The New York Times,
August 19, 2001 Sunday
Money and Business, Page
When the Numbers Just Don't Add Up
By KARL SCHOENBERGER
SAN FRANCISCO – Indus International, a computer software maker, moved to
Atlanta from the frenzy of Northern California's high-technology scene
earlier this year, after it paid $4.3 million to settle a passel of investor
lawsuits accusing it of fraudulently overstating revenue.
Executives of the once-profitable company, which sells software and services
to help large corporations manage their assets, say they are confident that
its revenue growth is back on track and that its bookkeeping problems are
But Indus International is not out of the woods. Not yet.
Back in San Francisco, officials of the Securities and Exchange Commission
and the Justice Department are completing parallel investigations of the
accounting methods used by the company in late 1999 that led to the investor
lawsuits. They are expected to announce their findings late this month.
People close to the investigation said that both civil and criminal charges
against the company and former employees were under consideration in the
Indus, in a document filed last week with the S.E.C., disclosed that it had
been cooperating with the S.E.C.'s formal investigation and had offered to
settle the matter without admitting or denying wrongdoing. J. Michael
Highland, chief financial officer of Indus, said the company otherwise had
no comment on the S.E.C. and Justice Department investigations.
As if things were not difficult enough for Indus and other technology
start-ups that managed to survive the Internet collapse through brutal
restructuring and job cuts, many are now under investigation by law
enforcement authorities for the way they recorded the ringing of their cash
registers during the feverish competition of Nasdaq's bubble years.
Responding to widespread concerns that investors were not always given
reliable financial information in that time of frantic revenue growth,
regional offices of the S.E.C., the Federal Bureau of Investigation and the
United States attorney's office here are cooperating in a legal crackdown on
A tough law-enforcement response to accounting irregularities, of course, is
not new. In the past year, federal investigators have pursued cases of
irregularities at companies like Waste Management, Cendant and Sunbeam. But
now the government is turning up the heat in Silicon Valley, home to a
preponderance of questionable accounting, particularly among software
companies, during the Internet boom.
Over the last four years, nearly one in five accounting restatements -- red
flags for potential misconduct -- have been by companies in California,
according to a study by Arthur Andersen, the accounting firm. (Arthur
Andersen was itself the recent subject of an S.E.C. civil sanction for the
way it audited the books of Waste Management, the trash-disposal company,
and agreed to a settlement without admitting or denying civil fraud
allegations.) In the same four-year period, the total number of restatements
for all industries has nearly doubled, Arthur Andersen's report said.
So far in the technology sector, federal investigators and prosecutors here
have set their sights on relatively small companies, where a high proportion
of problems center on what accountants call improper "revenue recognition"
-- the recording of revenue that does not exist. It could be, for example,
from a pending sale that is misclassified as completed, or a service
contract in which money has not yet changed hands.
The Arthur Andersen study of accounting restatements from 1997 to 2000
showed that 27 percent of the restatements nationwide had been filed in the
software and computer industries. About 62 percent of the software companies
involved had annual gross revenue of less than $100 million.
The rise of accounting fraud investigations, specifically related to
overstatement of revenue, reflects a serious white-collar crime trend in the
high-technology sector in recent years, said Leslie B. Caldwell, chief of
the securities fraud section for the United States attorney's office here.
"The pressure to do this in the technology industry was intense because the
expectation for growth was so high, and it wasn't sustainable," she said,
without commenting on specific cases.
The inquiry at Indus International focused on revenue for the third quarter
of 1999. According to the shareholder lawsuits against the company and
former executives, the revenue total included sales derived from "irregular
contracts," money that was not received during the quarter in question. Last
October, Indus International agreed to settle the suits for $4.3 million
without admitting or denying wrongdoing.
Previously, Ms. Caldwell said, her office waited for the S.E.C. to refer
cases for criminal investigation. But now, "we're taking the bull in our own
hands," she said.
"There are a number of matters under investigation of corporations that
cooked their books to meet Wall Street's expectations -- expectations that
the companies themselves created," she added.
Harris Miller, president of the Information Technology Association of
America, a trade group, said accounting problems in the software industry
had arisen because of what he called vague rules covering sales of licensing
agreements, which resulted in many companies claiming revenue that they
expected to receive.
