April 2001

The E-Business Downturn and CPAs

From early January 1994 to mid-March 2000, the Nasdaq experienced extraordinary growth, rising in value from 771 to its historic high of 5,133, a 565 percent increase. During the same period, the Dow Jones Industrial Average grew from 3,756 to 9,929, a more modest increase of 164 percent. The Nasdaq had declined to 2,661 by February 2, 2001, a loss of more than 48 percent off the peak.

During the period of the Nasdaq decline, the Dow grew to 10,685, or 9 percent (see the Exhibit). The value of the decline in the Nasdaq is used as a proxy for the e-business downturn because the Nasdaq’s growth—and subsequent decline—was largely driven by hi-tech stocks, particularly in e-business companies.

CPAs must understand the accounting and auditing implications of the dramatic decline in the Nasdaq, the moderate growth of the Dow, and the downturn for e-business.

Accounting Implications

CPAs in industry who are responsible for financial accounting should recognize that the downturn will create pressure to improve the bottom line. One way to do this is to create non-generally accepted accounting principles (non-GAAP) performance measures such as “pro forma” earnings, just as Amazon.com has. This measure excludes many expenses and charges required by GAAP.

Pro forma earnings overstates earnings and hides real net losses from naive investors. Historically, overstated earnings results in real losses for investors.

Other difficult accounting issues that CPAs in industry will have to face include revenue recognition, gross vs. net revenues, impairment of e-business investment asset values, compensation expense for re-priced stock options, and going concern disclosures.

Auditing Implications

The e-business downturn forces auditors of e-businesses to face two difficult issues—the pressure for financial reporting fraud and the ability of e-businesses to continue as going concerns. When management compensation is tied to stock market performance (as is the case for most e-businesses) and stock prices have plummeted, managers have a powerful incentive to overstate revenue, understate expenses, and omit charges and losses.

Many remaining e-businesses do not have enough cash to fund losses for the next 12 months. Unless an e-business has a history of adequate positive GAAP earnings or positive cash flow, it probably will not receive future funding. Auditors should qualify their opinion for going concern of e-businesses that cannot meet projected cash requirements within 12 months of the balance sheet date and do not have written contracts for future funding.

The Nasdaq and e-business downturn was confirmed on April 14, 2000, by a steep slide in the market. Not coincidentally, an article appeared on the Wall Street Journal editorial page that morning. The writer of the article, Princeton economist Burton G. Malkiel, author of A Random Walk Down Wall Street, brought out into the open what investors either chose to ignore or had forgotten.

“Eventually every stock can only be worth the value of the cash flow it is able to earn for the benefit of investors,” Malkiel wrote.

Few e-businesses have positive cash flows—or any realistic chance of it. There is no mystery as to why the Nasdaq and almost all e-business companies suffered a collapse in value while the Dow and the blue chips maintained a steady course. In the words of Malkiel: “In the final analysis true value will win out.”

CPAs take note. When managers want pro forma earnings practitioners should just say “no.” Managers should be given GAAP earnings per share (EPS), which has proven value. Fifty years of stock market data show that GAAP EPS has more predictive power for stock prices than any other measure. And when auditors issue opinions, they should give users value.

If there are substantial doubts about a client’s ability to continue as a going concern, then opinions should be qualified. If an e-business client has neither enough cash to make it for 12 months nor any prospect of getting new funding, then statements should be qualified for going concern.