Taking Sides: How fishy audits fostered a fiasco

The company’s stock crashed and burned months ago, but secondary explosions at MicroStrategy Inc. continue to rattle windows at the suburban Washington software company.

MicroStrategy and its founder and CEO, Michael Saylor, were darlings of Wall Street during the height of the tech-stock boom in the late 1990s. But the stock crashed after Mr. Saylor was forced to acknowledge accounting irregularities and restate company earnings for three years.

Skyrocketing profits reported by the company in 1997, 1998 and 1999 turned into substantial losses, and the stock went into a death dive. From its Nasdaq Composite Index peak of $333 in March 2000, the stock is now trading at about $5 a share.

a case study

Needless to say, investors got clobbered, even if Mr. Saylor didn’t. But more on that later.

Since the tech-stock crash, the story has gone beyond a tale of overreaching by one greedy executive to become a bitter case study of all that is wrong with corporate financial accounting.

The latest development occurred earlier this month, when PricewaterhouseCoopers, one of the nation’s Big Five accounting firms and Micro-Strategy’s outside auditor, agreed to fork over $55 million to settle a class action.

The suit, filed by MicroStrategy shareholders, accused the accounting firm of defrauding investors by signing off on the company’s grossly inflated financial reports.

Of course, spin control efforts kicked into overdrive after the settlement. PricewaterhouseCoopers executives denied all the accusations, claiming they settled the case merely to avoid “the uncertainty” of protracted litigation.

But details contained in court papers paint a far more disconcerting picture. According to published reports, the relationship between MicroStrategy and its outside auditor was fraught with conflicts of interest.

In one instance, plaintiffs unearthed e-mail messages in which a senior accountant who managed the company’s accounting team had lobbied MicroStrategy for a high-ranking job. The accounting firm also received payments for recommending and selling MicroStrategy software to its other clients.

At the same time that it was reviewing MicroStrategy’s books, PricewaterhouseCoopers was also engaged in discussions to develop a joint venture with the software maker, although that deal never happened.

Joseph Carcello, a financial-reporting-fraud expert at the University of Tennessee, says that corporate financial fraud almost always involves a company’s chief executive or chief financial officer – and usually both.

Mr. Carcello, the subject of a One on One interview this week with InvestmentNews reporter Sarah O’Brien, adds that it is very difficult for investors to spot financial fraud. But there are some warning signs that can at least raise red flags about a company’s financial health, he notes.

Cash flow and capital structure can be clues, he says. Carrying too much debt on the books, could signal liquidity problems.

A sudden spate of resignations among senior executives or board members could also point to trouble. The executives may be bailing out to avoid being pressured into making inappropriate decisions, especially if the reasons for their departure are vague or unconvincing.

Examining a company’s governing structure could also raise red flags. Mr. Carcello says that companies with no audit committees, or committees dominated by insiders, should be troubling to investors. In some cases, companies have oversight committees, but upon closer examination, investors may discover that they rarely, if ever, meet.

Once again, MicroStrategy is a case in point. Decision making in the company was concentrated in the hands of Mr. Saylor, co-founder and chief operating officer Sanjeev Bansal and former chief financial officer Mark Lynch. As it turned out, the trio worked in concert to cook the books.

The Securities and Exchange Commission is currently investigating PricewaterhouseCooper’s role in MicroStrategy’s financial fiasco, but don’t expect it to mete out swift or severe punishment.

In December, the SEC settled civil fraud charges against Mr. Saylor and his cronies in a deal that amounted to a slap on the wrist. Mr. Saylor continues to head the firm.