Its a trend that confounds investors and customers alike and is stigmatizing the entire technology sector: Facing enormous pressure from Wall Street and new accounting rules, record numbers of high-tech companies have inflated their financial results, only to have to restate them later under pressure from the Securities and Exchange Commission.
Never has one industry so cornered the market on bad numbers. The tech sector accounted for 39 percent of all companies that restated their earnings in 1999 and 2000, according to Min Wu, a doctoral candidate at New York University who is researching capital markets and the effects of earnings restatements. In the first six months of 2001, there were 27 more restatements from high-tech firms, representing 31 percent of all revised earnings.
Getting caught with inflated numbers can prove costly. In many cases, the restatements have pushed sickly tech companies onto the critical list — a fact that has enterprise customers losing sleep over questions about the stability and viability of crucial vendors as the Internet economy continues to plumb the depths of a stubborn recession.
Bec Wilson, chief technology officer at Altra Energy Technologies, an independent energy exchange in Houston, says his company keeps an eye on financial restatements and takes accounting practices and board member sophistication into account before choosing a vendor. He says the rash of restatements is confirmation of his firms decision to choose large, well-established vendors rather than younger start-ups.
“Our vendors predate the Internet hype,” Wilson says. “They arent restating earnings. They were here before the boom, and theyll be here after it.”
To be sure, accounting is as much art as science. Often, a companys financial officer must make a judgment call about how to handle complex transactions. But such calls are increasingly growing aggressive enough to raise concern among investors and government regulators. Among the calls that have been questioned recently are the following:
When RSA Security totaled its first-quarter earnings in April, it boosted the top line $1.7 million by including revenue from shipments of its software to distributors. That appears to counter the SECs stated preference that revenue be booked only after distributors have actually sold the products.
SmartForce, a supplier of e-learning software, drew fire from the Center for Financial Research & Analysis, an accounting watchdog group, for seven items in its first-quarter earnings report dealing primarily with how and when expenses are recognized.
Twice in one week in May, business-to-business software company PurchasePro revised its first-quarter earnings report, raising its loss to $33.5 million. Thats up from $32.4 million, which itself was a revision of the $18.1 million originally reported in April.
Analysts agree that restatements hurt customer confidence and make sales more difficult. Pawan Malhotra, an analyst at SG Cowen Securities, says that PurchasePro will have problems with customers because of all the negative publicity surrounding its restatements and management changes. PurchasePros “financial position is solid enough to get over the hurdle, but any time you have significant financial questions, it takes awhile for customers to get comfortable,” Malhotra said.
Financial analysts say companies are feeling pressured to take aggressive accounting steps to meet both their own too-optimistic earnings projections and the overblown expectations of Wall Street.
“High-tech companies for the last few years have been trying to maintain at least the impression of growth for investors and Wall Street, and that has led to earnings management,” Wu says. The term “earnings management” is applied to financial techniques that produce desirable earnings figures, irrespective of a companys actual performance.
Also, inexperienced managers at entrepreneurial start-ups often lack sufficient skills to run the businesses they start — a deficiency that has been magnified by the irrational market values such companies attracted in the last three years.
“Technology companies are more vulnerable only because their valuations have been so inflated,” says Andy Schopick, a securities analyst at Nutmeg Securities in Westport, Conn.
Evidence of serious problems is abundant. From 1995 to 2000, financial reports from 235 high-tech companies were restated, representing 38 percent of the 625 companies across all industry sectors that were forced to restate earnings.
The most immediate victims of earnings management are investors. The Financial Executives International Research Foundation estimates that shareholders of 30 companies that restated earnings from 1998 to 2000 lost $73 billion. Ten of those companies — BMC Software, Legato Systems, Lucent Technologies, Lycos, MicroStrategy, SmarTalk, Telxon, Texas Instruments, Xilinx and Yahoo! — were technology concerns that together accounted for $34.8 billion, or 45 percent, of that loss.
Pat McConnell, an accounting analyst at Bear Stearns, said she senses a falloff in restatements now, but only because of the recent slowdown in mergers and acquisitions. After accounting for 39 percent of all restatements in 1999 and 2000, tech firms accounted for only 31 percent of the total in the first six months of this year.
With fewer acquisitions, she said, there are fewer issues about how the acquiring companies write off in-process research and development projects. Abuse of R&D write-offs was a major reason the SEC passed new rules in 1998 to clean up this kind of accounting.
But “pro forma accounting” — which can mean just about anything a company wants it to mean — is alive and well. Pro forma infuriates many investors because it gives companies wide latitude to spin their numbers by, for example, eliminating important expenditures or adding questionable revenue. Neither the Financial Accounting Standards Board nor other regulatory bodies dictate standards for pro forma accounting, making it a free-for-all of creative accounting.
The SEC has no authority over what companies claim in press releases unless their statements are actually fraudulent, a commission spokesman said.
Even where rules are in place, standard accounting can be troublesome. In its 10Q filing with the SEC, RSA said that because it was experiencing low returns from distributors, it had begun recognizing revenue upon shipment to three distributors, rather than waiting until the products were actually sold to end users. That change added about $1.74 million in first-quarter revenue.
While such a practice does not break any law, it appears to fly in the face of SEC efforts over the last two years to force companies to recognize revenue only after products have been sold retail. RSA did not respond to repeated requests for comment.
“When they did this, they were holding the users conference, and in the midst of that they did not want to fall short of their revenue,” says Kevin Wagner, a securities analyst at Boston brokerage Adams, Harkness & Hill, referring to RSA executives. “They were already short of top-line estimates by a couple of million dollars, and if they had not recognized revenue from three of their 10 distributors, they would have been closer to $4.5 million short.”
In a recent speech about the status of financial accounting, Lynn Turner, the SECs chief accountant, said the quality of financial reporting is better than it was 25 years ago or even 10 years ago, but he urged accountants and corporate executives to work harder to improve their professions, and he encouraged standards bodies to move faster in adopting rules. “How widespread are the problems with financial reporting?” he asked. “I wonder, at times, just how big is the iceberg below the waterline?”