MicroStrategy's Big Time Bungle

By Richard McCaffery (TMF Gibson)
July 18, 2000

Not a good year for data mining software company MicroStrategy (Nasdaq: MSTR), the high-flying firm that aggressively booked revenues and ended up restating its financials for the last two years.

Before the damage, MicroStrategy reported 1999 earnings of $0.15 per diluted share. That became a $0.44 per share loss in the wake of restatement. The company's share price fell from a high of more than $300 to a low around $18. Ouch. MicroStrategy is now the poster child for aggressive accounting.

Revenue recognition issues aren't new in the dot-com age. They're at the heart of accounting matters. A March 1999 report sponsored by the National Commission on Fraudulent Financial Reporting found that more than half of financial reporting frauds in the study involved overstating revenue.

The issue moved into the spotlight recently, as investors rely more on revenues and less on profits for their favorite high-flying technology stocks. The central question in revenue recognition is this: When is a sale a sale, and when do companies get to recognize revenues?

Under the accrual basis of accounting, companies get to recognize revenues when two events have occurred:*

1. A firm has performed all or most of the services it expects to provide.

2. The firm has received cash or some other asset capable of reasonably precise measurement.

* From Financial Accounting, ninth edition, by Stickney & Weil. [Note to reader: I've looked at a lot of accounting books lately, and this is a very good one.]

It's vital that investors read annual reports to get at least a basic understanding of a firm's revenue recognition practices. After all, applying those seemingly simple rules varies quite a bit depending on the nature of the company and the method of recognition it uses. Understanding it is more difficult than it seems.

Take, for example, an insurance company. If it sells you a one-year life insurance policy in January, it doesn't get to book all those revenues in the first quarter, at least not according to U.S. Generally Accepted Accounting Principles (GAAP). Rather, it has to wait to book those revenues until it has provided coverage. In January, the company hasn't provided insurance coverage for November. Therefore, it has to book that extra money as a liability and call it something like "advances from customers."

That said, it's very difficult for individual investors to determine whether a company is way off base booking revenues, at least not without a lot of practice and not without being very familiar with the company's financials. On the latter issue, Foolishness assumes you are familiar with your favorite company's financials, and getting more so by the day. As far as booking revenues, we have to rely on auditors for help with this pony, and PricewaterhouseCoopers really blew it on the Microstrategy call.

Accounting sleuth Howard Schilit, a CPA and founder of the Center for Financial Research and Analysis, spotted problems at MicroStrategy way ahead of the crowd. His book Financial Shenanigans is a must read for any serious investor.

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