Accounting Mischief In New Economy

Updated: Apr 16 2002, 05:30am hrs
Forget the number crunching scams of old economy companies like Enron. Ever wonder about the kind of accounting mischief the new economy is capable of spawning In fact, from the accountants point of view, its almost a blessing that the dotcom boom went cold when it did. Indeed, the blind quest for valuations was a ticking time-bomb in the books of new economy start-ups. The slowdown, and the consequent cooling-off period offers a much needed respite during which the accounting world can catch up with the Net world, and reconcile the need for new accounting practices and rules with improvements in practice.

One very apt example of the kind of mess accounting in a dotcom: Value America. The dotcom quickly became a poster brand for the new economy when it first surfaced in 1996. Within three years, it was a $ 3 billion company, internets second largest e-tailer and went public in April 1999. Seven months later, it was floundering, and two of its promoters, Craig Winn and Rex Scatena, had left the company. On August 11, 2000, the company filed for bankruptcy under Chapter 11. Entrepreneur-promoter Craig Winn bounced back into the news this month with his book In The Company of Good and Evil co-authored with Ken Power, another co-founder which essentially details Winns take on the true story of seduction and betrayal that brought down his pure Net play. If you read between the lines, however, the book clearly reflects how the dotcom boom was head-on in collision with accounting practices.

Winn believes that one of the reasons why Value America failed was because Wall Street failed to see e-tailing as the same as retailing. That analysts and investors refused to acknowledge that the power behind each retail revolution think Wal-Mart or Dell was the result of a paradigm shift in the distribution practices. Value America thought it could bring about such a tectonic shift by its business model. The investment community understood that it took a retail chain at least five years to build a scale necessary to turn a profit...yet most emerging retailers found the capital markets receptivequite willing to give them the vast sums of money they needed to build their systems, advertise, and achieve scale, many years before they became profitable...Sadly, however, no dotcom analyst would ever grasp the correlation between the established mode of evaluating retailers and the new retail world of dotcom.

When making a presentation to Goldman Sachs, Winn apparently said in his passionate, entrepreneurial style: You all view Amazon as an internet company that just happens to sell stuff...but this business of e-tailing will make a lot more sense if you look at us as retailers who just happen to conduct our business online. Why was this so important for Winn Its because Value Americas model was to replace the inventory of old economy retailers by systems, and their distribution centers by technology. It wanted to be an electronic conveyor belt between brands and consumers, linking supply directly to demand.

That raised the first accounting problem: inventory. In the Value America model, brands would showcase their products on the website, customers would place orders directly with the brand through the website, and so, at no time would Value America own any inventory. Diminishing the cost of inventory by maximising turn was what separated successful retailers from dead ones... our plan was to make inventory exposure virtually non-existent. You could call it hot-potato inventory. The customer bought the item, the factory shipped it, and the customer received it; we never actually touched it, say Power and Winn.

The second accounting hitch lay in revenue recognition. According to the founders: We, like every retailer, counted our revenue as the full price our customer paid us for a product. Under accrual-based accounting under Generally Accepted Accounting Practices, that raised a red flag. Coopers & Lybrand, which was representing a union that was planning to invest in Value America, raised a valid objection: if Value America was operating on a virtual inventory model, its revenues were not the price of the products sold through the website, but rather the margins it made on the products.

Winn and the other founders, however, were livid at that, and saw the objection being raised merely to drive down the dotcoms valuation. In response to the accountants query, they defended their position by dredging a risk of loss clause in Gaap: We incurred risk of loss while the product was in transit, from the time it left the manufacturers warehouse until the customer accepted it. Technically, we owned the product when it was en route. Right. So it wasnt quite the inventory-less model Winn was promoting to investors, was it

The real issue was that the founders were so excited by the key success factor of their inventory-less model, and so high on the valuations their early successes drew that there was little regard and positive antipathy to any voice of concern from accountants. Perhaps Craig Winn is right, e-tailing operations will need a rewriting of Gaap to accommodate the new paradigm but that did not mean that the solution was to shove accounting issues under a carpet. Much before an accounting scandal could bubble out of its books, Value America died because it ran out of cash. But for dotcoms who have survived, the decelerated pace offers a chance to revisit the basics. Set your house and also your books in order.