Restating Revenues and Earnings at INVESTools Inc.
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INVESTools should definitely capitalize these expenses. The practice of not capitalizing these expenses has led to routine recording of net losses lately due to the company’s new focus on deferred-revenue contracts. By capitalizing these expenses, management can paint a much clearer picture of the company’s financial health, especially since the deferred-revenue streams will hopefully continue to grow in the future. 2. Board members are right to be concerned about the restatement being issued because of the severely negative consequences it may cause. The current business climate has caused INVESTools forthcoming restatement to be just another in a long line of accounting problems being experienced by the business community, this time specifically related to realizing subscription revenue too early.
An internal study, performed by the company’s new CFO, of other companies’ recent restatements shows that INVESTools’ impending restatement was most closely related to that of Red Hat Inc., who also had to deal with accounting issues relating to subscription issues. Red Hat suffered a 23% drop in their stock price as a result of the news of its restatement, and everyone at INVESTools feared a similar fate. The CFO’s review revealed that many companies’ restatement announcements were soon followed by large declines in their stock price that lasted even a month after the disclosure. The board was also upset about the restatement because they felt the company’s future had never looked brighter, in spite of the recent accounting issues. 3. Investors should make their evaluations based on cash sales when evaluating INVESTools revenue.
The company is going through a period of extreme growth in deferred revenue, which is negatively affecting current period earnings by putting an undue cost burden upon it. Cash sales give a clearer picture of the company’s true revenue and growth potential, since the company’s accounting policy doesn’t allow it to recognize the majority of the profit it’s receiving until later periods. The company itself also realized that cash sales was a much better indicator to point to for objective evaluation of the company’s performance as the article cited; “the company sought to focus market attention on sales transaction volume—the dollar value of customer registrations (i.e. cash sales)—by voluntarily disclosing this metric in the management, discussion, and analysis (MD&A) sections of its SEC filings and by discussing the potential understatement of earnings and sales growth in its earnings announcement press releases.”
Investors should rely on the company’s internal earnings measure when evaluating the business. The GAAP-based earnings measure hides the fact that the company is creating value and large new renewable revenue streams through its lifetime customer approach. The article states: “Depending on the terms of the commission or revenue-sharing arrangement, the costs associated with a deferred-revenue contract could range from 20% to 55% of total revenue under the contract.” So currently the company is expensing costs of 20% to 55% of the total revenue of a contract, while only realizing about 20% of that revenue in the same period.
This accounting practice is skewing the current net income figures and making the company appear as if it is routinely recording net losses, while the company is truly in great shape and just experiencing a paradigm shift in its business model and struggling with an accurate way to report it. 4. Currently management has two problems on their hands. The first and most pressing is the fact that they have to issue a restatement of previous years’ financial statements due to accounting errors associated with premature revenue recognition. The second problem, which may have contributed to the first problem, is the fact that the company’s revenue streams are drastically changing and they hope that they continue to evolve into lifetime revenue streams, which unfortunately defer revenue significantly. This change in revenue streams and the associated recognition of that revenue, at the appropriate time, has caused INVESTools the issue of having to make the restatement.
Since both issues need to be addressed and can be at the same time, it might be in the company’s best interest to do so simultaneously. The company historically chose not to capitalize most expenses that could have been capitalized under SAB 104 since their business didn’t rely on many deferred revenue streams at the time. The company would have undoubtedly preferred to change their policy for expensing deferred-revenue contracts were it not for the SEC’s preference that such costs were treated consistently and for the additional fact that they would have to make their case to the SEC, gain their approval, and restate all previous year’s financial statements. Now that the company is facing having to restate past financial statements, they might as well approach the SEC in regards to changing their deferred-revenue expense policy.
The company will need to make their case to the SEC as to why capitalization is now a preferable accounting treatment and they can use their recent struggles in applying the rules as good reasoning. Also, they can point out the myriad issues in the business industry with inaccurately recognizing subscription revenues as evidenced by the many recent restatements. Finally, the company can cite the continued shift in their business model, borne out by the change in the percentage of cash sales from largely being workshops to revenue-deferred streams like personal training and website renewals. The fact that INVESTools has been experiencing issues with their current accounting practices, that many other companies have also, and that INVESTools will only be experiencing more deferred-revenue streams in the future, the SEC may decide in their favor.
INVESTools should make a press release announcing their intention to approach the SEC to change the company’s accounting treatment of deferred-revenue contracts while simultaneously releasing their written statement to the press, that previous financial statements will be restated. The objective is for investors to see that the company realizes that the GAAP-based revenue and earnings measures are not perceived to be as flattering as they could be and that by seeking to change their accounting treatment, they are making it easier for investors to discern the true value the company is adding through its lifetime customer approach, which is heavily geared towards deferred-revenue contracts. Hopefully this announcement will somewhat overshadow the restatement announcement or at least take away some of the limelight.
Currently INVESTools management and board of directors only have limited information in regards to the scope and impact of the restatement. They can use that to their advantage, since they truly do not know the extent, and make the announcement somewhat vague, while pointing to the fact that they were planning on issuing restatements anyways, assuming the SEC approved their request to change their accounting treatment of deferred-revenue contracts. The tone should be soft and one of educating their audience of stakeholders to show that the company realized there was an issue with the way things were being reported. They can point to the fact that internally, they had already adopted a convention of adding back 80% of the change in deferred revenue to the GAPP-based earnings to come to a more objective measure of evaluating the company.
Unfortunately, when referring to the many other companies who recently made restatements, it doesn’t appear that the guidance they gave on the “Stated Effect on Financial Performance” made much difference to shareholders, as one company, Navistar International, announced that their restatement was going to have a positive effect on earnings and their stock price still dropped by 5.9% the day of the announcement. Hopefully, by purposefully intertwining the two issues of the restatement and the SEC request, stakeholders will view the restatement as something that was “somewhat” already in the pipeline due to the SEC request and that the restatements are a necessary short term evil that must be dealt with in order for future financial statements to give a much more accurate description of the company’s financial health.
The fact that there is no mention of any effect on the total amount of revenue to be received from the subscriptions in question in the restatement should also help quell any shareholder fears, even though the same comments didn’t save the management of Red Hat from experiencing a precipitous decline in their share price over a short period of time. To help sway the tide of public displeasure, the company should include in the restatement, its internal measures for better matching revenues to expenses, the cash sales percentage growth over the last four years, and point out the almost two year rise in stock price to help show the audience that the company is in fact on solid financial ground.