On a symbolic level, March 20, 2000 could serve as the day when the dot-com bloom really began to wilt. The groundwork that led to the fading fortunes of many Internet companies had been laid several months earlier, when the US Securities & Exchange Commission began a crackdown on the aggressive accounting methods that a number of them were using.
In December 1999, the SEC announced new guidelines requiring companies that had used lax accounting practices to restate their financial results by the end of their next fiscal year's first quarter. The commission's objective was to ensure that the rapidly developing dot-coms were reporting their revenues accurately. It probably anticipated that some companies would have to issue moderate restatements. It probably did not anticipate what happened to MicroStrategy Inc., a software company based in Vienna, VA.
On March 20, MicroStrategy announced a restatement of its 1998 and 1999 financial results. Instead of a US$12.8-million profit for 1999, it reported an estimated loss of between $33.6 million and $39.9 million. Following the announcement, MicroStrategy's shares took a 62% nosedive - from $226 to $86. The fall continued the next day. By the time the plummeting stopped, about $20 billion of Micro-Strategy's market capitalization had been wiped out (it's now at US$213 million).
"MicroStrategy's faux pas? It had recognized millions in revenue too soon," reported BusinessWeek. "In the second half of [1999], for example, it originally reported $36.5 million out of $103.5 million in three new contracts as revenues, deferring the rest to be reported when the work was completed. But to comply with the SEC, it now plans to defer all of that revenue until each contract is completed. That will be years from now." Although MicroStrategy's freefall was spectacular, it was not unique. More than 30 other dot-coms restated their earnings last year because of the SEC's guidelines.
While the reining in of the aggressive accounting practices of some dot-coms is not the only reason for their declining value, it is certainly a significant factor. Faced with regulatory pressure to provide investors with a more accurate picture of their financial health, many dot-coms no longer look as vibrant as they once did. With the first wave of the dot-com gold rush now behind us, it's time to assess the ways in which some companies stretched generally accepted accounting principles to inflate their value. In some cases, they may have even crossed the thin grey line between aggressive accounting and fraud. By examining some of the questionable practices that are known to have taken place, we might reduce the potential for some mistakes being repeated in future.
The trouble with most of the dot-coms that sprouted up in the past few years is that they didn't have any earnings. Consequently, they were under considerable pressure to show revenue increases. "I have seen a few companies pump up their revenues in this context, which you don't find in most ordinary companies," says lawyer Steven Golick, chair of the banking, insolvency and restructuring group in the Toronto office of Osler, Hoskin & Harcourt, LLP. "That's because the people who are looking at the books and records and financial statements are primarily investors. They don't care about the growth of a company. Rather, they care about the stability of the company."
The most prominent examples of ailing firms can be found primarily in the United States. "Canada was never infected by the same kind of venture capital disease [as the US]," says K.K. Campbell, a Canadian Internet business consultant who sold his web-development firm several years ago when the price was right. "We have fewer dot-coms, and many that exist are privately held, so we don't get much insight about what's going on."
It should be noted, however, that the recent trend toward aggressive accounting is not the sole domain of the dot-coms. Former SEC Chairman Arthur Levitt made it clear in a speech he delivered on September 28, 1998 to New York University's Center for Law and Business that questionable accounting practices are a widespread problem. "Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding commonsense business practices," he said. "Too many corporate managers, auditors, and analysts are participants in a game of nods and winks."
The result, said Levitt, was an erosion in the quality of earnings - and, by extension, financial reporting in its entirety. "Managing may be giving way to manipulation. Integrity may be losing out to illusion." A major impetus for these excesses, he noted, was a marketplace that is unforgiving of companies that don't meet their estimates. "I recently read of one major US company that failed to meet its so-called 'numbers' by one penny, and lost more than 6% of its stock value in one day," he said.
But the dot-coms "have taken this foolishness to even new heights," says William Lerach, a leading securities lawyer in the San Diego office of Milberg Weiss Bershad Hynes & Lerach LLP, which specializes in class action suits on behalf of plaintiffs. "Billions in underwriting fees have been made from IPOs of dot-com companies that instantly created thousands of 20-year-old multimillionaires and enabled venture capitalists to reap returns measured in thousands of percent," he says in a paper entitled "An alarming decline in the quality of financial reporting." And yet, he continues, "it appears that many of these 'new-economy' companies are engaging in age-old tricks to create phoney revenues and boost operating margins." Prevalent among the tricks he cites is, not surprisingly, premature revenue recognition.
