CALLING THE SIGNALS

Aspiring analysts should extract at least one invaluable lesson from the study of Informix’s aggressive revenue recognition: Staying alert to evidence of flawed, or possibly fraudulent, reporting is essential, even when the audi­tors put their blessing on the numbers.

The specific answer is not the same in every case. As a rule, though, dis­torting one section of the financial statements throws the numbers out of whack in some other section. Assiduous tracking of financial ratios should raise serious questions about a company’s reporting, at a minimum. To il­lustrate this point, let us consider another example from the computer soft­ware industry.

KnowledgeWare’s chief executive officer was Pro Football Hall of Fame quarterback Fran Tarkenton. After retiring from the National Football League in 1978, the one-time record-holder in touchdowns and passing yards founded Tarkenton Software, which he merged with KnowledgeWare in 1986. Specializing in client-server development tools, a type of software used in creating programs for networked personal computers, the company came to be regarded as an emerging star in its industry. In the early 1990s, however, KnowledgeWare fell behind its competitors in adopting new tech- nology⁸ and overextended itself through a series of acquisitions.⁹ As the company’s new products failed to take off, KnowledgeWare began report­ing losses and in July 1994 laid off a quarter of its workforce. With opera­tions reporting negative cash flow, KnowledgeWare “appeared to be close to being out of money,” according to an industry analyst.¹⁰

At that point, Tarkenton, who was renowned as a scrambler during his professional football days, managed to get KnowledgeWare out of an ex­tremely tight spot.

The rebound in KnowledgeWare’s fortunes proved short-lived, however. Within a month of its pact with Sterling, the company announced a $19.0 million loss for the fiscal year ending June 30, 1994. In addition to recording $15.4 million of red ink in the fourth quarter, KnowledgeWare restated its earnings for the first nine months. The previously reported $4.46 million profit turned into a $3.6 million loss and the company’s stock price plunged by 45% in one day.

KnowledgeWare’s new travails arose from a decision implemented dur­ing fiscal 1994. In an effort to boost revenues, the company began supple­menting its own sales force’s efforts with agreements to market its products through resellers. Almost immediately, the company started to encounter difficulties in collecting receivables generated by the resellers. In restating the results, management said that it had booked as revenues certain sales for which collections were not made.

The revelation of financial reporting problems initially threatened to scuttle the acquisition by Sterling Software.¹¹ In the end, though, Sterling agreed to go ahead on revised terms. Instead of paying 0.2893 of its own shares for each of KnowledgeWare’s, Sterling slashed its offer to 0.1653 shares. Furthermore, Sterling announced that it would acquire only 80% of KnowledgeWare’s stock for the time being. The other 20% of the purchase price would go into escrow as a contingency for possible lawsuits by Knowl­edgeWare shareholders.

Fran Tarkenton succeeded in obtaining approval of the reduced terms, but the shareholders’ meeting was testy.

Despite all his nimbleness, Tarkenton failed to emerge from the affair entirely unscathed. In 1999, the Securities and Exchange Commission charged him with directing a plan to overstate KnowledgeWare’s revenues and profits during 1993 and 1994. According to the allegations, the com­pany recorded sales in instances in which distributors were told that they did not have to pay for software unless they succeeded in reselling it. The SEC claimed that the objective was to convince investors that Knowledge­Ware was making a comeback from its fiscal 1992 operating loss.¹³

Tarkenton settled the SEC charges by paying a $100,000 civil penalty and disgorging an amount equivalent to the bonus he received as a consequence of the overstated profits—$54,187, plus interest. His attorney hastened to say that his client had neither admitted nor denied the charges and was “pleased to have this matter behind him.” Continuing in a vein familiar to aficionados of financial reporting scandals, the lawyer added, “The events in question took place about five or six years ago during Mr. Tarkenton’s tenure at KnowledgeWare, and he has long since moved on with his life and to other business ventures.”¹⁴

To be fair, KnowledgeWare amended its financial reporting practices once the receivables problem came to light.

Fixing the accounting problem after the fact, however, did not help in­vestors who valued KnowledgeWare on the basis of its originally reported profits. Analysts had to rely on their own devices to identify the potential for an earnings restatement before the disclosure devastated Knowledge­Ware’s stock price. At least a few analysts, it appears, did just that. Around the time that the Sterling Software deal was announced, some analysts were reportedly worried that liberal revenue recognition would lead to a write- off.¹⁵ They could have drawn that inference by careful scrutiny of standard financial ratios.

Exhibit 6.1 shows that revenues and receivables began moving out of sync from the moment KnowledgeWare launched its reseller program. In the first quarter of fiscal 1994 (ending September 30, 1993), revenues dropped by 15.5% from the preceding quarter, yet receivables rose by

EXHIBIT 6.1 Revenues and Accounts Receivable

KnowledgeWare, Inc. ($000 omitted)

size=1 color=black face=Cambria>*As reported by company.

Source: KnowledgeWare Forms 10Q and 10K.

0.5%. Management’s discussion and analysis in the Form 10-Q for the pe­riod noted that in terms of days sales outstanding, receivables leaped from 83 to 98 days.

To seasoned financial analysts, the diverging trends of revenues and re­ceivables looked worrisome even in fiscal 1994’s first quarter. Manage­ment’s discussion of the matter, however, was as brief as its analysis was thin. The “Liquidity and Capital Resources” section of the MD&A for Sep­tember 30, 1993, elaborated on the data only to offer the encouraging news that the percentage of gross trade accounts receivable subject to payment terms beyond 90 days had fallen from 25.0% to 21.7% during the quarter. The change implied that KnowledgeWare would be able to convert assets to cash more swiftly than formerly, thereby bolstering its liquidity. On the face of it, the quality of KnowledgeWare’s receivables was improving, possibly offsetting concerns about their increasing quantity. In the quarter ending December 31, 1993, management proudly reported a further drop in the portion of receivables dated beyond ninety days, to 10.4%.

