Until recently, each time a consumer bought an item through on-line auction house Bid.Com International Inc., the purchase price was recorded as part of the auction company's soaring revenue.
While it lasted, this aggressive accounting treatment helped the tiny Mississauga-based company record quick growth -- to revenue of $20-million in 1998 and $31-million in 1999 from $2.7-million in 1997. And it also helped fuel a huge surge in Bid.Com's share price, giving the company a total market value on the Toronto Stock Exchange of more than $1-billion at its peak last year before it sank back down.
Bid.Com is not alone in using this accounting treatment, which it discontinued in October when it changed its business focus. But analysts say the practice can give some investors the wrong impression about the size of a startup firm's sales.
"I suppose that would be a bit like a brokerage firm saying its revenue was the value of everything they traded in the year, which is in the billions of dollars," said analyst Paul Bradley of Canaccord Capital Corp. "But in fact the real number was $10-million or whatever their net commission was."
Debates about accounting practices can seem as exciting as city council meetings on cable TV. But that lack of public interest has changed quickly this year as investors have watched technology companies restate revenue figures and miss revenue targets. Suddenly, people are taking note of the creative ways in which technology companies have been massaging revenues to boost share prices.
The Washington-based Securities and Exchange Commission has already cracked down on revenue problems in the United States. Now the Ontario Securities Commission has started a broad review of revenue treatment by TSE-listed technology companies -- including the way companies record revenue when they are helping to sell others' goods on Internet sales sites. It has asked 70 unidentified technology companies to explain in detail how they record revenue.
"We thought it was important to send a message as to the kinds of the things the OSC is going to be doing in continuous disclosure, which is identifying hot-button issues," said John Hughes, the OSC's manager of continuous disclosure. "And there's nothing more important than revenue."
He said the commission is reviewing the responses and drafting comments, and hopes to issue a report in January, likely recommending that the Canadian Institute of Chartered Accountants review Canada's generally accepted accounting principles (GAAP) regarding revenue treatment in certain areas.
Technology companies have become more aggressive with revenue numbers because many are too young to have profits, and are therefore valued on revenue forecasts. That means higher revenue often translates directly into higher share prices, and it means unwitting shareholders can pay too much for a stock valued on inflated numbers.
"If a company had inflated revenue and earnings, the stock price presumably was inflated as well," warned accounting expert Howard Schilit, who runs the Centre for Financial Research and Analysis (CFRA) in Rockville, Md.
"Investors can get hurt if revenue is restated to reflect a lower and slower growth rate."
The pressure on companies is enormous. Just this fall, such technology heavyweights as Nortel Networks Corp., Intel Corp. and International Business Machines Corp. saw their shares plunge when they reported revenue below analysts' expectations. But companies that become overly aggressive to meet targets are punished even more harshly when they have to restate inflated revenue.
It happened in the case of Lucent Technologies Inc., which revealed in November that it would have to restate its fourth-quarter results, reducing revenue by $125-million (U.S.) and sending the company's share price to a 52-week low on the New York Stock Exchange that day. Shares of Microstrategy Inc. fell 62 per cent on the Nasdaq Stock Market in one day last March when the company announced it was restating three years of revenue. It is now under SEC investigation.
The SEC is ahead of Canadian regulators on drafting tougher revenue guidelines for technology companies, announcing its controversial Staff Accounting Bulletin 101 last year. It takes effect this quarter, and offers specific guidance to companies on how to interpret revenue rules in controversial areas.
"Think about a bottle of fine wine," explained SEC chairman Arthur Levitt in a speech to announce the revenue crackdown. "You wouldn't pop the cork on that bottle before it was ready. But some companies are doing this with their revenue -- recognizing it before a sale is complete, before the product is delivered to the customer, or at a time when the customer still has options to terminate, void or delay the sale."
Corel Corp. saw its share price sink on both the TSE and Nasdaq after the Ottawa software maker restated its revenue in 1998 at its auditor's request. The company had bartered Java technology with other companies in 1997, and had recorded the value of the software as revenue. It was later required by its auditors to reduce revenue by $28-million, sparking a class-action lawsuit by U.S. investors. The case was settled this year with a $5.19-million payment by Corel.
