Monday, November 28, 2011

Did j2 Global Communications Fumble in Accounting?

Last week, I suggested that j2 Global Communications Inc. (NASDAQ:JCOM) could have misinterpreted certain accounting rules and that it should consider restating its financial reports issued in 2010. My analysis was based on a report issued by independent research firm Gradient Analytics and an examination of accounting rules and company disclosures. This blog post will examine how j2 Global has attempted to downplay certain problems in its financial reporting and provide even more compelling reasons for the company to consider restating its financial reports.

Background

Up to 2010, j2 Global apparently estimated the remaining life under its annual contracts with eFax customers to compute its deferred revenues, revenues, and earnings. In the first quarter 2011 10-Q report j2 Global disclosed that it upgraded its accounting systems and started using the actual useful life under its annual contracts with eFax customers to compute those numbers:

In the first quarter of 2011, the Company made a change in estimate regarding the remaining service obligations to its annual eFax subscribers. As a result of system upgrades, the Company is now basing the estimate on the actual remaining service obligations to these customers. As a result of this change, the Company recorded a one-time, non-cash increase to deferred revenue of $10.3 million with an equal offset to revenues. This change in estimate reduced net income by approximately $7.6 million, net of tax, and reduced basic and diluted earnings per share for the three months ended 03/31/11 by $0.17 and $0.16, respectively. [Bold/underline added for emphasis.]

The determination of the actual remaining life of an annual service contract involves a simple computation. For example, assume a company has a December 31 year-end. On November 1, a customer purchases an annual contract with an advance payment of $120. The company earns $10 per month under the annual contract ($120 divided by 12). At year-end, the company reports $20 of revenue to reflect income earned during November and December. In addition, it reports a deferred revenue liability of $100 to reflect the unearned income for the remaining 10 months under the contract. It’s not rocket science. Apparently, j2 Global’s accounting systems could not make such a computation, so the company estimated the number. It turns out that its estimates were significantly incorrect.

In the first quarter of 2011 j2 Global upgraded its accounting systems and was now able to calculate the actual remaining life under its annual service contracts with eFax customers. In that quarter, the company recorded a one-time cumulative adjustment to increase deferred revenues by $10.3 million, decrease in revenues by $10.3 million, and decrease net income by $7.6 million to accurately reflect its actual remaining service obligations under annual contracts with eFax customers.

Cumulative one-time adjustments in current periods relate to numbers reported in prior periods. Therefore, the company apparently understated its deferred revenue liability and overstated both revenue and net income reported in 2010 because it was unable to accurately measure the remaining life of annual service contracts with eFax customers. j2 Global claimed that those adjustments stemmed from a “change in estimate” under accounting rules. Therefore, it could use a one-time cumulative adjustment in the current quarter to correct unearned and earned income reported in previous periods.

Last week, independent research firm Gradient Analytics issued a report that questioned whether j2 Global appropriately treated those adjustments as a change in estimate. Based on its examination of the j2 Global’s financial disclosures, applicable accounting rules, and limited feedback from the company, Gradient reported that “…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results.” If those adjustments were considered an accounting error rather than a change in estimate, a restatement of j2 Global’s 2010 financial reports may be warranted if such errors are considered material under accounting rules.

Earlier company disclosures

For years, j2 Global warned investors about potential "failures or errors" in its billing systems. For example, in the 2010 10-K report issued just months before it made those one-time adjustments, the company disclosed:

We are in the process of upgrading our current billing systems to meet the needs of our growing subscriber base. Any failures or errors in our billing systems or procedures or resulting from any upgrades to our billing systems or procedures could impair our ability to properly bill our current customers or attract and service new customers, and thereby could materially and adversely affect our business and financial results. [Emphasis added.]

If there were no “failures or errors” in j2 Global’s billing systems, logically there would have been no one-time adjustments in the first quarter of 2011 to correct an understatement of deferred revenue liabilities and overstatement of revenues and net income reported in 2010. However, when the accounting adjustments came as warned, the company did not admit to any foul ups. In its first quarter 2011 10-Q report, it tried to put a good face on the issue. The company said it upgraded its systems and started using actual numbers for the remaining life of annual contracts to eFax customers. It's like an army general who doesn't want to admit retreat and brags about advancing to the rear.

SingerLewak LLP signed off on j2 Global's 2010 audit and internal controls on February 25, 2011, 56 days into the first quarter of 2011 (See 10-K report page 62). The close timing of the sign off by the auditors and the subsequent report of one-time adjustments raises concerns about the quality of their audit work and internal control environment at j2 Global.