"The rules for revenue recognition were a bit cloudy, not just for software
companies but for any company that delivers services over time," Mr. Miller
said. His organization, he said, was not making excuses for executives who
intentionally violated regulations. "Yes, there was pressure to drive the
top line," he said. "But you can never justify misconduct."
Ms. Caldwell's unit of seven lawyers, responsible for expediting complicated
and paper-intensive securities investigations, was created in February 2000
by Robert S. Mueller, United States attorney for the Northern District of
California, whom President Bush chose to serve as director of the F.B.I.
Matthew J. Jacobs, a spokesman for the United States attorney's office here,
said Mr. Mueller had made the prosecution of accounting fraud a major
objective because of its prevalence in both economic booms and declines. Mr.
Mueller was not available for comment, the United States attorney's office
said on Friday.
In its most prominent case to date, Ms. Caldwell's team obtained indictments
last September against two former executives at McKesson, the pharmaceutical
and medical technology company based here. The defendants were charged with
accounting fraud related to the 1999 merger of McKesson and HBO & Company, a
software company based in Atlanta. Prosecutors said $9
billion in shareholder losses resulted. The defendants pleaded not guilty to
the charges, and the case is in the pretrial phase.
THE F.B.I. and federal prosecutors here are investigating about 50 cases of
possible criminal securities fraud in the district, more than a dozen of
them focusing on companies suspected of accounting fraud.
In addition to Indus International, at least six small and medium-size
software companies in Northern California are under federal criminal and
civil investigation, according to officials. Among them is Critical Path, a
San Francisco company that sells e-mail messaging technology to other
businesses and reported $135.7 million in sales last year. In February,
after an internal investigation that led to the departure of its chief
executive and two other executives, Critical Path restated revenue for the
third and fourth quarters of 2000, subtracting a total of $19.4 million from
what it had claimed. The company's share price plummeted and class-action
suits were filed, contending deception and fraud. Critical Path has said it
is cooperating with investigators.
In another case, the S.E.C. filed a civil complaint last September in
Federal District Court here against three former executives of the Cylink
Corporation, a Santa Clara company that makes cryptographic software for
computer network security, accusing them of violating accounting rules by
recognizing spurious transactions as sales in quarterly earnings statements.
The complaint said Cylink recognized more than $900,000 in revenue in the
second quarter of fiscal 1998 for sales in which some customers were given a
three-month window to cancel their orders.
"When senior officers are involved in this kind of conduct we're going to
hold them responsible," Robert L. Mitchell, head of the S.E.C.'s enforcement
office in San Francisco, said when the complaint was issued. "Companies only
act through individuals." The S.E.C. settled a separate administrative
"cease and desist" proceeding with the corporation. In the civil litigation
against three former Cylink executives, each was accused of securities
fraud, circumvention of Cylink's internal controls and falsification of
IN July, according to court records, one of the former Cylink executives,
Thomas Butler, who had been vice president for sales, signed a consent
decree, without admitting or denying the charges, agreeing to pay a $100,000
fine and forfeit a $25,000 bonus he had been awarded by Cylink for his sales
performance. Litigation against the two other defendants is still pending.
Robert Fougner, Cylink's general counsel, said that he and other company
executives could not comment on the case.
In cases in which criminal charges are brought against company executives,
potential penalties can be harsh. In addition to fines imposed by the S.E.C.,
a conviction of an executive on a criminal securities fraud charge can
result in a prison sentence of up to 10 years and a fine as high as $1
million. Conviction on a lesser charge, like wire fraud or conspiracy,
carries a maximum five-year sentence and $250,000 fine.
Until recently, the pace of these investigations had been plodding, owing to
their complexity and a shortage of resources. For example, Scorpion
Technologies, a software company that was based in Los Gatos, Calif., and is now defunct, was
accused of fraudulently claiming as much as $3.6 million of its $12.4
million in reported 1991 revenue. The S.E.C. filed civil charges and federal
prosecutors indicted company executives on securities fraud charges in 1996.
The last of the Scorpion defendants, John T. Dawson, was indicted in 1999.
Last November, he pleaded guilty to charges that he had helped create
offshore companies that masqueraded as buyers of Scorpion software products.
Mr. Dawson's sentencing hearing is set for Oct. 2.