Experts say there are dozens of techniques used by companies to report hefty revenue. Sometimes they book the full amount of revenue for product shipped, even when goods can be returned by retailers or when there are future obligations such as free upgrades. Another technique is pre-billing future sales, or asking customers to buy in advance to boost the current quarter results.
Analyst Joseph Vejvoda of TD Securities Inc. said certain types of revenue boosting often end up hurting bottom-line profit margins because revenue is so enormously out of synch with profits, but he said young companies often don't care.
"Some of those dot-coms were supposed to lose money anyway, but they wanted to get people excited about their revenue growth," he said. "In a mature company, where you actually have earnings, the [effect]is brutal because you're hurting your net margins."
Mr. Bradley of Canaccord said issues of revenue recognition tend to come up most often for software companies because of the greater mix of revenue sources, including licensing, consulting, support and maintenance.
"In the software business, there can often be significantly more leeway in what is revenue, what should be recognized now and what should be recognized over the term of a contract," he said. "I think it's been an area where there is more scope for enthusiastic accounting."
JetForm Corp. of Ottawa changed some aspects of its accounting system after coming under scrutiny in an influential, private report published at the end of 1998 by Mr. Schilit's CFRA in the United States.
The report stated that JetForm was boosting revenue by using aggressive policies for consulting contracts and software licensing. In one quarter of 1998, the CFRA report says, revenues were inflated by 18 per cent and profit quadrupled as a result.
The report disagreed with the company's policy to record revenue from consulting contracts based on estimates of the percentage of the project completed, but not on the basis of actual customer billing. The report argued unbilled receivables from consulting contracts had soared over six consecutive quarters.
The report appears to have had an impact. In the few days after it was issued in 1998, the company's stock hit a 52-week low on the TSE. In 1999, about four months after the report was issued, JetForm said it would make accounting changes.
"The company has since stopped giving out those long-term receivables. If you look at their balance sheet now, their long-term receivables are almost zero," said analyst Brandon Osten at Sprott Securities Ltd.
JetForm chief financial officer Jeff McMullen said the company responded to the wishes of shareholders and stopped granting lengthy payment terms to customers after the CFRA report was issued.
He now says the technology industry would benefit from the more detailed accounting rules that have been developed in the United States.
"Any of the initiatives by the OSC are interesting, and certainly we would support whatever takes place if it means there's a more level playing field and more harmonization with U.S. rules," Mr. McMullen said.
For several years, some analysts have criticized the accounting system used by Imax Corp. of Mississauga to record revenue for the leases of its theatre systems, saying the revenue is loaded up-front on long-term leases.
For example, Mark Rosen and Anthony Scilipoti -- who co-founded boutique analysis firm Veritas Investment Research Corp. with accounting expert Al Rosen last fall -- criticized Imax in a 1999 private report, saying 90 per cent of cash for the theatre systems was collected prior to the systems' delivery by way of up-front fees.
They also expressed concern about the company's strategy of booking revenue for 10 or more years of future royalty payments up-front when a system was delivered. They said this could be dangerous if companies could not pay the minimum payments down the road, because the revenue had already been recorded.
Both of these practices are standard features of lease-type accounting and are required under Canadian GAAP. Imax would have to change its business model to change its accounting system -- for example, by no longer requiring minimum royalty payments up-front. Imax officials did not want to comment on the issue.
But Mr. Scilipoti said that Imax chose its business model based on assumptions that encouraged up-front revenue recognition, and argued there are other ways to account for lease operations.
"They don't have to account for the revenue all up-front," he said. "They could account for it as they receive the cash."
In the case of Bid.Com, ultimately business reality helped convince the company to change its revenue system. The company decided to get out of business-to-consumer sales on its auction site -- which saw all sales recorded as revenue -- and instead focus on business-to-business sales, which produce revenue as fees and a percentage commission on sales.
Bid.Com marketing director Joe Racanelli said the decision will greatly improve the company's finances.
"When we were in the business-to-consumer space, we recorded all revenues, so anything that was sold -- whether [for]$5 or $100 or whatever -- was recorded directly," Mr. Racanelli said. "While our revenues are going to depreciate over last year, our profit margins are going to improve."
The revenue debate has also sparked renewed criticisms that Canadian GAAP is too imprecise and allows far greater accounting leeway than U.S. GAAP.
"We think [Canadian]GAAP is completely unsuitable for high techs," said Mr. Rosen, the accountant.
