Accounting inquisition takes centre stage in IT

IT managers aren’t supposed to be financial analysts. In the wake of the collapse of energy giant Enron Corp., however, the revelations of financial problems and accusations of accounting irregularities at some IT vendors are forcing technology executives to take a harder look at the financial health of their suppliers.

It’s not enough anymore to just know technology when there is growing fear that some of the biggest vendors may not be as financially healthy as they claim to be. No one wants to get stuck with products from a supplier that has gone out of business.

Stoking these fears are recently revealed probes into the finances of software maker Computer Associates International Inc. (CA) and bankrupt telecommunication services provider Global Crossing Holdings Ltd. Accounting practices also have come under scrutiny at companies including EMC Corp., Enterasys Networks Inc., Qwest Communications International Inc., Qualcomm Inc., IBM Corp., and Microsoft Corp.

Skepticism about accounting practices also has crossed the Atlantic, after the bankruptcy of former up-and-coming Belgium-based star Lernout & Hauspie Speech Products NV, which allegedly booked about US$100 million in business to fictitious Asian customers.

In one of the more high-profile cases, CA recently learned that it’s under investigation by the U.S. Federal Bureau of Investigation, the U.S. Attorney’s Office, and the U.S. Securities and Exchange Commission. While details of the probes are still secret, several class-action lawsuits filed recently by disgruntled shareholders have accused the company of using complex financial reporting to mask the fact that its flagship product is not selling well.

The lawsuits allege among other things that CA has inflated revenue for its flagship Unicenter enterprise management software.

CA bundles free or heavily discounted copies of the software with sales of its mainframe software, then counts some of the revenue from the mainframe software sales to the Unicenter line, according to the lawsuits. CA maintains that it has accounted for all of its sales in line with the U.S.’s GAAP (Generally Accepted Accounting Principles).

The rash of allegations have sent CA’s share price tumbling to levels not seen in nearly a decade.

“No company is receiving the benefit of doubt anymore. The market is shooting first and asking questions later,” said Sanjay Kumar, Computer Associates’ president and chief executive officer, in a conference call defending his company from accounting allegations.

Given the heart-stopping speed of decline and fall in so many technology companies in the past two years, investors have justification for bailing out early. Customers have the same reasons to be nervous.

For example, in April 2001, Memorial Health Services Inc. had a crisis on its hands when the Southern California hospital chain lost its Internet and managed security services provider, Pilot Network Services Inc. Pilot declared bankruptcy and shut down at the speed of a spontaneous combustion.

“They were on our internal watch list,” said Scott Cebula, vice-president of information services for Memorial Health. “We had plans in place to switch,” he said. However, with the speed of Pilot’s collapse (layoffs in the previous month, then a no-notice shutdown), “We essentially had to do a crash transition.”

There were warning signs. Pilot’s chief financial officer resigned in October of 2000, three weeks after taking the job. Pilot then announced a review of its revenue recognition policies, and said it wouldn’t make its earnings projections for the next quarter. Its stock instantly lost three-quarters of its value. A few weeks later, Pilot restated US$425,000 in earnings.

“The big lesson learned was to keep a critical eye on our vendors’ financial performance,” Cebula said. “If a vendor is critical to your operation, you have to be prepared if they fail or there is a service disruption.”

Flameouts of other service providers like NorthPoint Communications Group Inc. and Excite@Home Inc. made casualties of many of their customers. In the largest telecom failure of all time and the fourth largest bankruptcy in U.S. history, Global Crossing filed for Chapter 11 bankruptcy protection on Jan. 28. After raising billions in stock offerings and bond sales to build an international fibre-optic network, the company found itself loaded with debt and customer demand waning.

A former financial executive accused the company of improperly inflating its revenue through “capacity swaps.” In an improper swap, one carrier buys fiber-optic capacity from a customer to whom it would then sell nearly equal capacity. Though neither company is better off, either could report the sales as revenue and the purchases as a capital expenditure and not an operating cost. The SEC is looking into the allegations against Global Crossing.

All this had been academic for customers of Global Crossing so far, but on Friday the company announced layoffs of 1,600 workers in addition to the 800 that left voluntarily as part of restructuring plans. Global Crossing also said it would make a range of program cuts and narrow its service offerings, without elaborating on what programs and services. In their quest to preserve what money remains in Global Crossing’s bank accounts, bondholders may try force the company to shut down operations, as has happened at other service providers.

Customers probably would have liked to have known about these financial risks before signing on with the carrier. Their defense against unknown risks come from senior executives lending their financial expertise to IT buying decisions.

Chief financial officers and even chief executive officers have been getting more involved in the purchasing process at least since the technology business shakeout started almost two years ago, and in many cases long before that, said Mark Winther, a telecommunciation analyst from IDC.

“Anybody who is going to make a decision about services is taking a much closer look at the balance sheet of the vendors,” Winther said. “What is happening is that the purchasing process involves the CFO, particularly in midsize and large businesses,” he said.

U.S. investment analysts have traditionally looked for steady quarterly revenue growth, but wary industry insiders say the dot-com bubble increased the pressure, pushing some vendors toward questionable sales and accounting tactics.

“I think the dot-com furor made a lot of raised expectations,” said William J. Eline, vice-president for information technology at Parker Hannifin Corp., a motion-control technology manufacturer that makes parts for aircraft, robots and industrial controls. “A lot of bad decisions were made because of those raised expectations.”

Bad decisions were made by sales people looking to boost revenue, and by customers listening to those sales people.

“What would really help would be if the hype level dropped just a bit, so that marketing noise didn’t clutter the marketplace,” Eline said.

Meanwhile, some big accounting firms are scrambling to address real and perceived conflict of interest problems caused by their practice of providing nonaudit consulting services — which often involve IT projects — to clients they audit. The concern here is that accounting firms will go easy on these types of clients during the auditing process in order to avoid upsetting them and losing the nonaudit contracts.

Deloitte Touche Tohmatsu announced in February it will separate its Deloitte Consulting unit. In January, PricewaterhouseCoopers LLP made a similar announcement when it said it would spin off PwC Consulting via an IPO. Arthur Andersen LLP has also addressed the issue, saying in a February statement that it will “no longer accept assignments from publicly traded U.S. audit clients for the design and implementation of financial information systems.”

The two other Big Five accounting firms had already separated their consulting units before the Enron situation. Ernst & Young sold its IT consulting services unit to Cap Gemini in 2000, while KPMG LLP spun off its consulting business into an independent company called KPMG Consulting Inc. which went public in February 2000.

More than the collapse of the dot-com bubble, more than Sept. 11 effect, the basic fear that companies may simply lie in order to stay afloat will drive investment even farther away from technology companies, limiting the kinds of new hardware, software and especially telecom services that might otherwise have a chance to emerge, analysts say.

The iconic image of accountants — bow tied, bowler hatted and boring — is sharply different from that of the fast-talking, Armani-clad marketer, but the professions are two sides of the same golden corporate coin. Marketers tout the value of a company and its products. Accountants give proof for the claims. Or they should.

“For Global Crossing, it’s really an unbelievable story,” said Vik Grover, wireline telecom analyst for Kaufman Bros. LP. “But it’s not just technology. It’s everything. It’s Enron,” he said.

“It’s a tragedy, what’s happening on Wall Street,” he said. “I think that it’s bad right now that there’s no money for innovation, so you’re left to rely on these old, bloated monopoly companies,” he said. “If we’re relying on the regional Bells and the cable companies for innovation, we’re in trouble.”

(Juan Carlos Perez in Miami and Stacy Cowley in New York contributed to this report.)