Red Hat Stock Hammered on Accounting Change

Red Hat suprised the market by changing its accounting methods, and the market hit back.

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.