SMARTMONEY.COM: Special Report: Avoiding The Next Enron
22 Feb 19:20
By Monica Rivituso
Of SMARTMONEY.COM
When stodgy old pipeline company Enron (ENRNQ) grew bored of its ho-hum
station in life, it jumped on the Internet bandwagon and quickly transformed
itself into a trading behemoth, wheeling and dealing energy, commodities and
even telecom bandwidth. The fun didn't last long, of course: Enron's empire has
since crumbled in an accounting scandal the likes of which has never been seen.
But while Enron pushed the envelope more than any other company, it wasn't
the only one to do so. The Internet boom benefited a variety of fast-growing
technology industries - including software makers trying to meet the suddenly
insatiable demand for e-commerce and Internet applications. Many of the
software makers capitalizing on this New Economy trend were characterized by
supercharged revenue growth - and stock prices to match.
Unfortunately, when that growth started flagging, some of those software
companies resorted to aggressive accounting to make it look as if the party
were still going strong. A case in point: David Thatcher, former president of
e-mail software maker Critical Path (CPTH), pleaded guilty last week to
exaggerating his company's revenue to create the illusion that business was
booming in 2000. He faces a maximum prison sentence of five years and a fine of
$250,000. Shareholders, meanwhile, were punished last April, after the company
restated fiscal 2000 third-quarter, fourth-quarter and full-year results. It
lowered revenue by $9.7 million for both the third and the fourth quarters, and
by $19.3 million for the full year. The revenue changes increased the company's
full-year net loss to $78.9 million, or $1.31 cents a share, from $57.2
million or 95 cents a share. The stock, which traded as high as $113.91 in
March 2000, now sells for a little more than $2.
Belgian speech-recognition software company Lernout & Hauspie, meanwhile,
ranks as one of software's biggest accounting scandals. After The Wall Street
Journal questioned the company's fast-growing revenue, L&H conducted an
internal investigation. Audits later showed that revenue from early 1998 to
mid-2000 had been inflated by $373 million, or 45%. The software maker, which
had sought bankruptcy protection in Belgium and the U.S. in November 2000, had
its remaining assets auctioned off late last year, raising about $46 million -
a fraction of the $450 million in debt it had at the time of its bankruptcy
filing.
Nowadays, accounting questions tend to fester - and batter a company's stock
- more than ever. About a year and a half ago, Computer Associates (CA) changed
the way it accounted for revenue, ostensibly to disperse it more evenly over a
contract's lifetime. But the pro forma method it chose left investors, analysts
and journalists befuddled. Even worse, the company acknowledged Friday that the
U.S. Attorney's office and the Securities and Exchange Commission have
launched separate investigations into its accounting practices. CA's stock has
fallen 41% this week alone.
Of course, the vast majority of software companies probably keep their books
strictly by the books. But it's also true that this industry lends itself to
creative accounting more than most. That may be because it presents both motive
and opportunity for green-eyeshade shenanigans. Motive, in that investors have
had such high growth expectations of software makers - expectations that can
amount to relentless pressure on managements to keep making their numbers. And
opportunity, in that software is a business of complex products sold under
complex contracts, which can leave a lot of wiggle room for clever managements
or CPAs. Investors in software companies might want to keep an eye on the
following accounting trouble spots.
Revenue Recognition
This is the No. 1 area of abuse among software makers, according to experts.
Intricate sales contracts are often the vehicle for fudging revenue numbers. A
software-sales contract will often span months or years and can involve
software, maintenance, upgrades and service. Companies should, to the best of
their ability, exclude from current revenue those items or services that
haven't yet been delivered, says Itzhak Sharav, accounting professor at
Columbia Business School. But a company looking to goose the top line might
book an entire contract's revenue up front, or - even worse - recognize all the
revenue, but spread out the associated costs over time.
"Unfortunately, the way revenues are recognized is a ripe area for fraud and
abuse," says Joseph Wells, founder and chairman of the Association of Certified
Fraud Examiners.
This is precisely how MicroStrategy (MSTR) ran into trouble. In March 2000,
the one-time software darling drastically restated results, saying that some of
the revenues it booked should have been spread out over many years. For fiscal
1999, it reduced its previously reported revenue of $205.3 million to between
$150 million and $155 million. That resulted in a diluted net loss of between
43 cents a share and 51 cents a share - far worse than the previously reported
profit of 15 cents. For fiscal 1998, the company lowered revenue of $106.4
million to between $95.9 million and $100.9 million. Consequently, net income
of eight cents a share was reduced to one cent to four cents a share. The
stock, which rose an astonishing 2,449% from March 1999 to March 2000 and
peaked at $313, sank like a stone after the news hit. On March 20, 2000, when
MicroStrategy announced the restatement, the shares plummeted 62%, from $226.75
to $86.75. Now, they change hands at just $2.80.
Accelerated Shipping
Another way a company can exaggerate revenue is by improperly accelerating
product shipments. Stuffing the channel - that is, shipping out more products
than a customer has asked for - is one way to do that. A company might also use
extended payment terms with its customers, allowing them to take longer to pay
for goods in exchange for accepting them early.
Other, brasher tactics include packing a truck to the brim with products and
simply driving it to another part of a parking lot, or shipping goods to a
company-owned warehouse. Veterans who've scrutinized accounting practices for
years say they've seen it all.
Uncovering such tactics usually requires the kind of access afforded only to
auditors. But Thomas J. Phillips Jr., director of the school of professional
accountancy at Louisiana Tech University, says individual investors should
examine quarterly financial statements to see if a company realizes an
unusually big boost in revenue at the end of the year. While it may be a
result of seasonal factors or a hot new product hitting the market, such a
surge could also signal that a company is scrambling to hike revenue before
year-end.
"In most cases, if you're seeing revenue go way up, there has to be some
explanation," says Phillips. "And I'd be looking for that explanation."
Investors should also be sure they understand the particulars of extended
payment terms, he adds.
Research & Development
R&D is a key area for any technology company, since future success rests on
the ability to create innovative new products. Since, by nature, high-tech
companies must keep R&D spending levels high, a big drop in such spending at a
software company should raise a red flag, says Robert Bricker, professor of
accountancy at Case Western Reserve University's Weatherhead School of
Management. Why? If a company is struggling to meet projections in other areas
of the business, management might decide to siphon off some of its R&D funds to
make up for that shortfall.
Investors should also closely watch what happens to R&D in acquisitions. If
one company buys another, but doesn't think that the acquisition candidate's
R&D will yield any valuable products, it can write off the other company's
in-process R&D. The problem occurs if a marketable product actually emerges
from that research and development. If it does, any profits from that product
are overstated, because the costs associated with developing it and bringing it
to market have been written off, explains Craig Greene, a partner in charge of
the Financial Investigation Services Group at Rome Associates, based in
Chicago.
As Enron showed, inflated revenue and other creative accounting can go
unnoticed when times are good. But when the economy and the stock market head
south, shadowy accounting suddenly sees the light of day. "You end up with
debacles," says Bricker, "where everything that could go wrong, does."
For more information and analysis of companies and mutual funds, visit
SmartMoney.com at smartmoney.com.
(END) DOW JONES NEWS 02-22-02
07:20 PM |
