Late Friday three video game publishers, Activision (NASDAQ:ATVI), Acclaim (NASDAQ:AKLM) and THQ (NASDAQ:THQI) disclosed that the Securities and Exchange Commission has launched an investigation into their accounting practices. All three stocks were off sharply in early trading Monday morning.
At issue in all cases is an accounting convention that Activision in its 8-K called "common to the interactive entertainment industry, with specific emphasis on revenue recognition." The practice involves booking revenues when the title of a product is transferred to a customer, which is standard procedure. The catch is that all three allow returns from certain customers under certain conditions, which vary from company to company. As a result, each company must estimate returns and price rebates for each quarter, and because the return option is typically granted to the largest customers -- i.e. big retailers -- the effect on revenue can be meaningful.
My guess is that this is at issue in the investigation. Neither the SEC nor the companies will comment, but that's the only aspect of each company's revenue recognition policy that strikes me as potentially aggressive. Keep in mind, wherever you introduce an estimate -- or any type of reserve -- into financial reporting, you introduce the opportunity to fudge the estimate and thus boost (or in rare cases, reduce) earnings in a given quarter. Worst case: A big retailer (or several) returns a lot more product than "estimated" and -- shazam! -- the game manufacturer has booked way too much revenue and must true up. Not pretty.
And not necessarily illegal. And not necessarily what the SEC is looking at -- just an informed guess on my part. The SEC has advised each company that the investigation does not in any way indicate that the commission believes that laws have been broken. And make no mistake, the actions here today come nowhere near the seriousness of the ongoing investigations of impropriety at Take Two Interactive (NASDAQ:TTWO).
Still, even when we like a company -- Activision has been highlighted on numerous occasions by David Gardner in Motley Fool Stock Advisor -- we're not fans of aggressive accounting. Let's hope an SEC investigation will be enough to prompt all three companies to toe the straight and narrow.