Bid.Com International Inc. has been identified as a Canadian dot-com that once engaged in this practice. The small Mississauga-based company, which started out as an online auction house, saw its revenue soar from $2.7 million in 1997 to $31 billion in 1999. These reported numbers contributed to a $30 share price and pumped up Bid.Com's market capitalization to approximately $1 billion before it eventually fell back to earth.
One reason for Bid.Com's booming revenue was a practice, not exclusive to the former online auction house, of recording the full purchase price of every item bought online as part of its revenue. (In late 1999, Bid.Com changed its business focus and became a B2B provider of Web-based services.) "That's the common and accepted practice," says Joe Racanelli, director of marketing for Bid.Com, who was not with the company when it was an auction house. "It's not as if we weren't following accepted or traditional accounting measures [for] online [firms]."
Analyst Paul Bradley of Canaccord Capital Corp. begs to differ. He says that Bid.Com's method of revenue recognition gave some investors the wrong impression about the size of the startup firm's sales. "I suppose that would be a bit like a brokerage firm saying its revenue was the value of everything they traded in one year," he said in an interview, "which is in the billions of dollars."
Priceline.com, which used Canadian actor William Shatner to advertise its "name-your-own-price" approach to selling airline tickets, hotel rooms and car rentals, has come under criticism for its revenue-reporting practices. As part of its strategy, Priceline recorded as revenue, for example, the entire fee paid by a customer for a hotel room - generally known in the travel industry as the "gross booking"- instead of the portion remaining after Priceline had paid the hotel chain that supplied the room. This amount was classified as "product costs."
"In its most recent quarterly SEC filings," according to a March 2000 article in Fortune, "Priceline reported that it earned US$152 million in revenues ... [but its product costs] came to $134 million, leaving Priceline just $18 million of what it calls 'gross profits,' and what most other companies would call revenues. And that's before all of Priceline's other costs - like advertising and salaries - which netted out to a loss of $102 million. The difference isn't academic: Priceline [at the time traded at] about 23 times its reported revenues but at a mind-boggling 214 times its 'gross profits."" The company defended its practice by saying that, unlike a travel agency which has a fixed commission, it purchased the hotel room outright, had assumed the full risk of ownership and could control the profit made on each sale.
Some dot-coms also boost their revenue by bartering advertising with other web-based firms. "Two companies would get together and set a price for advertising on each other's website at, say, one million dollars," says K.K. Campbell. "They would then swap banners and [each] declare one million on their revenues and one million on their expenses. Tons of them did that."
Chartered accountants should be wary of dot-coms reporting significant advertising revenues these days. "Banner advertising is probably dead," says Campbell. "In 1995 the click-on rate [the percentage of visitors to a website who clicked or opened an advertiser's banner] was 4%. The last time I checked, it was .4%."
The prevalence of this type of sleight-of-hand accounting so disturbed the UK Accounting Standards Board that last year it issued a new regulation entitled "Barter transactions for advertising." Peter Buckler, audit chief at RSM Robson Rhodes, told Business Weekly that, in future, barter transactions may be included in turnover only if the company could have sold the space for cash. "Dot-coms will have to demonstrate conclusively that the deal was a genuine cash transaction and not an artificial stitch-up," he said.
One of the most popular advertising gimmicks on websites is the offer of coupons and discounts and the like. Many Internet users have a garage-sale mentality when it comes to visiting and/or purchasing goods on a site: they like to get things free or at a highly discounted price. Coupons are so popular on the Net that eCoupons.com, which provides advertisers with more than 150 million coupon views a month, was named the fifth fastest-growing website during March 2000 by Media Metrix, a company that tracks web visits.
While coupons, discounts and other freebies definitely act as a draw, the seduction doesn't come cheaply. After the SEC crackdown, it became apparent that some dot-coms were accounting for their loss leaders in a questionable manner. Fogdog.com, a popular online sporting goods store, was one such example.
Fogdog used several promotions to lure a million people to its website each month. For example, customers who bought a pizza from Pizza Hut received $10 off their next purchase; and visitors to the site could enter a sweepstake to win a round of golf with French professional Jean Van de Velde. But how was Fogdog accounting for these costs? They were "shoving [their] giveaway and shipping costs into marketing expenses instead of recording them as a cost of goods sold," says Forbes. "That plumped Fogdog's gross margins and made it look as if lots of people really wanted to buy tennis rackets and jogging shoes online." In December 1999, on the heels of the new SEC guidelines, Fogdog reclassified approximately US$1.5 million of these types of expenses as cost of goods sold. "The gross profits line is very sensitive, and any change in gross margin nowadays is very noticeable," CFO Bryan LeBlanc said at the time. And with good cause. Fogdog's reclassification chopped ten percent off its 1999 gross profits.
