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Should j2 Global Communications Restate its 2010 Financial Reports?

j2 Global Communications Inc. (NASDAQ:JCOM) may have misinterpreted certain accounting rules and needs to consider restating its financial reports issued in 2010 based on certain new information it obtained from a “systems upgrade” in early 2011 that “permitted an accurate measurement of the remaining useful life” in its annual contacts with eFax customers.

Background

If a customer pays an annual fee in advance, a company reports a deferred revenue liability (unearned fees) because the fee is not yet earned. As time progresses on the annual contract, the company reduces its deferred revenue liability and increases its revenues as those fees are earned. Up to 2010, j2 Global apparently estimated the actual remaining life under those contracts to compute its deferred revenues, revenues, and earnings.

In the first quarter of 2011, j2 Global upgraded its accounting systems and started using the actual useful life under its annual contracts with eFax customers to compute deferred revenues, revenues, and net income. 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 a decrease in net income of $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 change unearned and earned income reported in previous periods.

Gradient Analytics questions accounting treatment

Yesterday, 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 are appropriately 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.

Was there a change in estimate or an accounting error?

Gradient Analytics suggests that j2 Global should have considered adjustments affecting deferred revenues, revenues, and net income as stemming from an accounting error, rather than a change of estimate:

One of the most significant quality-of-earnings-specific concerns noted during our analysis of JCOM was the unusual nature of the $10.3 million one-time charge to revenue and offsetting increase in deferred revenue (previously discussed). The disclosure in question is copied below in its entirety (Q1 2011 10Q):
"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]"
Based on this disclosure, it appears that JCOM is asserting that it was unable to determine the actual remaining service obligation to its customers before Q1 2011. However, because of an upgrade to its internal accounting systems, the company is now able to determine the actual amount of remaining customer obligations. Furthermore, the above disclosure implies that deferred revenue was previously understated by approximately $10.3 million. It follows that recognized revenue was overstated by the same amount over some number of periods before Q1 2011.
While there is little question that prior-period revenues were overstated by approximately $10.3 million, it is not entirely clear why this occurred. That is, while management has elected to treat this new information as a change in accounting 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.

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. Further analysis is provided below.

Materiality

If an accounting error is material, a company is required to restate its financial reports to correct the error. According to Securities and Exchange Commission Staff Accounting Bulletin No. 99 (SAB No. 99) one of the measures used to determine if accounting error is material is “whether the misstatement masks a change in earnings or other trends.” For example, if a misstatement causes a company to report an increase in revenues rather than properly report a decrease in revenues, it’s considered material. Another measure used to determine materiality under SAB No. 99 is “whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.” In other words, if a misstatement causes a company to match or beat analyst’s estimates, it is considered material.

As I detailed above, j2 Global first quarter 2011 adjustments reduced revenues by $10.3 million and reduced basic and diluted earnings per by $0.17 and $0.16, respectively. Those adjustments appear to affect 2010’s reported numbers.

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. In addition, its third quarter 2010 earnings per share matched the previous year's comparable numbers. RTT News reported that j2 Global beat earnings beat analyst’s estimates by just $0.01 per share in the third quarter of 2010 :

Excluding share-based compensation expense, non-GAAP earnings was $21.75 million or $0.47 per share compared to $21.36 million or $0.47 per share last year. On average, nine analysts polled by Thomson Reuters expected the company to earn $0.46 per share in the quarter. Analysts' estimates typically excludes special items. [Emphasis added.]

Therefore, if j2 Global's adjustments to revenue and net income are considered accounting errors, they could have caused the company to report higher revenues and earnings per share in the third quarter of 2010 compared to the previous year's third quarter. In addition, they could have caused the company to beat analyst's estimates for third  quarter and possibly the second quarter, too.

RTT News reported that j2 Global’s second quarter 2010 earnings beat analyst’s estimates by just $0.01 per share:

Net earnings per diluted share on a Non-GAAP basis, which excludes share-based compensation and related payroll taxes and certain acquisition costs, was $0.46….
On average, 9 analysts polled by Thomson Reuters expected the company to report profit of $0.45 per share for the quarter. Analysts' estimates typically exclude special items. [Emphasis added.]

Assuming that j2 Global’s adjustments to revenues and net income are considered accounting errors, the relative size of those adjustments compared to the company’s second and third quarter financial results suggest that such misstatements could be material and a restatement of financial reports is warranted.

Written by,

Sam E. Antar

Update

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.

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