If you are in the market for new technology, one of the things you absolutely must do as part of due diligence is make an assessment of a company's financial condition.
Right now there are hundreds if not thousands of start ups vying for attention. Many will not succeed. Unlike the past where an ailing company would likely get picked up by another investor, it is far from clear whether this will happen in the current climate. This is especially worrisome in a technology shift like cloud where gaining access to your data when a vendor is distressed may be vital for the continuance of your business.
That's why I gasped when I read reports of Groupon's explanation of how it is currently recognizing revenue and costs:
Apart from the revenue forecast, investors were concerned about the way Groupon records the revenue it gets from its merchandise sales, known as Groupon Goods. Groupon records not just its share of the payments from buyers but the total amount paid.
In the conference call, Jason Child, Groupon’s chief financial officer, said that if the company booked only its share of sales, it would give too much information to competitors about its business costs. If just Groupon’s share was counted, he said, revenue growth in the second quarter would have been 30 percent, not 45 percent.
“If you strip out the Goods business, they were down 7 percent from the last quarter,” said Ken Sena, an analyst with Evercore Equities. “It shows there is a softness in the deals side,” which should be the more profitable part of Groupon’s business, he said.
My emphasis added. In other words, let's invent some fresh ways to mask our true underlying performance. Fortunately for you and I, wily analysts are not that easily fooled. Most of the time.
It is why I wrote awhere, according to some, Lars Dalgaard, CEO SuccessFactors is a 'revenue recognition artist,' whatever that means.
It is why an understanding of the process and accounting systems failures blamed for Manganese Bronzein their accounts matter.
The problem stems from the way US GAAP on revenue recognition has been framed. Put simply, US GAAP provides very little wiggle room for applying judgment to the way accounts are presented and therefore the manner in which numbers are allocated in the accounts. This is largely an outcome of the litigous climate in the US. That often means companies have to provide much more detail about the business and its model than would be the case in say the UK or other English speaking countries where judgment has been routinely applied over a 100 plus years.
However, the newer models that are being created by cloud businesses in particular are giving rise to problems because there is room to apply judgment to revenue recognition. Given this is a key indicator for everyone, its manner of computation matters a great deal.
Provided the computational method is methodical, logical, consistent, provides additional insight and is capable of independent audit including controls over any judgments or estimates made, then all is (usually) well. However, mixing rules based systems with those that allow judgment is a bit like mixing oil and water. It doesn't work so well, as Groupon found out when it got involved in a much more serious revenue recognition tangle.
Similarly, where things genuinely go wrong due to systems failure, then understanding why provides insight into management quality. Great software is never enough. the vendor has to be seen to be running a professional ship. Remember when Google hired Eric Schmidt to provide 'adult supervision' during the hype growth years?
If in doubt, take the advice of someone experienced at looking at these kinds of number and how to interpret them. It could save a lot of heartache further down the track.