For example, he notes that Ballard Power Systems Inc. of Burnaby, B.C., has recorded large one-time revenue gains under Canadian GAAP when it has formed jointly held partnerships and transferred assets to the new firms. Under Canadian GAAP, the value of the assets above their book value becomes revenue on Ballard's books, but not under U.S. GAAP.
Mr. Rosen said that under U.S. GAAP rules, Ballard would have lost $62.5-million (Canadian) in 1998 and $34.2-million in 1997, rather than reporting profits in both years under Canadian GAAP.
Ballard vice-president of finance Paul Lancaster said the company is compelled under Canadian GAAP to use the accounting treatment that is now in place, and said there are pros and cons to both the Canadian and U.S. systems.
Ballard is affected by the differences between the two, both when transferring assets to an affiliate and when the affiliate issues shares above their book value. Both accounting transactions cause revenue gains under Canadian GAAP, but not under U.S. accounting.
"It's a serious question," Mr. Lancaster said. "Jointly held companies and joint ventures and working with partners is more and more the norm. I'd like it if Canadian and U.S. GAAP were harmonized, because having to explain differences is not something that's particularly productive."
Mr. Lancaster said he does not believe either country's GAAP system has the best answers. "I think there are specific accounting issues that need to be looked at and we have to find ways of dealing with things."
Peter Martin, a principal with the Accounting Standards Board at the Canadian Institute of Chartered Accountants, said there is an effort under way to bring Canadian and U.S. GAAP into harmony. For revenue recognition, Canada has broad principles, while U.S. GAAP contains more detailed guidance.
"The Accounting Standards Board has talked about this in the past few months, and its current view is that since there's still a lot of discussion and uncertainty in the U.S., and now the OSC is doing this review, it's a bit premature for us to be doing anything much," Mr. Martin said.
Still, he said it's a myth that Canadian GAAP is always more permissive than U.S. GAAP. There are areas, such as accounting for takeover using a pooling-of-interests approach, that are more permissive in the U.S. system.
Analysts, meanwhile, say investors are not helpless. They are watching the quality of revenue being reported by technology companies by monitoring such factors as the growth of accounts receivable, unbilled receivables and deferred income -- possible warning signs of aggressive accounting.
Experts say there are dozens of ways that companies can aggressively boost their reported revenue, often crossing the line of common practice, but not strictly breaking specific rules. Here's a sampling of popular techniques:
Recognizing the full amount of revenue when products can be returned, such as software shipments to retailers, or when there are other future obligations such as free upgrades;
Booking service revenue up-front when there is a long period of service required in the future;
Recording shipments to company-owned facilities as sales;
Recording revenue before development commitments are fully performed;
Pre-billing future expected sales, or urging customers to stock up in advance in order to record revenue in a desired quarter;
Bartering to trade services with another company, then recording the value as revenue;
Recording revenue for the gross value of sales when the company is an agent or broker, rather than a principal who assumes the risk for unsold goods;
Accepting options or shares in a private company as payment for goods, and then assigning a subjective value to the stake;
Deferring revenue and drawing down from it in periods when sales are slow.
What is GAAP?
Canadian Generally Accepted Accounting Principles (GAAP) are the basic accounting guidelines used by companies in Canada. The standards are broadly similar to those in the United States, but there are some significant differences.
In the area of revenue recognition rules, Canadian GAAP contains a relatively short, generic standard for revenues with almost no specific guidelines, says Peter Martin, a principal with the Accounting Standards Board of the Canadian Institute of Chartered Accountants.
U.S. GAAP, by comparison, provides much more detailed guidance about how to record revenue under a wide variety of different business situations.
Critics say that means Canadian GAAP provides much more leeway for companies to design favourable accounting systems. And it can mean companies in the same industry sector apply the standards quite differently from each other, and from required U.S. methods. Accounting watchdog Al Rosen argues Canadian GAAP is especially unsuitable and out of date for new technology companies.
"You're essentially dealing with an obsolete product," he said. "It just doesn't fit the high-tech industry. You can still cook the books quite a bit under U.S. GAAP, but you can cook them far easier under Canadian GAAP."
Mr. Martin, however, argues that while much more specific, the U.S. standards can be inconsistent between different industries and lack a general interpretation that can give guidance in new business cases.
Janet McFarland