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Defending the bottom line

A sweeping Securities and Exchange Commission review of corporate accounting practices has reached into the Internet and high-technology industry.

A sweeping Securities and Exchange Commission examination of corporate accounting practices has reached into the Internet and high-technology industry.

Last month, Net security firm CyberGuard said that it would restate its third-quarter financial results and even moved to suspend its chief executive and chief financial officer, prompting the SEC to inquire about the company's financials.

"The SEC had called and asked some questions pertaining to our potential refiling of our third-quarter [results]," a spokeswoman said. "There is currently no SEC investigation going on to our knowledge."

CyberGuard is an extreme example, but it is one of a growing list of companies Development costs: Timing is everything that are restating their financial numbers or undergoing SEC scrutiny for certain one-time charges. The queries are part of a fact-finding mission begun in August to examine the accounting practices of U.S. businesses.

Some analysts blame the spate of special charges and restated earnings on the recent bull market that had driven high-tech and Internet stocks to dizzying heights. The high valuations on many of these stocks, some of them with no earnings, leads to tremendous pressure for companies to live up to expectations.

"You certainly don't want to come in under earnings estimates; but for Internet companies, even being on target isn't terrific," said David Simons, managing director of Digital Video Investments, an institutional research firm. "The objective is to provide reason to keep valuations pegged to expectations for two or three years."

Neither the SEC nor Wall Street analysts have accused any specific companies of wrongdoing as part of the investigation. But the charges are drawing wide attention beyond Washington because earnings propel a company's stock price.

The high valuations on many Internet stocks...lead to tremendous pressure for companies to live up to expectations.

"Our concern arose based on the number of companies that either have announced they are going to restate something that they accounted for, or accusations of misdeeds in terms of accounting at the company," SEC spokesman Duncan King said. "We're just trying to figure out where there is a breakdown--if any--in terms of accounting practices."

The SEC's chief accountant, Lynn Turner, is assessing accounting practices related to one-time charges and research and development. The agency declined to talk about the accounting practices of any specific companies or industry.

The SEC has been meeting with executives and accountants to discuss the trend. Some analysts speculate that the inquiry could lead to tighter accounting rules.

"We haven't made any pronouncements or come to any conclusions yet," said Chris Ullman, director of public affairs at the SEC. "We are trying to figure out if some of these issues are genuine problems or if they are systemic to public companies in general."

The objective is to provide reason to keep valuations pegged to expectations.

Recent major accounting problems at companies such as Cendant and Sunbeam have drawn intense public scrutiny, but some high-tech and Internet stocks have been the focus of attention as well, though their problems appear minor by comparison so far.

For example, 3Com was criticized by some analysts earlier this year for restating earnings related to its merger with U.S. Robotics following an SEC review. 3Com said the changes were based on generally accepted accounting standards.

So-called Internet companies have also been approached by the SEC for clarifications about their accounting practices.

America Online said last month that it could not disclose Japan weighs U.S. accounting its net income because it was in discussions with the SEC about some special charges. The issues in question are related to research and development at Mirabilis and NetChannel, companies AOL recently acquired.

AOL said it was prepared to report its full earnings but decided to wait. "The treatment of in-process research and development is something that the SEC has been paying more and more attention to lately," an AOL spokeswoman said. "We wanted to reach out to the SEC in advance to give them an opportunity to review the accounting treatment for our acquisitions."

There are no new developments in the discussions between AOL and the SEC, and the online company still has not scheduled a date to release it full earnings statement for the last quarter, the AOL spokeswoman said today.

There is no shortage of other examples in which special charges were taken. Internet portal company Excite tried to exclude $56.8 million as a one-time charge incurred in a marketing partnership with Netscape Communications' Netcenter.

"We believe our accounting treatment was prudent," said Greg Kalben, vice president of investor relations for Excite. "The majority of analysts didn't have an issue with the our treatment of our transaction, just a few vocal ones."

Kalben added that the company was surprised that the accounting treatment "had snowballed into such an issue, especially since our outside auditors, Ernst & Young, had approved the transaction."

Be wary of a company after an accounting dance. It should say to people that we need to take a good hard look at the quarter.

Still, some analysts and accountants argue that marketing charges should be included in operating earnings because they are operating expenses.

Online auctioneer Onsale also recently wanted to pass off a marketing charge as a one-time cost, a payment to Cendant related to a partnership with Resort Condominums International. "It is true, especially within the financial community, that a marketing charge is usually ongoing," an Onsale spokesman said. "But in this case, we just had a one-time charge that was really a set-up cost to get the site up and running."

This year, Netscape changed the date that closed its fiscal year, a shift that allowed it to separate January from its newly defined second quarter. But during that month, the company incurred a sizable loss of $54.2 million; for the second quarter, it posted net profits of $8,000

High-tech earnings is ground that hasn't been as trodden, so you are going to have more fuzziness.

The accounting changes made it difficult for analysts to determine Netscape's overall financial health. The company said it was headed toward a recovery, but financial site Briefing.com called the shift the "worst attempt in concealing a lousy quarter in recent memory."

"Certainly I would be wary of a company after an accounting dance," said Marc Usem, who follows Netscape for Salomon Smith Barney but made it clear that he was not referring to the company in his comments. "It should say to people that we need to take a good hard look at the quarter."

Added Simons: "This kind of thing doesn't usually happen with old technology companies such as Microsoft, Intel, Oracle, and Cisco...It goes on mainly with Internet stocks."

One reason: Because the industry is relatively new, interpretations of accounting standards used by more mature industries do not always apply.

"It's very different from a brick-and-mortar company," said Terry McCrary, vice president of research at Waldron and Company. "It's ground that hasn't been as trodden, so you are going to have more fuzziness."

To be on the safe side, he said, "my general feeling is that the more information a company represents the better it is. If you want to present data on a pro-forma basis, that's fine as long as it is clear and no one is being misled. Of course, misleading is in the eye of the beholder."

Unlike more mature technology industries such as software, chipmaking, and cable, the fledgling Internet sector still does not have one rigorous set of criteria that analysts examine consistently.

"In 'old tech,' there are well-established metrics and methodology for what companies report and how," Simons said. "With Internet stocks, there are few such standards. This leaves companies with a lot of flexibility in managing expectations. Information and presentation can more easily be selected and modified to suit the situation and desired message."

Indeed, the current financial landscape can often be painted in vast hues of gray.

"There's a broad spectrum for valuing companies on tangible metrics like earnings or cash flow vs. wild speculation based on no fundamentals," said Michael Graham, an Internet analyst at Raymond James. "Somewhere in the middle is where Internet stocks lie at the moment." 

Go to: How to spot red flags