A variation on this theme involves the accounting of goods sold to customers who use coupons. A typical scenario might be the sale of a hockey sweater, which cost the online retailer $50, to a consumer for $100. The catch, though, is that the consumer has a $15 coupon, reducing the online retailer's gross profit to $35 from $50. While the dot-com retailer should account for the transaction in a way that shows only a $35 gross profit, some have recorded $50 as gross profit and, again, shunted off the $15 under marketing expenses.
Other expenses that can end up under the handy "marketing expenses" rubric include the cost of warehousing, packaging and shipping goods to customers. These are typically recorded as cost of sales by offline companies, but some dot-coms have directed these "fulfilment costs" to below the line.
The impetus to bend and stretch GAAP is not only to give potential investors a rosier picture of a dot-com's health. It's also driven by a change in recent years in how executives receive compensation, both in dot-coms and the rest of the business world. "Virtually all corporate executives now get cash bonuses only if a year's earnings reach preset targets," says Milberg Weiss's William Lerach. "And they receive stock options, not to hold for the long term, but rather to exercise and sell each quarter for cash, most often in a trading window that opens a day or two after the company reports its closely watched quarterly numbers. It is not hard to see the temptation to manipulate reported results to meet internal targets and investor expectations under these circumstances, especially when the efficient market - it's really a ruthless market - will savage the stock for the slightest earnings disappointment."
In light of the accounting tricks played by some dot-coms and other offline companies, Canadian regulators have begun to examine the requirements for recognizing revenue. John Hughes, the OSC's manager of continuous disclosure and the person in charge of an OSC study on 75 Canadian high-technology firms, suggested that changes might well be in order. "When revenue recognition policies were disclosed, they were often limited to vague or boilerplate language that provided little information relevant to the issuer's specific circumstances," he says in his report. "For example, the disclosure stated merely that revenue is recognized when earned. It is staff's view that such disclosure provides no useful information and does not meet the requirements of CICA Handbook - Section 1505, 'Disclosure of accounting policies." " The OSC also noted that revenue is often recognized when goods are shipped, not when they are sold, despite the fact that the company could be exposed to returns.
Also disturbing was the level of cooperation the OSC received from respondents. Only 5% of the companies surveyed answered the questions in full. Approximately 35% of the responses generated followup questions on disclosure issues. But a full 60% of the respondents had to be pursued for additional information on recognition, measurement or presentation issues.
These preliminary results, along with a growing tide of dissatisfaction in the US regarding revenue recognition, are being analyzed closely by the Canadian Institute of Chartered Accountants. Changes may be forthcoming, but they should not be expected overnight, says Tricia O'Malley, a member of the International Accounting Standards Board. She points out that the need for change in Canada is not as compelling as in the US; the regulatory approach to the accounting of revenue recognition in the two countries has evolved differently. In the States, says O'Malley, guidance tends to be "industry specific." As a new industry or problem developed, guidance was written to account for it. In Canada, we have kept to general principles (which she thinks are applicable to most situations, including the emergence of the dot-coms). "At the end of the day, we will probably have some more detailed guidance," she says, but notes that both the CICA and the international standards boards have many other pressing items to consider as well.
As forensic accountants and auditors begin to conduct post-mortems on failed dot-coms, and are asked to assess the viability of those that remain, they need to be aware of the smoke and mirrors employed by some firms. But their analysis should hinge on one fundamental question: Did the dot-com make business sense? In most cases, says Osler's Steven Golick, an insolvency expert who works with numerous dot-coms, the answer is no. In Golick's opinion, many of them failed "because they were ideas rather than sound, fundamental businesses."
While sifting through the ashes of the dot-coms that were misguided, CAs need to be on the lookout for indications of deliberate misrepresentation of revenue calculated to deceive investors, as opposed to a genuine misinterpretation of the accounting rules of the day. By the time the next wave of dot-coms emerge - "It will happen. The Internet is not going away," says K.K. Campbell - there may be new accounting standards to help make that distinction clearer. But one factor is likely to remain unchanged: greed. As long as the desire for fast profits exists, hucksters will continue to hype their offerings, and gullible investors will continue to believe them. And that means some new accounting tricks will be created, whatever rules are in place. "It's only human nature that some people will take advantage of them," says the CICA's Tricia O'Malley. But this time we should be more prepared.