Gradient raised similar concerns in its report:

Our research identified a number of troubling issues that point to a potentially weak audit-and-control environment. For example, the company’s disclosure of a $10.3 million one-time-target to revenue and offsetting increase in deferred revenue appears unusual in our view, and may be indicative of an error in in JCOM’s revenue reporting. In addition, we are concerned by management’s decision to omit disclosures relating to acquired revenues since 2010. We have further concern regarding PCAOB reports on the work of JCOM’s external auditor SingerLewak (hired in 2007) and a 2006-2007 internal investigation into incorrect stock-option-grant dates between 1999 and 2005.

A recent Public Company Accounting Oversight Board (PCAOB) inspection report issued on April 29, 2011, cited SingerLewak for various audit deficiencies, including "the failure to perform sufficient procedures related to the testing of revenue." The PCAOB report did not identify the company involved in that audit.

j2 Global attempts to play down significance of one-time adjustments

On May 5, 2011, CFO Kathy Griggs sought to downplay the significance of its one-time adjustments during the first quarter 2011 earnings call with investors and analysts:

The difference relates to a change in estimate implemented in Q1 2011 regarding our remaining service obligations to annual eFax subscribers. As a result of systems upgrades we are now basing the estimates on the actual remaining service obligations to these customers. As a result of this change we recorded a one-time noncash increase to our balance of deferred revenues of $10.3 million with an equal offset to revenues. This change is insignificant considering that our prior estimation techniques have been in place for over thirteen years, a period of which we reported over $1.6 billion in revenues cumulatively. [Emphasis added.]

The so-called first quarter 2011 “change in estimate” related to annual eFax subscribers. Logically, those one-time adjustments can only relate to revenues reported in 2010, not the entire thirteen year period. The adjustments increased deferred revenue liabilities by $10.3 million, decreased revenues by $10.3 million, and decreased net income by $7.6 million. Griggs used thirteen years of cumulative revenues amounting to $1.6 billion to make an inappropriate comparison to the $10.3 million revenue adjustment. She should have compared the $10.3 million revenue adjustment to $255.4 million of revenues reported in 2010.

Kathy Griggs tried to explain the significance of its one-time adjustments purely in terms as a percentage of cumulative revenues. That was wrong, too. Relatively insignificant misstatements in reporting revenues can have a significant effect on reported growth trends in revenues and earnings. Furthermore, relatively small revenue misstatements can hide a company’s failure to meet or beat analyst’s consensus earnings forecasts. Whether you call it a change in estimate or an accounting error, relatively small misstatements of revenues can have a significant impact on a company’s reported financial performance.

Was it a change in estimate or an accounting error?

Last week, Gradient Analytics examined j2 Global's first quarter 2011 10-Q report and questioned whether j2 Global had appropriately treated those adjustments as a change in estimate:

…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results. The distinction between a change in estimate and a correction of an error is important in that it may have implications for an evaluation of the effectiveness of internal controls.
Under U.S. GAAP, a change in accounting estimate occurs when new information or additional experience causes a company to change its estimate of an amount that is subject to uncertainty, such as future warranty obligations or the useful life of an asset. In contrast, errors result from mathematical mistakes in applying accounting principles or oversight, or misuse of facts that existed when preparing financial statements. In the case of JCOM, if the remaining service obligation for eFax customers can be determined with certainty, as is implied by the disclosure in the firm’s 10-Q it would appear to us to be a result of oversight of facts existing at the time of financial statement preparation. That is, the disclosure appears to indicate that the company’s internal control systems were not able to determine the remaining service obligation, despite the fact that the remaining service obligation was important both to revenue recognition and to customers who depend on accurate billing on their accounts and accurate tracking of remaining services they are owed. Furthermore, if the firm’s legacy system could not properly identify or track the underlying facts and figures required to properly value deferred revenue, as implied by the disclosure in the Q1 2011 10Q, it would appear to indicate a deficiency in internal control before Q1 2011.
In order to gain more clarity on this issue, we contacted the company on several occasions before publication. The first response we received was from investor relations (IR) representative Laura Hinson, who stated that the “systems upgrade permitted an accurate measurement of the remaining useful life of an annual customer and therefore permitted a more accurate measurement of the remaining useful life of an annual customer and therefore a more accurate picture of the amount of deferred revenue.” We followed up with a question asking why the company determined that the situation should be treated as a change in estimate, rather than the correction of an error. However, the company declined to answer our follow-up question. [Emphasis added.]

I'll try to explain the situation involving j2 Global's accounting issues in simple terms. A person could not count the fingers on his right hand without a calculator. He looked at his right hand and estimated that he had four fingers. After that person bought a calculator, he realized that there are actually five fingers on this right hand instead of four.