During the quarter ending March 31, 1994, according to Knowledge­Ware’s Form 10-Q, the percentage declined once again, to 9.4%. Curiously, though, the company now indicated that the beyond-90-days ratio on June 30, 1993 had been 17.8%, rather than 25.0%, as previously reported. Management did not explain the discrepancy or even draw attention to it. Analysts had to discover the restated number by comparing the latest 10-Q with its predecessors.

The March 31, 1994, report also contained several entirely new dis­closures:

■    On top of the 9.4% of receivables subject to payment terms beyond 90 days, another 16% were subject to government funding provisions and would likely take more than 90 days to collect.

■    Notwithstanding the relative decline in receivables dated beyond 90 days, the number of transactions with “extended payment terms” (not sp ecifically defined) was growing.

■    Resellers in the nongovernment market accounted for approximately 6.2% of revenues for the three months ending March 31, 1994. Many of the resellers, said KnowledgeWare, were not well capitalized and therefore represented greater credit risk than the company’s typical end-user customers. KnowledgeWare compounded the inherent credit risk of dealing with resellers by offering them payment terms in excess of 90 days. Management hoped that the generous terms would induce resellers to initiate, increase, or accelerate revenues.

■ On March 31, 1994, KnowledgeWare had $3.1 million of accounts re­ceivable (6.1% of the net total) that were past their due date by 90 days or more.

In summary, the receivables-related bombshell that KnowledgeWare dropped on August 30, 1994 was telegraphed by a simple comparison of revenues and receivables in KnowledgeWare’s 10Q for the first fiscal quar­ter, received by the SEC way back on November 2, 1993. The company blunted the impact of that danger signal by stressing the declining ratio of receivables subject to payment terms beyond 90 days. Days sales outstand­ing continued to escalate over the following two quarters, however. In the fiscal third-quarter report, KnowledgeWare suddenly began disclosing addi­tional, less upbeat, details about its receivables. Battle-scarred analysts of fi­nancial statements would have guessed that management’s increased candor was the product of external prodding. To those alert enough to notice the unexplained change in the previously reported receivables-beyond-90-days ratio for the end of fiscal 1993, the sense of impending disaster should have become inescapable. By the middle of May 1994, more than three months before KnowledgeWare’s restatement, the company’s reported revenues were highly suspect. Not even the great Fran Tarkenton, in his glory days in the National Football League, benefited from so many tip-offs of his oppo­nents’ moves.

An Income versus Cash Disparity

The financial statements of a computer manufacturer likewise telegraphed future problems in the area of revenue recognition. Shortly before Kendall Square Research’s October 1993 revision of its previously reported earn­ings, a research service known as Financial Statement Alert warned that the company was recognizing revenues too early.

Kendall Square reported $45.4 million in revenue in the first six quar­ters after it went public in March 1992. Loren Kellogg, copublisher of Fi­nancial Statement Alert, compared this income statement information with a figure from the company’s statement of cash flows. Over the same 18­month period, Kendall Square’s “cash received from customers” was just $25.7 million. Kellogg viewed the $19.7 million disparity between the two numbers as evidence that a large proportion of sales being booked by Kendall were dubious.

The warning proved prescient. Less than a month after Kellogg’s analy­sis was reported in The Wall Street Journal, Kendall Square disclosed that its third-quarter 1993 revenues would be “substantially below” securities ana­lysts’ expectations. In lieu of earnings per share of 11 cents (the consensus forecast according to the forecast-tracking firm of Zacks Investment Re­search), the company said that it would report a loss. Additionally, Kendall Square delayed the release of its third-quarter earnings and announced the resignation of its senior vice president/treasurer, who had joined the com­pany only a month earlier. All these developments, by the way, were classic indications of serious corporate problems.

Revenue recognition controversies were central to Kendall Square’s dif­ficulties. The company indicated that although third-quarter shipments were “generally in line with expectations,” there was some question about the proper amount of revenue to recognize from the shipments. Jeffry Canin, an analyst at Salomon Brothers, speculated about a possible area of disagreement within the company. Some officials, he suggested, may have objected to counting as revenue rebates that might have been given to cus­tomers who agreed to upgrade to Kendall’s next generation of computers. Smith Barney Shearson analyst Barry Bosak proposed the possibility that Kendall Square had been hurt by its reliance on sales to universities. A num­ber of these institutions, which were in turn dependent on diminishing gov­ernment funding, proved unable to pay. Indeed, some critics insinuated that Kendall Square had made research grants to educational institutions as quid pro quos for orders, a charge that management denied.

At any rate, Kendall Square’s troubles continued, as auditor Price Wa­terhouse withdrew its clean opinion from the company’s 1992 financial statements. Management revealed that the year’s sales figure, originally re­ported as $20.5 million, included $4.2 million of “improperly recognized” revenue. Unaudited numbers for the first half of 1993 would also require re­statement, the company added.

In the wake of these announcements, Kendall Square demoted and then fired its president, its chief financial officer, and the head of its technical products group. The company’s acting chief executive officer announced that henceforth, Kendall Square would concentrate on building computers to order, instead of creating inventories in anticipation of orders. That re­form was likely to reduce problems associated with revenue recognition, but by the time it was introduced, the damage to users of financial state­ments was substantial. At 7½, the company’s stock price was down by about 70% from its peak three months earlier.¹⁶