Sunday, 19 January 2014

Are Those Revenues For Real?

DON’T ASK STEPHEN COTUGNO WHAT HE THINKS of the accounting profession unless you are prepared for an earful. Executive vice president at Professional Detailing, an Upper Saddle River, N.J. firm that recruits and manages sales staffers for drug companies, Cotugno’s company had the embarrassment of having to chop 5% out of 1999 revenues after a confrontation with PricewaterhouseCoopers, the company’s auditor. Professional Detailing was including in revenues the reimbursements it gets from clients for placing help-wanted ads. The auditors went along with this little gimmick–until early this year. Amid a crackdown by the Securities & Exchange Commission on revenue recognition, the auditors decided the treatment of expenses was no longer kosher.
Small as the change was, Wall Street didn’t like the smell of audit trouble. Within a month of when Professional Detailing announced the revenue revision, its stock was down 31%.
“[Auditors] don’t know what the hell they’re doing,” fumes Cotugno. “They make this crap up a lot of the time.”
There’s some truth to the charge. Accountants have been fiddling with profit and loss rules for as long as there has been accounting. And now, with the SEC on the warpath over inflated revenue figures, companies and their outside auditors are on the defensive.
The agency has slapped enforcement actions on dozens of executives and companies, plus issued an all-points bulletin reminding businesses what existing rules require. Bear Stearns & Co. has identified 120 companies that have, in the past several months, announced that they have changed or will change their revenue recognition rules. Such companies as Alexion Pharmaceuticals and Genome Therapeutics confess that the changes will have an impact on their future earnings. Shareholders are forewarned.
“Companies making changes are acknowl-edging that their previous accounting policies were too aggressive,” says Howard Schilit, head of the Center for Financial Research & Analysis, accounting watchdogs in Rockville, Md.
For investors, revenue hyping can dig deep financial potholes. They may overpay for stocks of companies engaging in it. Further, to erase the excesses, companies are recording one-time charges and moving previously booked revenues into future quarters. That could make investors think a company’s operations suddenly improved. “Care must be taken to avoid giving companies credit for the same revenue twice,” says Bear Stearns’ Janet Pegg.
Ventro, a hot business-to-business Web site that includes in revenues the entire value of laboratory products it brokers, noted in recent SEC filings that any rule changes “could cause the market price of our common stock to fall significantly.” That’s the danger with these dot-coms that trade not on earnings but on revenues.
The danger is not to be underestimated. MicroStrategy, a high-flying software company developing Internet-related databases, was trading at $225 when we criticized its accounting (FORBES, Mar. 6). Within weeks the company scaled back its reported 1999 revenue from $205 million to $155 million. Now the stock is at $25.
Where else might trouble surface? Read on.
Revenues booked before contract completion. Physician & Hospital Systems & Services booked amounts for services not only before finishing the work but before mailing out bills. The concern, which does back-office work for doctors and hospitals, had been following that practice prior to when it was bought by National Data Corp. in Atlanta in December 1997, says David Shenk, chief financial officer of National Data. In fiscal 1999 National Data, a credit card and check processing company, reported $22.3 million in “unbilled accounts receivable,” up from $18.8 million the prior year. Now the unit books revenue only when it sends out bills. In its Nov. 30 fiscal quarter the company took a $13.8 million charge to fix this mess, turning a profit of 9 cents a share for the fiscal first half into a loss of 31 cents. Since the charge was announced in January, the stock has fallen 23% to $27.
A variation on this theme is booking revenues for loan services immediately instead of over the loan’s duration. First American Financial Corp., a Santa Ana, Calif. outfit that tracks borrowers’ property tax payments, was a bit too grabby here. A year ago the company announced it was taking a cumulative charge of $55.6 million in the first quarter of 1999. That knocked its 1999 profits down by 63% to $33 million from what would have been $88.6 million.
ITT Educational Services got caught, too. The Indianapolis company, which runs 68 technical institutes, had been immediately booking in revenue the fees it charges students to apply, register and use the laboratory. Now it’s going to spread out those fees over the average length of the program, which is two years, says Edward Hartigan, ITT’s senior vice president of investor relations. To fix past errors, ITT took a charge of $2.8 million in the Mar. 31 quarter, chopping earnings 70% to $1.2 million.
Membership fees prematurely recorded. Cendant, a firm in Parsippany, N.J. that is just surfacing from a massive accounting fraud, runs a time-share exchange program, Resorts Condominiums International, in which vacationers swap vacation spots. The company used to record up front about a third of the fees it charges. That made sense, it seemed, since this revenue offset the cost of setting up these memberships, which can last years. It doesn’t make sense now, with the SEC getting nasty. Cendant now says it will spread those fees over the life of the memberships. It also took a $56 million charge in the first quarter of 2000 to correct past problems, cutting the quarter’s net income 45% to $69 million.
MemberWorks, a Stamford, Conn. company that manages credit card membership award programs for companies like Sears and Citigroup, had been immediately booking in revenues the refundable fees paid by 6.2 million consumers to join its programs. Whoops! The company says it will reverse course this July and will spread those refundable fees over the membership terms. MemberWorks expects to take up to a $30 million one-time charge in July, which could vaporize its profits for the year.
Licensing fees reported prematurely. Software and biotech concerns that aren’t selling a lot of their own products rely on licensing revenues to make ends meet. How to account for them? It can get tricky.
Exelixis, a fast-track biotech concern in San Francisco, had been immediately recording revenues from licensing fees it charges big drug companies like Bayer, Bristol-MyersSquibb and Pharmacia to access its gene database to develop new drugs. To fix its errors, Exelixis recently erased $3.1 million in revenues in the first quarter of 2000. That’s a big chunk of change for Exelixis, which pulled in just $10.5 million in revenues last year and posted a loss of $18.7 million. It recently backed off from immediately recording a $10 million licensing deal from Bayer in the first quarter, and will spread that revenue out over the deal’s eight-year term.
Likewise, General Magic, a Sunnyvale, Calif. developer of telecommunications technology, said it overstated by $1.2 million the $5 million in revenue it had booked in the fourth quarter of 1999 for a fee General Motors paid to license its voice-interface system. In February it announced that it would recognize the revenue over the period of the license agreement. Little differences in revenue make a big difference in investor perceptions at a young company like this one. Since the announcement, General Magic’s stock has fallen 38% to $5.
How can you see these disasters coming? Often, you can’t. But one old rule of thumb in investing definitely applies here: Check out items like accounts receivables, unbilled receivables or deferred income in financial statements. If they are high or rising fast, be very wary.

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