,000, an immaterial difference
of $799.
Present
Values % Allocation Diff
PV of Debt 266,667 95% 252,466 14,201
PV of Warrants 15,000 5% 14,201 799
----------------- -------------------------
281,667 266,667 15,000
================= =========================
At the time of issuance of this Laurus debt, the initial conversion
feature was at a price of $0.35 and the FMV was $0.365. The amount related to
the conversion feature was approximately $11,400. This was not booked by the
Company as it was not significant. The $11,400 associated with the conversion
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July 26, 2005
Page 6
feature would have been expensed to interest expense over a 2-year period if it
had been booked.
Form 10-QSB for Fiscal Quarter Ended March 31, 2005
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Note 6. Summit Acquisition, page 6
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Comment:
6. We note that it does not appear that you recorded any significant amount
of amortizable intangible assets in connection with your acquisition of
Summit Research Corporation. However, it appears that the co-founder of
Summit will continue to manage his current customers for you and you
indicated in a recent press release that you acquired a customer base
that includes the U.S. Army Aviation and Missile Command in Alabama.
Please identify any amounts that were allocated to customer-related
intangible assets and explain how you considered the guidance in
paragraph 39 of SFAS 141 and EITF 02-17.
Response:
The Company allocated $2,594,564 to intangible assets in the second
fiscal quarter of 2005 and has begun the amortization of these intangible
assets. Of this amount $2,227,873 was allocated to customer base intangibles and
$366,691 was allocated to employment agreements and non-compete agreements. The
Company will amortize these intangible assets over five and four years,
respectively. The Company noted in Form 10-QSB for the fiscal quarter ended
March 31, 2005 that it was still in the process of evaluating the intangibles
purchased and the purchase price allocation had not been finalized.
Non-contractual customer relationships provide the basis for the
intangible assets recognized by the Company. Summit Research Corporation's
contracts were generally of a short-term nature(less than 1 year); however
Summit Research Corporation's two executives have strong customer relationships
defined in EITF 02-17 paragraph 3. The employment and non-compete agreements
with the Summit executives minimizes the risks associated with the loss of the
customers and related cash flows.
Comment:
7. We note that you combine goodwill and intangible assets on your balance
sheet. Please explain to us how you considered the guidance in paragraph
43 of SFAS 142.
Response:
The Company allocated $2,594,564 to intangible assets in the second
fiscal quarter of 2005 and in future filings the Company will segregate goodwill
and intangible assets. The intangible asset listed on the Company's balance
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July 26, 2005
Page 7
sheet at December 31, 2004 is goodwill. In the notes to the consolidated
financial statements for the Company's 2004 10-KSB filing, (Note 4, page F-11)
the Company identified the intangible assets as goodwill.
Comment:
8. You indicate in your 2004 Form 10-KSB that the convertible note issued in
connection with the Summit acquisition may be converted "at any time."
However, you indicate in your interim financial statements that the
beneficial conversion feature related to this note is being amortized
over the life of the note. Please explain to us how you considered the
guidance in paragraph 9 and footnote 6 of EITF 98-5.
Response:
EITF 00-27 paragraph 19 states that the Task Force reached a consensus
that the Issue 98-5 model should be modified for convertible instruments that
have a stated redemption date (such as debt) to require a discount resulting
from recording a beneficial conversion option to be accreted from the date of
issuance to the stated redemption date of the convertible instrument, regardless
of when the earliest conversion date occurs.
In EITF 00-27 Paragraph 21 the Task Force reached a consensus that for
instruments with beneficial conversion features all of the unamortized discount
(both the discount from an allocation of proceeds under Opinion 14 to other
separable instruments included in the transaction and the discount originated by
the beneficial conversion option accounting) remaining at the date of conversion
should be immediately recognized as interest expense or as a dividend, as
appropriate. If the amount of unamortized discount is recognized as an expense
(because the convertible instrument was debt in form), the expense should not be
classified as extraordinary.
Based upon EITF 00-27 which modified EITF 98-5, the Company is amortizing
the beneficial conversion feature through the stated maturity date of the debt.
If the debt is converted prior to maturity then the portion of the conversion
feature related to the debt converted would be expensed at the time of
conversion.
* * * *
Securities and Exchange Commission
July 26, 2005
Page 8
The Company acknowledges that the adequacy and accuracy of disclosures in
filings are the responsibility of the Company. The Company further acknowledges
that staff comment or changes in response to staff comment in the proposed
disclosure in the Form 10-K do not foreclose the Commission from taking any
action with respect to the filing. The Company also represents that staff
comment may not be asserted as a defense in any proceeding initiated by the
Commission or any person under the federal securities laws of the United States.
Please do not hesitate to contact the undersigned at (256) 837-2821 ext.
407 or Chris Brunhoeber, Vice President of Finance of the Company, at (256)
837-0432 ext. 109 if you have any questions or would like to discuss any of our
comments in more detail.
Very truly yours,
Digital Fusion, Inc.
By: /s/ Roy E. Crippen III
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Roy E. Crippen III
Chief Executive Officer and
Chairman of the Board