The Justice Department has a high threshold for criminal prosecution in
these cases, with a distinction being made between misleading accounting
practices and criminal fraud, Ms. Caldwell said. A suspicious accounting
trick, by itself, cannot be the basis for seeking an indictment without
other facts establishing deliberate fraud, she said.
Some major technology companies, including Lucent Technologies, have been
subject to recent class-action suits contending irregularities in the way
the companies accounted for their growing revenue before their businesses
weakened. The S.E.C. started examining Lucent's books last November, after
the company had disclosed an accounting problem, fired an employee and filed
a restatement lowering its revenue for its fiscal year 2000 by $679 million.
Lucent, however, seems an exception. For now, at least, it appears to be the
smaller technology companies that are receiving the most scrutiny.
A common thread in the companies under investigation is the restatement of
quarterly financial results after internal accountants or outside auditors
have found problems. A restatement almost always results in plunging stock
prices, indignant investors and shareholder class-action suits.
The S.E.C. has strengthened its investigations of revenue-recognition cases
since its former chairman, Arthur Levitt, warned of what he called the
erosion of the quality of financial reporting in corporate America in a
speech at New York University in September 1998 and announced tightened
enforcement. Mr. Levitt said he was concerned that "the motivation to meet
Wall Street earnings expectations may be overriding common-sense business
"Too many corporate managers, auditors, and analysts are participating in a
game of nods and winks," he added.
INVESTOR advocates like Barbara Roper, director for investor protection at
the Consumer Federation of America, have expressed concern that Mr. Levitt's
successor, Harvey L. Pitt, a Wall Street lawyer, may take a less aggressive
approach on enforcement. Mr. Pitt, a former general counsel for the S.E.C.
who, while in private practice, represented Ivan F. Boesky, who was
convicted of insider trading, has advocated streamlining S.E.C. regulations.
But Mr. Pitt assured the Senate Banking Committee at a confirmation hearing
in July that he would "ensure vigilant enforcement of sound rules that
protect all investors against fraudulent, deceptive and manipulative
Charles D. Niemeier, chief accountant for the S.E.C.'s division of
enforcement in Washington, said the agency took action in 100 cases of
suspected financial disclosure fraud last year, compared with 75 in 1998 and
40 in 1991. Fifty-seven of last year's cases involved revenue-recognition
problems, Mr. Niemeier said.
He described a snowball effect -- the possible compounding of
revenue-recognition problems from quarter to quarter.
"Once a company goes down the path of earnings management, it's very
difficult to get off, because artificial earnings become the floor of future
earnings," said Mr. Niemeier, who also serves as co-director of the S.E.C.'s
new Financial Fraud Task Force. "What starts out as a small accounting
problem by the end becomes monumental. It's like having a noose around your
neck, and you're the one tightening it."
Software companies like Indus, Critical Path and Cylink are particularly
susceptible to encountering accounting problems -- and accusations of fraud
-- because of the complex nature of the licensing agreements they must
negotiate to sell their products. Unlike service providers in other
industries, software vendors have relied heavily on a customer base of
dot-com start-ups, many of them now insolvent or financially unstable.
Indeed, the software sector figured prominently in the roster of federal
securities class-action lawsuits filed in 2000. It was the single biggest
industry category -- 18 cases out of the total of 107, or nearly 17 percent
of those involving accounting violation charges., according to a study by
PricewaterhouseCoopers. The study also showed a sharp increase in total
cases involving companies in the computer services, electronics and
telecommunications industries -- to 45 percent of the total last year from
34 percent in 1999.
The securities class-action suits may be a rough barometer of the severity
of the problem, law enforcement officials say. But the real test for federal
investigators is determining whether accounting violations were isolated
errors or a part of a pattern of deception known as "revenue management," in
which corporate officers act with the intent to bend accounting rules or to
cover up past mistakes.
"The cases we take on involve the corporate culture, the true situation at
the top of the organization, where the boss says, 'We have to make these
numbers or else,' " said Ms. Caldwell. "The Justice Department is not
interested in renegade salespeople."
At Indus International, the accounting problems appeared to be limited to
one quarter, and the company's board took swift corrective action, issuing a
restatement of the revenue in question and restructuring the company's upper
At issue in the case was a practice said to be common among many companies,
including those in software, that artificially inflates revenue to meet
ambitious growth targets by pushing products and licensing agreements on
customers. It often involves transactions in which money does not
necessarily change hands. Such deals typically pivot on undisclosed side
letters or confidential agreements laying out terms allowing distributors to
return unsold products, for example, or default on financing.