Is the one finger adjustment a change in estimate or an error under accounting rules? In such a case, the actual amount of fingers already existed, was not subject to uncertainty, and did not come about because of new information. Therefore, the adjustment should not be a change in estimate under accounting rules. The person made a mathematical error. The miscounting of fingers arose from an oversight or misuse of facts at the time they were counted. If he couldn't count his fingers, he should have used a calculator to count them. Therefore, the adjustment should be considered an accounting error. The same logic appears to apply to adjustments made by j2 Global to deferred revenues, revenues, and net income.

Gradient's concerns seem well-founded. If we are to accept j2 Global's rationale that its adjustments were a change in estimate, any public company that does not have adequate internal controls in place to report correct numbers can avoid reporting an accounting error when it turns out that previously reported numbers were incorrect.

j2 Global treated its adjustments of overstatements of deferred liabilities and understatement of revenue and earnings as a “change in estimate” under accounting rules. That allowed it to make a one-time cumulative adjustment in the current quarter to correct unearned and earned income reported in previous periods. If j2 Global had considered those adjustments as stemming from a material accounting error it would have been required to restate its previously affected financial reports rather than make a one-time adjustment.

Furthermore, it's troubling that j2 Global apparently stopped responding to Gradient as it made further inquiries about the change in estimate. Why clam up? The company did find time to comment about other aspects of Gradient's report to CNBC Senior Stock Commentator Herb Greenberg (Video link to "Herb Alert" on CNBC).

Materiality

If we assume that j2 Global’s adjustments to deferred revenue, revenue, and net income stemmed from an accounting error instead of a change in estimate, the next step is to determine if the misstatement was material in affected previous reporting reports. According to Securities and Exchange Commission Staff Accounting Bulletin No. 99 (SAB No. 99) some of the measures used to determine if accounting error is material are: “whether the misstatement masks a change in earnings or other trends” and “whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.” If a misstatement causes a company to report an increase in revenues rather than properly report a decrease in revenues or if a misstatement hides a failure to match or beat analyst’s estimates, it is considered material and previously issued financial reports must be restated.

In the third quarter of 2010, j2 Global’s revenues increased by a mere $977,000 to $62.778 million compared to $61.801 million in the previous year’s third quarter. Its earnings per share matched the previous year’s comparable numbers – no growth. RTT News reported that j2 Global beat earnings beat analyst’s estimates by just $0.01 per share in both the third quarter and second quarter of 2010.

The understatement of deferred revenues and overstatement of revenues and earnings by j2 Global could have caused the company to report higher revenues and earnings per share in the third quarter of 2010 instead of lower revenues and earnings when compared to 2009's third quarter. In addition, they could have caused the company to beat analyst's estimates for third quarter and possibly the second quarter of 2010, too. Therefore, based on the size of the one-time adjustments it is possible there was a material misstatement of j2 Global’s financial performance in 2010.

Other items

In its recent 8-K report for the third quarter of 2011, j2 Global presented a full non-GAAP income statement and reconciled it side-by-side with its GAAP numbers. According to S.E.C. Regulation G Compliance and Disclosure Interpretations, the company cannot present a full non-GAAP income statement. See below:

Question 102.10
Question: Is it appropriate to present a full non-GAAP income statement for purposes of reconciling non-GAAP measures to the most directly comparable GAAP measures?
Answer: Generally, no. Presenting a full non-GAAP income statement may attach undue prominence to the non-GAAP information. [Jan. 11, 2010].

The company should change its future non-GAAP presentations to comply with S.E.C rules.

Closing comments

Whether or not there was a change in estimate or an accounting error, j2 Global needs to be more transparent with investors about its financial reporting issues. Mistakes happen. Best to be forthright about them early and move on, than to downplay them and create further investor uncertainty.

Written by,

Sam E. Antar

Update:

November 29, 2011: Fraud Files - j2 Global Communications Trying to Hide Accounting Errors by Tracy Coenen

March 8, 2012: Grumpy Old Accountants - JCOM: When Will The SEC Call and Error An Error by Ed Ketz and Anthony Catanach

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood, for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time. My past sins are unforgivable.

I do not own any securities in j2 Global Communications, long or short. I am an eFax subscriber. In the past, I have permitted Sabrient Systems LLC, which owns Gradient Analytics, to republish certain of my blog posts as a professional courtesy. I have never received any compensation from either Sabrient or Gradient and have no financial relationship with either firm.

No comments:

Advertisement - Forbes Network

Advertisement - Google AdSense

Advertisement - Google AdSense