The Effect of the Dot-Com Decline on Independent Accountants and Auditors

May 2003

The Effect of the Dot-Com Decline on Independent Accountants and Auditors

By Mary-Jo Rebelo

The many failures among dot-com companies during the last few years have been accompanied by malpractice lawsuits against their accountants and auditors. A portion of the blame tends to falls on accountants and auditors because potential investors and lenders have relied upon the audited financial statements to guide their decision making, and accounting firms and their insurers are generally perceived as having deep pockets.

Common-law negligence, fraud as defined by Rule 10b-5 of the Securities Exchange Act of 1934, as well as other areas of federal securities law, can all be the basis of claims made by failing dot-coms. Accountants are commonly sued under the federal securities laws because their financial statements are used in connection with various kinds of securities offerings, as well as in connection with annual reports and other periodic filings required of public companies by the SEC. The appeal of federal securities claims is that they are not necessarily subject to a privity requirement: In many jurisdictions, accountants or auditors do not owe a duty of care that can give rise to negligent actions to the client’s lenders or shareholders.

A positive point for accountants is the impact of the Private Securities Litigation Reform Act of 1995 (PSLRA), which eliminated joint and several liability for securities law claims. An accountant assessed with only tangential or minor responsibility for a securities law violation will not have to pay for the full amount of a plaintiff’s losses. The accountant will be assessed only for the proportionate share of the losses that the jury finds the accountant caused, as long as the accountant has not acted knowingly, or with any intent to defraud, as compared with mere reckless disregard. This provision may reduce a plaintiff’s incentive to look to the accounting firm and its insurer as the deepest pocket at the table.

If the plaintiff has sufficient information to support a claim, particularly of negligence or fraud, it is often impossible to have the case dismissed before trial. The accounting firm will find itself immersed in protracted and costly litigation, with a potential for liability.

Notice Red Flags

While regulators are getting a grip on “creative” accounting practices, there is still room for shenanigans at many dot-coms. GAAP does leave room for those so inclined to mislead a lender or investor while remaining within the letter of the law. Dot-coms anxious to book a profit and report rapidly increasing revenues have resorted to several ways to bend the applicable accounting rules.

Revenue recognition tops the list of creative accounting techniques employed by many dot-coms. The decision to capitalize or expense is inextricably intertwined with this point. A company defers as many costs as possible. Capitalized costs are reported as an asset on the balance sheet rather than an expense on the profit-and-loss statement. Never before has an entire industry had sales matter so much to its lenders and investors. For a website trading at 200 times expected sales, even a small increase in reported revenues can translate into a dramatic increase in market capitalization. Here are a few examples of how it can be done:

The gross-up. Many dot-coms gross up revenues by reporting the entire price a customer pays at their site even though the company may actually keep only a small percentage of that total amount.
Contra deals or barter. This method involves booking revenue ahead of when the sale actually occurs. A dot-com exchanges advertising space on its website for advertising space on another to build brand recognition and use up excess advertising capacity without using cash. GAAP requires recording barter transactions at fair value, but does not specify how to determine fair value. Many dot-coms have treated such barter advertising deals as a sale, thereby accelerating revenue as well as expenses.
Expenses. Dot-coms often manipulate the categorization of expenses in an effort to report a more favorable operating performance. Because dot-coms rarely report net profits, the focus is on gross profits before the deduction of indirect expenses. Dot-coms try to minimize direct expenses by reclassifying them as indirect. The primary area for abuse is coupons or discount vouchers, which are reported as indirect expenses. By reducing direct expenses while increasing indirect expenses, the company breaks even at the gross profit level even though net losses are the same. Additionally, fulfillment costs, the expenses associated with warehousing, packaging, and shipping products, are used in creative accounting. Companies usually record fulfillment costs as a cost of sales, but dot-coms classify fulfillment costs as a marketing expense. This categorization allows dot-coms to conceal operational expenses within the hefty marketing costs that lenders or investors likely believe are associated with establishing brand awareness.

Once these creative accounting techniques are combined, the profit picture looks more promising. When dot-coms have crashed, the creative accounting employed in an effort to enhance financial performance has often been placed in the lap of the outside accountant or auditor to explain and justify.

Preventive Measures

In the context of accounting malpractice, the factors affecting the application of the due-care standards of GAAS are constantly evolving. In an area of emerging risk, practitioners must consider and evaluate these standards within the context of satisfying the SAS 59 going concern needs.

Internet companies have generally been valued differently than traditional companies, and this can place immense pressure on management to manipulate the revenue numbers. It is essential that the auditing team be staffed at all levels with individuals familiar with e-commerce and the client. Adherence to applicable accounting and auditing standards must be ensured. In addition, all activities should be documented as thoroughly as possible. This provides the best opportunity to identify and evaluate the risk of failure areas that could cause ultimate disaster.

Mary-Jo Rebelo, Esq., is a director of the law firm Houston Harbaugh, P.C., Pittsburgh, Pa. (www.hh-law.com).

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