Joan P. Platt, the chief financial officer at Indus in 1999, said in a brief
telephone interview that the use of side letters by the company's sales
force -- without the knowledge of company accountants -- caused the
revenue-recognition problems under investigation. She declined to elaborate.
Ms. Platt, a 20-year veteran of Coopers & Lybrand, resigned from Indus in
December 1999 to join MarketWatch.com, a financial news service, as chief
financial officer and vice president for finance.
The management realignment that coincided with Ms. Platt's departure led to
the replacement of the company's chief executive, William J. Grabske, in
early January 2000 by Kent O. Hudson, who had been a full-time management
consultant at the company. At the end of that month, Mr. Hudson and his new
management team issued a statement saying that the company's third-quarter
1999 revenue had been overstated by $5 million, "all of which related to
Mr. Grabske, who led the company during the period when the problems
occurred, could not be reached for comment last week.
The adjustment lowered revenue for the quarter to $45.8 million and reduced
net earnings to $1.1 million from $3.5 million. The company later reported
net earnings of $23.8 million for all of 1999 on revenue of $178.5 million.
Last year, the downturn in the industry cut the company's revenue by 18
percent and left it with a net loss of $58.7 million.
Results for its latest quarter suggest that Indus is getting back on its
feet: revenue rose 32 percent, to $43.1 million; its net loss was $6.7
million, including the effects of an $8 million restructuring charge,
compared with a net loss of $20.2 million a year earlier. Its stock price,
which hit a bottom of $1.50 in December, now trades at $7.10.
COMPARED with Lucent's financial accounting restatements of $679 million and
the problems that have befallen that company, the amount of shareholder
equity lost in Indus's case seems inconsequential. Indus's $4.3 million
class-action settlement was also relatively small. To settle its lawsuits
last year, Cendant, the big real estate and travel company, paid $3.5
billion -- more than 10 times greater than the second-largest federal
securities class-action settlement in history, which was paid by the network
equipment company 3Com, also last year. In proportion to income, however,
the settlement by Indus was a significant burden for the company.
Federal regulators have taken action against some big companies. The S.E.C.
penalized Arthur Andersen, the big accounting firm, in June, obtaining a $7
million fine for Andersen's failures at Waste Management, which led to a
$1.43 billion restatement of revenue in 1998.
The S.E.C. would not comment on other Fortune 500 companies that may be
under investigation, but there are clues suggesting possible targets.
Federal investigators say they monitor Stanford Law School's securities
class-action clearinghouse, a database of court records that includes a wide
variety of accounting fraud charges against public corporations of all
sizes. The number of cases tracked by the Web site, at
securities.stanford.edu/index.html, has been climbing rapidly since the
Nasdaq plummeted last year. Many of the lawsuits contend wrongdoing in
allocations of shares in initial public offerings. More than 270 cases have
been reported so far this year, versus 211 for all of last year.
Bill Parish, an independent investment portfolio manager and financial
analyst in Portland, Ore., is one of many investment professionals who blame
the accounting industry for the rise in accounting irregularities. An
accountant who formerly worked at Arthur Andersen's Portland office, Mr.
Parish said the big accounting firms had placed too high a priority on
expanding their lucrative tax advisory and business consulting operations in
recent years, at the expense of traditional accounting services. As a
result, the firms have become less rigorous in examining client books and
lack the necessary independence as auditors to challenge irregular
practices, he said.
The S.E.C. civil fraud complaint against Arthur Andersen in June is a case
in point, he said.
"If you want to know how these things are allowed to happen, you have to
look at the accountants," Mr. Parish said. "There's been a collapse of the
integrity of accounting profession. In a way, I feel sorry for the
But the circumstances behind accounting fraud are rarely simple, and fault
is hard to pin down, said Harvey Kelly, a partner at PricewaterhouseCoopers
who practices forensic accounting, the examination of books for possible
legal violations. The lines are particularly blurry in the high-technology
industry, he said, where there are "increasingly creative transaction
Accounting for the revenue from these transactions is a challenge. "The
accounting industry and the regulators have come out with guidelines for
this," Mr. Kelley said, "but it's not uncommon for the creativity of the
business side to outpace the rules."