Barron's is full of bearish views on the market this weekend. Here's a story on development in the "backroom" definitly a development to watch. Howard Schlitt, Mr. P$nks favorite forensic analyst is quoted here.
Mad2
Internet Stock Mavens Beware: The SEC Is Cracking Down on Dot-Com Accounting
By Mark Veverka
Internet company executives and their venture-capital backers often get worked into a lather at the suggestion that hyper-inflated Internet stocks have all of the fundamental financial backbone of multi-level marketing scams.
But what about when it's the SEC that is doing the suggesting?
Last week, the SEC sent a clear signal that it is sick and tired of shoddy accounting practices being employed in World Wide Webland. In particular, agency officials are concerned about 'Netcos that egregiously overstate their revenue numbers.
Consequently, the SEC has asked the Financial Accounting Standards Board to tighten certain rules that govern how revenues should be booked by various profitless practitioners of electronic commerce. The FASB has turned the matter over to a special "task force" that is expected to modify at least two accounting guidelines that apply to all companies, but are particularly relevant to bean counters at fledgling dot-com firms. FASB spokeswoman Deborah Harrington indicated that its panel could make some rulings as early as this week.
Considering that some Internet companies have been playing fast and loose with accounting rules for years, the SEC's actions were deemed better late than never by some financial analysts and portfolio managers.
"They should have [acted] a long time ago," says Howard Schilit, founder and principal of the Center for Financial Research & Analysis in Rockville, Maryland, and a leading authority on fraudulent financial reporting. Many of the accounting practices employed by 'Netcos have been "preposterous," he says. "People should know better. Accounting rules are pretty straightforward."
Of course, most investors toss fundamentals out the window when it comes to evaluating Internet stocks. Because only a very few are even in the black, such as America Online and Yahoo, investors by and large have been willing to turn their heads and forgo expectations for earnings growth in exchange for signs of expanding market share.
In fact, the mantra out of Silicon Valley has been "pay attention to the top line," because 'Net stocks are revenue-growth stories. And because all of the emphasis has been placed on revenue growth and revenue multiples, the way these companies account for their revenues is pretty darn important.
That's why portfolio managers and analysts who are sticklers for fundamental research have been so aghast at the seemingly blatant practice of padding revenue figures.
Of the 20 or so issues raised by Lynn Turner, the SEC's chief accountant, two in particular are getting immediate review by FASB. One key issue centers on the recognition of gross revenue as opposed to net revenues. The other main topic is how companies account for barter deals, which are prevalent among Internet companies.
For the most part, as Schilit points out, the accounting rules are pretty straightforward. Thus, any rulings that come from the FASB task force are basically interpretations of existing guidelines and not new rules per se.
The gross sales versus net sales issue is basically common sense. At issue is whether a company should recognize revenues in the gross amount billed to a customer or whether it should book the revenues it actually gets to keep from a transaction. Most portfolio managers and analysts think it should be the latter.
For example, many e-tailers don't stock inventory and may employ independent warehouses or fulfillment houses to drop-ship merchandise on their behalf. Yet Internet companies routinely book gross revenues. On the other hand, travel agents and direct retailers, faced with the same accounting issues, tend to book net revenues. It seems that only in cyberland has the practice been embraced so vigorously.
"If you are Priceline.com and getting a transaction fee for being a middleman, that is not a novel concept for a business. It just uses a different medium," Schilit says.
Thus, "if they are booking the full price of an airline ticket as revenues, they should be criticized," he adds. (Many point to Priceline as an offender, but without specific disclosure, it's hard to tell.)
What's more, if companies choose to use gross revenues, then they should disclose "cost of sales" as well, which allows investors to calculate what the true "net" revenue figures are. Too often, publicly held Internet companies aren't reporting cost of sales, which should provide a red flag that the revenue picture at a particular firm is murky at best.
Judging by a FASB executive summary on the issue, the board is likely to crack down on this practice. "How companies recognize revenues for the goods and services they offer has become an increasingly important issue," reads the summary, "because many investors appear to value companies that sell products on the Internet based on a multiple of gross revenues rather than a multiple of gross profit."
In other words, if 'Netcos are padding their top lines they are also helping to inflate their stock prices. The bottom line: FASB is likely to recommend that most Internet companies report their net revenues on their top lines, which could greatly shrink their reported revenues. In turn, their share prices will probably suffer if, indeed, Internet financial models have any value and are taken at all seriously.
"A tightening of revenue recognition rules could have a significant impact on the valuations of some less-conservative companies," stated Credit Suisse First Boston analysts Lise Buyer and Jim Marks in a research note.
"We have long believed that reliance on revenue multiples for valuation purposes would inevitably produce distortions and manipulation in the way that revenues are reported. We are, unfortunately, placed in a position where multiples of revenues are often the only available metric," Buyer and Marks wrote.
To be sure, for every AOL or Yahoo, which are considered conservative in their accounting, there are dozens of lesser-known dot-coms with marginal business models that are probably the worst perpetrators of questionable accounting practices.
However, the bigger issue to be taken up by FASB may be how Internet companies book their barter transactions.
"The problem with barter revenues is that there is no cash involved and because of that, there is more opportunity for abuse," says Roger McNamee, a principal with Integral Capital Partners. Scores of Internet companies enter into advertising barter deals with one another, in which they exchange rights to place free advertisements on each other's Websites. And according to an SEC memo, the 'Netcos are all over the place as to how they book these transactions.
"The [SEC] staff believes a prerequisite to reflecting these transactions in the accounting records is that the value of the transaction must be reliably measurable. In addition, registrants should be making transparent disclosure that will clearly convey to investors the accounting being used," the SEC memo states.
Nonetheless, because bartering is so common among 'Netcos, FASB isn't likely to rule that companies won't be allowed to book such deals as revenues, explained Buyer and Marks. Companies may just have to show the math at how they arrived at their particular valuations. "The SEC's desire appears to be that the value of a transaction must be reliably measurable. In addition, it wants full disclosure regarding barter revenues," they noted.
"Barter transactions have always been suspect because when companies do barters, no money is actually changing hands. But someone eventually gets to book the transaction as revenues," Schilit explains.
Because he is such an ardent practitioner of fundamental reporting, Schilit has had difficulty taking seriously Wall Street's creative approach to Internet stock valuations. He has never bought in to the argument that because the Internet is unique, the industry merits its own set of valuation metrics.
Says Schilit: "They should have to play the game the way everybody else has to play."
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