MicroTragedy and Other Revenue Wrecks
Grossing up is just one of the tricks in the revenue-recognition playbook. There are numerous other ways of making sales appear greater than they really are. An instructive scheme was employed by Micro-Strategy, a producer of data-mining software that parlayed its deception into a brief run as a Wall Street darling, before a restatement revealed one of the era’s defining accounting charades—at least until Enron and WorldCom came along.
In March 2000, MicroStrategy announced that it was retroactively changing its revenue-recognition policies and restating its revenue and earnings for fiscal years 1998 and 1999. Revenue, originally reported as $205 million in 1999, was reduced to $151 million. Similarly, 1998’s revenue, originally reported as $105 million, was restated downward to $94 million. The 1999 reported profit of $12.6 million was transformed into a loss of more than $33 million; 1998’s profit of $6 million was converted to a loss of $2 million. The day MicroStrategy announced the restatement, its stock fell 62 percent, obliterating $12 billion of market value. It kept falling uninterrupted for almost two months, quickly earning the nickname “MicroTragedy” from rueful investors. All told, shares fell from $333 in March 2000 to less than $20 in May 2000, at which time MicroStrategy faced at least three class-action lawsuits by shareholders as well as investigations by the SEC.
The reaction of investors to the restatement vividly illustrates the market’s penchant for reading sales and earnings reports, for good or ill, as a gauge of the future. The restatement required investors to revise their view of MicroStrategy’s prospects and thus the value they assigned to MicroStrategy’s stock. But how had MicroStrategy managed to paint such a misleading portrait of the state of its business in the first place? It took advantage of the latitude managers have in deciding when to recognize revenue.
MicroStrategy sold its software bundled with multiyear consulting engagements. Its product was not simply a set of coded instructions to a computer but also the company’s expertise in customizing those instructions to a client’s unique circumstances. Payment to MicroStrategy wasn’t a one-time affair but a stream of fees that flowed in over the course of the consulting deal. Rather than spread the revenue from the software sale over the life of the contract, though, the company recorded it immediately.
The SEC had noticed that aggressive revenue recognition was becoming the norm among software companies, and the agency had complained to some of them. The policies not only overstated a company’s growth rate, the agency pointed out, they also violated a fundamental accounting principle: Revenue should be matched against the costs associated with it. MicroStrategy, for instance, incurred costs—consultants’ and software developers’ salaries, mainly—in the course of fulfilling its consulting obligations to clients. Since MicroStrategy was receiving periodic payments from those clients, it would have been a simple matter to recognize those payments as they flowed in and match them against related costs incurred in the same period. Instead, Micro-Strategy immediately booked all the revenue a software contract would generate over its lifetime. The move not only gave revenue a swift kick, it sent profits into overdrive, since the company continued to recognize costs as they were incurred, rather than all at once.
MicroStrategy’s outside audit firm, PWC, offered an opinion that the company’s revenue-recognition practices conformed to standard U.S. accounting guidelines. A few months later, when regulators compelled the company to restate its results, PWC opined that the new numbers also conformed to U.S. accounting guidelines. If both statements are technically correct, then such assurances actually assure very little. In legal terms, according to a law firm that investigated MicroStrategy, the company’s only questionable acts were to backdate a few contracts. Right—and according to prosecutors in the 1930s, all Al Capone did wrong was to evade income taxes. PWC paid $51 million in 2001 to settle its part of the MicroStrategy class-action lawsuit.
For a brief period, MicroStrategy’s revenue-recognition game won it an enthusiastic following among investors and the business media. Of course, the game also ensured that there would be no future revenue to match against future costs, but that was tomorrow’s problem. In the meantime, MicroStrategy stock soared. It had a growing base of loyal customers, thanks in part to PWC Consulting, the consulting arm of MicroStrategy’s audit firm, which recommended the software to its clients. Company CEO Michael Saylor was lauded as a brilliant visionary—an assessment in which he publicly and enthusiastically concurred. Suddenly wealthy, thanks to the rapid rise of MicroStrategy’s share price, he pledged to endow an Internet university that he claimed would rival Harvard.
MicroStrategy’s newly won prominence, however, made it an inviting target to the SEC. The company’s apparent revenue and profit growth was sending investors a wildly misleading signal about its condition and prospects. Its SEC-mandated restatement sent investors a more accurate signal, and they responded by radically revaluing MicroStrategy’s shares. With shareholder lawsuits looming over him and the company he started, Saylor shelved his plans for an online university.
Investors’ embrace of MicroStrategy, their willingness to believe the astonishing sales growth claimed by the company, had a strong element of wishful thinking about it. Speculators in New Economy stocks wanted to believe that the Internet had unlimited potential, and MicroStrategy’s apparent prosperity, purportedly generated by brisk sales of software that analyzed Internet transactions, seemed to confirm that belief.