Tread Lightly Through These Accounting Minefields - Is Your Company Nudging the Numbers?

by H. David Sherman and S. David Young

Back in the 1980s, Tandem Computers' robust earning reports made it a darling of Wall Street. Its CEO and cofounder James Treybig had pioneered a superhot technology, a way to make "fault tolerant" computers for companies like banks and telecommunications businesses running data-processing operations around the clock. But in 1983, it came to light that Tandem had counted a chicken or two before they'd hatched. Some of the revenue reported in its most recent financial statements had not actually materialized, and earnings had to be restated. The Street's retribution was swift: Tandem's share price immediately dropped 30%. In time, the company recovered (it was ultimately acquired by Compaq), but the event left a lasting impression. When a Wall Street Journal reporter asked Treybig to recall his most exciting day at Tandem, he couldn't. But when asked to pick his worst day, he answered without pause: "The day we restated."

The nightmare of risky accounting is on the increase. In the current economic climate, there is tremendous pressure—and personal financial incentive for managers—to report sales growth and meet investors' revenue expectations. According to the SEC, misleading financial reports, especially involving game playing around earnings, are being issued at an alarming rate. Needless to say, it's a nightmare that affects more than CEOs' sleep. The shareholders suffer most—and today's stock price volatility makes Tandem's 30% hit look mild. Little wonder that lawsuits related to financial reporting are on the rise. Back in 1991, fifty-five security class-action suits alleging accounting fraud were filed in the United States. By 1998, the number had nearly tripled.

To avoid such a calamity, shareholders and their representatives on corporate boards should keep their eyes peeled for common abuses in six areas: revenue measurement and recognition, provisions for uncertain future costs, asset valuation, derivatives, related-party transactions, and information used for benchmarking performance. If disaster strikes, it will most likely occur in one of these accounting minefields.

Minefield 1: revenue measurement and recognition
Determining when a sale is complete or a service fully rendered is simple for many businesses: revenue is most often recorded when the product is shipped or received or when the service is performed. But for some businesses, pinpointing exactly when revenue has been earned requires considerable judgment.

For example, how should revenue be recognized if a customer takes delivery of a product but makes payments on it over several years? One approach is to consider all of the revenue as earned upon product delivery. But an alternative approach is to consider the customer's ability to pay its commitment in the future. What if the customer is a dot-com that might not survive?

	According to the SEC, misleading financial reports, especially involving game playing around earnings, are being issued at an alarming rate.
	—H. David Sherman and S. David Young

Judgment is also required on the question of what constitutes revenue. Suppose an auction business sells an item for $100. Of that amount, $5 goes to the auctioneer as commission. On its financial statements, should the auctioneer include the total amount of the sale as revenue and call the $95 payment to the item's original owner an expense? Or should it count only the commission as revenue and show no expense? Most accountants would say the latter approach is preferable. But some Internet companies, recognizing the importance investors place on sales growth, have taken advantage of ambiguities in revenue recognition rules to effectively do the former.

By contrast, suppose Dell sells a computer monitor it purchased from an independent manufacturer. Does it call only its profit margin revenue, or the full price? Obviously, revenue is recognized on the full price, with the cost of the monitor treated as an expense. But what if Dell were to arrange for the monitor to be shipped directly from the manufacturer to the customer (as it often does)? Should Dell include the monitor's selling price in its revenue, or only the profit on the transaction? In other words, should Dell's sales figures suffer just because of an efficient logistics arrangement? Or should the decision hinge on some technical legal question, such as who would be responsible if the goods were damaged in shipping?

The ambiguities suggested in just these simple examples begin to explain how one of the biggest accounting debacles in recent history could have happened. MicroStrategy, a producer of data-mining software, announced in March 2000 that it was restating its revenues and earnings for fiscal years 1998 and 1999. A change in revenue recognition policies transformed its reported profit of $12.6 million into a loss of more than $34 million.

What could account for such a drastic shift? The problem developed because MicroStrategy usually sells its software bundled with multiyear consulting engagements; customizing the software to a client's unique circumstances is a complex undertaking. But rather than spreading the revenue from the software sale over the life of the contract, the company was recording it immediately. It was a tactic the SEC had begun to see more often in software companies and had complained about. When MicroStrategy announced the restatement, it emphasized that it anticipated no reduction in the revenue it would ultimately realize. Even so, its stock price plummeted by a staggering 62% in a single day, destroying $12 billion of market value—and it kept on falling. All told, shares fell from $333 in March 2000 to less than $22 in May 2000, at which time MicroStrategy faced at least three class-action lawsuits by shareholders and investigations by the SEC.

Evidently, no one on MicroStrategy's board asked the right questions—or what came to be called the "MicroTragedy" never would have occurred. Shareholders who want to avoid the same fate should pass along these questions to the board audit committee:

• How is revenue defined? And what event triggers its recognition?
• Does this present a reasonable measure of the revenue earned by the business during the reporting period? Is it consistent with revenue measures used by domestic and global competitors? And is it clearly described in the financial statement footnotes?
• If revenue is measured in an unusual or new way, is that disclosed? Is the approach justified in terms of its risks and advantages?

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Excerpted with permission from "Tread Lightly Through These Accounting Minefields," Harvard Business Review, Vol. 79, No. 7, June-July 2001.

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H. David Sherman is the Cowan Research Professor of Accounting at Northeastern University in Boston.

S. David Young is a professor at INSEAD in Fontainebleau, France.

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