Red Hat Stock Hammered on Accounting Change

By Steven Vaughan-Nichols  |  Posted 2004-07-13

Red Hat Stock Hammered on Accounting Change

Red Hat Inc. on Tuesday announced that it was correcting how it was recognizing revenues for its Linux subscription agreements and therefore would be restating its financial results for the last three fiscal years and its unaudited financial statements for the latest fiscal quarter. The market quickly hammered the stock, driving it down by 17.69 percent by midday in extremely heavy trading.

The company said it is changing the manner in which it recognizes revenues for some of its subscription agreements. Instead of recognizing revenue for subscription agreements on a monthly basis—the method Red Hat had used for the last five years—it will start recognizing revenue on a daily basis over a particular contracts term. In addition, rather than recognizing revenue on the first day of a month, Red Hat will now recognize it on the last day.

Under the old method, Red Hat recognized revenue as if a subscription started on the first day of the month in which it was sold. For example, the company would have recognized one-twelfth of the revenue of a 12-month subscription in the calendar month during which the subscription began, even if it started on the last day of the month. The remaining subscription revenue was recognized over the next 11 months.

With the new method, only one day of a subscriptions revenue made on the last day of the month would be recognized, and it would be accounted for at the end of the month instead of at the beginning.

Because of these changes, Red Hat will restate its audited financial statements for the fiscal years ending February 29, 2004, February 28, 2003, and February 28, 2002, and its unaudited financial statements for its last fiscal quarter, which ended May 31.

Red Hat says that this decision resulted from recent discussions with its independent auditors, PricewaterhouseCoopers, which suggested this change on June 16. The next day, Red Hat issued its last quarters results using its old methods. According to Red Hat CEO Matthew Szulik, Red Hat went ahead and issued the results while management decided what to do with PWCs recommendations.

During an early morning press call, Szulik emphasized repeatedly that this correction was one in method only and that it had no effect on the amount of revenues that Red Hat will ultimately recognize from its Red Hat Enterprise Linux subscriptions. Nor does this change in accounting methods and restatements of earnings affect the sequential quarterly growth in the number of subscriptions sold over the last two fiscal years or the increase in operating cash flows that has resulted from this increase, he said.

That said, Szulik admitted that the new accounting method is expected to result in significant percentage differences in certain items such as quarterly operating profit and net income.

"The restatement is not expected to reflect any material difference in the meaningful historical trends of our business, nor will it adversely affect our business outlook, which remains strong," Szulik said. "We remain committed to meeting high standards in providing timely, accurate and transparent financial reporting, and our planned restatement reflects this commitment. The restatement will also assure that future comparisons to past periods are made on a consistent basis."

Next page: The market strikes back.

Page Two

The market, however, doesnt like this change one bit. Red Hat dropped in price by $4.33—more than 20 percent—on the NASDAQ by 1 p.m. EDT. The shorts and longs battled it out on the frantic Red Hat financial message boards at Yahoo. Some shorts asked, "Why didnt management say anything during the June conference call?" Others suggested that Red Hats previous chief financial officer resigned two weeks before the last earnings call because he knew the "books were cooked."

The longs, on the other hand, said simply: "The amount reported by the new method will be the same, just the date of recording the sale will be different. There is no objective evidence (that I can see) of a problem at Red Hat. This sell off is panic driven. Eventually panics end."

Szuliks response to short questions has simply been that just because PWC made a recommendation didnt mean that the companys management was going to change its accounting methods. "Red Hat had used methods that we believed were correct for the last five years. After analyzing PWCs recommendations, we elected to make the change."

While Red Hat executives during the press conference were vague about exactly why the firm was changing its accounting methods, Dan Kusnetzky, IDC vice president for system software research, speculated that it was because this new method is a better fit for Red Hats software subscription-based business model.

"Their accounting was more suited for product-oriented software revenues and costs, while their business model is more like professional services. With Sarbanes Oxley, organizations like Red Hat, but not Red Hat alone, must be more careful about how they present their revenues. My suspicion is that they thought what they were doing was acceptable accounting practices, but that it would be better to use a more granular, day-to-day approach. In this new regulatory environment, companies are having to make significant changes in how they manage, hold and make information available," said Kusnetzky.

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