A Hard Lesson Learned

SAB 101 Singes

SAN FRANCISCO -- SAB 101 is not the code name of some deadly chemical, but if Monday's action in MicroStrategy (MSTR Quote) is any indication, it is highly explosive.

SAB 101 is the shorthand reference to a bulletin on revenue recognition issued by the Securities and Exchange Commission last December. You can find the entire ruling here, but in a nutshell it says companies can't record revenues until after they've received the cash for a given service.

MicroStrategy said it was revising its accounting practices to conform with SAB 101 and thus would have to restate earnings for the past two years. Since earnings restatements are almost always of the downward variety (and this was no exception) MicroStrategy's stock was summarily and mercilessly cut by 60%.

"I was shocked at the reaction," said Robert Willens, a managing director (and accounting analyst) at Lehman Brothers, which has not done underwriting for the Internet software developer.

I'm sure those who were long MicroStrategy heading into today were also shocked. But, as Willens said, after high-profile accounting disasters at companies such as Sunbeam (SOC Quote) and Cendant (CD Quote) in recent years, investors are understandably leery of anything that sounds even remotely similar.

However, MicroStrategy's case "seems to be a timing of revenue issue," he said. "No one is calling into question the existence of the revenues, just when they're reported."

The stock's decline is "wildly disproportionate" to the issue of when the company will book its revenue, which Willens called "not huge, quite frankly."

Huge is in the eye of the beholder. In a broader sense, Willens referred to the difference between companies who falsely report (i.e., conjure up) revenues and those who maybe need to readjust when legitimate revenues are booked. But there's also the question of whether a company's aggressive accounting gives investors a false impression of its financial standing.

Separately there's the issue of whether MicroStrategy's stock has been "wildly disproportionate" to the reality of its business.

As was the case for seemingly umpteen companies, MicroStrategy's shares soared from mid-October, when they traded in the mid-30s, until very recently when they reached an all-time closing high of 313 on March 10. So dramatic was the upswing that even after Monday's free fall, which left the stock at 86 3/4, MicroStrategy is at 578 times the 17 cents per share the company previously reported earning last year (before the restatement, that is). Its price-to-earnings ratio is also nearly 350 times the 25 cents it was expected to earn in 2000 (although that figure is certainly to be lowered in the wake of Monday's news).

Without naming names, Willens predicted the fears of many investors will come true as other first-quarter earnings are reported. That is, "we'll see a lot of restatements" as more companies act to comply with SAB 101.

But Jeff Brotman, adjunct professor of accounting at the University of Pennsylvania Law School, who has long been critical of the accounting practices employed by many Internet companies, said the MicroStrategy case is bigger that just timing of recognition.

"If you're providing a service over a period of time, you have to spread revenue recognition," he said.

MicroStrategy's sin was its practice of immediately booking revenue for sales of software packages that included a long-term servicing element, instead of booking the revenue over the life of the deals. The company pledged to now use so-called contract accounting, whereby it will defer revenue over the span of a contract.

Brotman did not accuse the company of doing anything illegal (neither has anyone else for that matter). But the accounting professor said the company is one of many to have abandoned the principle of conservatism in its accounting.

"When in doubt, using the most conservative method" used to be the standard, he said. "That's been replaced. The rule of thumb these days is 'use the most aggressive method allowed.'"

One lesson of MicroStrategy's fall -- as well as Barron's controversial article about other Internet company's burn rates -- is that "cash is king," Brotman said. Despite all the talk about revenue growth, "you've got to focus on when you're going to get it and how it's going to be useable to fund your business," he said.

Finally, Brotman said MicroStrategy was snagged taking the opposite tack from Microsoft (MSFT Quote), which often is accused of being too conservative in how it books software licensing fees.

Microsoft has been criticized for using its "deferred revenue" stream to manage its earnings, he noted, which sounds like he's suggesting that accounting is like politics -- people usually don't go for extremes.

Postscript

The focus of this column is to look at the "macro" events affecting Wall Street. Occasionally, an individual company illustrates a bigger story. Today, MicroStrategy is that company.

In the past, I've used PurchasePro.com (PPRO Quote) as a firm which encapsulates the current milieu -- for good and bad.

On Monday, shares of PurchasePro.com slid 15% although the company announced an alliance with America Online (AOL Quote) that would seem to be a feather in the cap of the business-to-business concern.

PurchasePro.com was also among the many companies named in Barron's article as facing a potential cash shortage in the coming months, which may have contributed to its decline. However, CEO Charles Johnson, Jr. vehemently denied the charge in an interview on CNBC. (Other firms named in the article raised similar protests in various forms.)

I was unable to reach Johnson today or take a deeper look into the AOL deal. If I do and/or when I can, I'll dutifully report the findings here.