[A-List] Financial regulatory crisis

["Keaney Michael" <Michael.Keaney@xxxxxx>]

High-tech groups bear brunt of the new conservatism
Financial Times; Feb 16, 2002
By MICHAEL PEEL and ASTRID WENDLANDT

INSIDE STORY In the wake of the Enron affair, investors fear that some
companies accounting may be in advance of their technology, write Astrid
Wendlandt and Michael Peel

Guardian IT, the provider of disaster recovery services, had a
catastrophe of its own to deal with this week.

The company, which announced it was correcting accounting errors of up
to Pounds 4m, dismayed shareholders when it said its directors had been
unaware of the issues underlying the mistakes.

One shareholder said: "If the board could not have been expected to know
about these issues, then how can we be expected to know anything? I was
in disbelief when I heard the news."

The sense of anxiety is shared by an increasing number of investors in
high technology companies. The collapse of Enron, the US energy trader,
has triggered close examination of sectors for which accounting
standards are poorly developed or interpreted in debatable ways. The
result has been a series of revelations of financial reporting errors,
with investors questioning the validity of many practices common in the
sector.

Shareholders and analysts expect more discomfiting news as the company
reporting season begins in earnest this month. The audit profession,
heavily criticised since Enron's demise, will be keen to demonstrate
that it is erring on the side of prudence and is willing to stop
companies that engage in questionable accounting.

Andrew Marsh, an analyst at ING Barings Charterhouse, says: "Auditing is
an art. It's all about interpreting standards and some of these
interpretations may have to change."

The turmoil is affecting some of the world's leading technology
companies. Cable & Wireless, one of Europe's largest telecoms groups,
revealed this week that it had used controversial accounting techniques
to record swaps of capacity with other groups.

The announcement came as the Securities and Exchange Commission, the
main US financial regulator, said it was investigating whether Global
Crossing, the bankrupt telecoms group, had used hollow swaps to boost
profits artificially.

The inflation of revenues and profits is a theme of more than one
announcement of the past week. Baltimore Technologies, the internet
security group, said it had overstated revenues from its Japanese unit
by Dollars 1.5m (Pounds 1m) in the 18 months to last June 30.

Guardian IT declined to disclose details of its accounting
irregularities, but analysts have suggested they might be related to
revenue and cost recognition.

The lack of established rules and practice on revenue recognition has
long haunted accounting standard-setters. Regulators are concerned about
industries, such as software, in which businesses often have continuing
obligations to provide customers with services. Some companies take the
adventurous approach of booking the full value of a sale as soon as the
contract is signed, even though money is to be paid over the coming
months or even years.

In the US, the Financial Accounting Standards Board announced last month
that it planned to reform its standards on revenue recognition. It said
existing guidance was "flawed in certain respects", adding that revenue
recognition was the largest single issue in cases of fraudulent
accounting and revisions of companies' results. Britain's Accounting
Standards Board plans to overhaul its rules.

During the bull market, analysts and shareholders provided companies
with a motive for exploring the wilder shores of accounting for
revenues. Many companies made little or no profit, meaning that the
investment community focused on sales growth.

One banker comments: "The biggest issue with technology companies is
that they have been chasing the dream of their own success. They have
invented ways to keep living that dream."

Some companies came unstuck through trying to "create" flows of revenue
by making acquisitions. One example is Cedar, the software company that
was saved from insolvency by Alchemy, the private equity house, this
year. It bought Sword, a lossmaking gaming company, in part so that
Sword would buy Cedar's software and increase the parent company's
chances of meeting City expectations.

Investors have grown so fixated with "accounting risk" that even old
accounting stories have been put back under the spotlight. Shares in
Innovation Group, the insurance software provider, tumbled nearly 28 per
cent this week as analysts renewed their focus on a number of
transactions the company made in the past year and how it presented them
to shareholders.

Innovation announced on February 8 last year a deal to sell Pounds 4m of
software products and services to Claimsnet, a German internet company.
Attention focused on its statement to the market regarding the sale,
which failed to mention that Innovation had lent Pounds 4m to Claimsnet
and purchased a 20 per cent stake in the company. The loan and purchase
of shares appeared in a footnote in a separate acquisition document.

Six days later Innovation signed an agreement to buy Pyramid, a provider
of claims-handling software, from its parent Kemper, a US insurance
company, for Dollars 21.4m. On the same day, Kemper signed a separate
agreement to buy Dollars 13.6m of software licences from Innovation. The
second contract did not appear in the market statement, but was
mentioned in a note in the shareholders' circular describing the
acquisition.

Rob Terry, chairman and chief executive of Innovation, says the
contracts were unrelated and were "done on an arm's length basis". He
says there is nothing sinister in the statistic that Innovation has made
18 acquisitions since it floated in July 2000. The purchases were aimed
at broadening the group's geographical coverage and product offerings.

Another issue dogging the high technology sector is the aggressive
approach of some companies to accounting for goodwill. Goodwill, a
concept devised to balance companies books, is defined as the difference
between the cost of a corporate acquisition and the value of the net
assets bought. Goodwill, generally understood to include non-physical
assets such as employee expertise and customer loyalty, is generally
written down - or amortised - against profits by companies over a number
of years.

Sage, the software group, drew criticism from analysts last week for
saying that it did not need to write down goodwill. The approach, which
means Sage incurs no reduction in profits as a result of amortisation,
is permitted by accounting rules, provided the company regularly reviews
its acquisitions to see if their value has been impaired. Sage argues
there is no impairment because it has successfully increased the profit
margins of its acquisitions.

The scrutiny of Sage is indicative of the way accounting practices that
had attracted little comment are being questioned.

In some cases companies themselves are trying to pre-empt concerns by
making changes they think investors might demand. Accounting issues at
both Guardian IT and Sherwood International, the insurance software
provider that announced a surprise Pounds 15m exceptional charge this
month, came to light after new finance directors identified problems.

Reporting policies are becoming an important way of judging a company's
health. The high-tech sector is the most striking example of the new
conservatism gripping investors, companies and accountants, as they
ponder the flaws in reporting and auditing exposed by Enron. Investors
dismayed by Guardian IT's announcement ought to brace themselves for
more shocks.

Full article at:
http://globalarchive.ft.com/globalarchive/article.html?id=020216001707&q
uery=Michael+Peel

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney@xxxxxx