Did the Auditors Cross the Line at MicroStrategy?
The SEC has tough questions for the company and PWC

On a recent August morning, Michael J. Saylor, CEO of MicroStrategy Inc. ( MSTR), stood before an overflow crowd at a high-tech trade show in the bowels of the convention center in Washington. He spun his vision of the future, in which personalized news and alerts are delivered through wireless devices and clip-on computers equipped with voice recognition. The crowd was riveted.

The electrifying moment allowed Saylor to look past the software maker's calamitous earnings restatement of last spring. The company had booked $66 million more in revenue than it should have from 1997 through 1999--more than one-fifth its sales total. The restatement wiped out $55.8 million in earnings, turning profits into losses for each of those years.

But as diverting as the interlude may have been, recovery will not come that easily for Saylor and MicroStrategy. As he attempts to rebuild the company he founded 11 years ago, one of his chief hurdles is a Securities & Exchange Commission investigation into the company's accounting practices. BUSINESS WEEK has learned that the SEC is investigating whether MicroStrategy and its auditor, PricewaterhouseCoopers LLP, covered up a prohibited financial relationship by using a third party as a go-between. The agency also is probing whether PWC sacrificed its independence by entering into deals to buy MicroStrategy products for resale to consulting clients--a financial link the SEC thinks may have made PWC unwilling to make tough audit decisions. And the SEC is investigating whether MicroStrategy backdated documents to move revenues from one quarter to another.

FAST-TRACK PROBE. The swift fall of MicroStrategy exemplifies the questions that arise when auditors do more for a client than just examine the books. Shareholders lost $10.4 billion in stock value, and 10% of the company's employees have been laid off. The scope of investor losses, and the web of relationships between auditor and client, have persuaded the SEC to put its investigation on a fast track.

While MicroStrategy admits that it overstated revenues, it denies doing so deliberately. MicroStrategy and PWC representatives deny they used a third party to disguise their relationship or that any documents were backdated. And both companies deny that PWC's reseller role or any other factor compromised the auditor's independence. MicroStrategy insists the SEC eventually will agree with its view that the accounting debacle stems from the failure of the company's accounting system to keep up as MicroStrategy's product mix became more complex.

In the first detailed discussion of the sequence of events, MicroStrategy lawyer Ralph C. Ferrara of New York-based law firm Debevoise & Plimpton says the company largely sold off-the-shelf software in its early days. Accounting rules allow companies to recognize the revenue from such sales at the time of the sale. But soon the company began adding services and customization to the mix--''elements,'' as they're known in accounting lexicon. There, accounting rules dictate that revenue must be spread over the life of a job--as products and services are delivered or as project milestones are met--rather than all at once.

In simple terms, that's what the company failed to do and what its auditors failed to flag, MicroStrategy says. ''There was a realization the accounting model hadn't kept up with the business model,'' says Ferrara. But the SEC's case goes beyond technical questions of when to ring up software revenue. To investigators, MicroStrategy and its auditors had relationships that suggest the auditors had a financial stake in MicroStrategy's success. And that's a line an auditor isn't supposed to cross.

The company's problems date back to March, 1997, when MicroStrategy signed a three-year contract with Price Waterhouse, one of two PWC predecessors. The firm at the time did not audit MicroStrategy but was a ''value-added reseller,'' meaning the accounting firm acquired MicroStrategy software, then resold it to consulting clients. Price Waterhouse bought at least $500,000 worth of MicroStrategy products and services.

POSTMERGER DEALINGS. In 1998, Price Waterhouse merged with Coopers & Lybrand, MicroStrategy's auditor, to form PricewaterhouseCoopers. Seven months after the merger, the newly formed PWC ended the reseller agreement with MicroStrategy. A PWC spokesman says the firm did so ''in order to better assess independence issues.'' But the relationship continued on what both companies call a ''project-by-project'' basis.

Now the SEC is probing not only the basic relationship but also whether the postmerger dealings continued through an unnamed third party in an effort to mask them. Indeed, some purchases of MicroStrategy software by PWC were made through a vendor and not directly from MicroStrategy. ''It raises questions whether it was done to cover the tracks of what they knew was inappropriate,'' says one person familiar with the investigation.

In all, PWC consulting clients selected MicroStrategy products in eight projects over about 18 months, netting the firm $187,892, says PWC. A typical arrangement: PWC would purchase a license for its client, and in return the client paid PWC for the MicroStrategy software. ''These transactions were few in number, small in dollar amount, and within the firm's independence guidelines,'' a company spokesman says.

But the connections between MicroStrategy and its auditor ''show that the firm has become too allied in interest to the company they are supposed to be auditing with a neutral eye,'' says the person familiar with the SEC investigation. And the agency is likely to discount the idea that only small sums of money were involved, says one knowledgeable source, noting there are no degrees of independence.

BODY BLOW. Another key issue in the case: Did PWC's on-the-ground auditors consult with their own in-house experts? PWC declined comment. MicroStrategy's Ferrara says that the local audit partner did indeed consult with others in the firm ''as he thought appropriate. Both the company and the engagement partner felt they had gotten it right.''

But clearly they didn't get it right. The case may also expose a fault in the accounting profession's contention that consulting work improves the audit by helping the auditor better understand a client's business. In this case, PWC consultants certainly had access to MicroStrategy's software products. After all, they were selling them to PWC's own clients. But that inside knowledge didn't prevent the audit oversights.

What's indisputable is that MicroStrategy's restatement dealt the company a body blow--extending far beyond the simple matter of recalculating numbers. ''What's happened over the past six months is we had to basically strip the business down to zero and build it back up again, and check all of our premises,'' Saylor says.

On the way up, Saylor won recognition as the archetype of the New Economy executive, exuding a brilliance that dazzled with brashness and an aloofness that often repelled. Today he pronounces himself chastened and humbled. He has even given up some authority. On Sept. 4, Saylor appointed John Sidgmore, vice-chairman of WorldCom Inc., to head MicroStrategy's wireless services unit,

Nevertheless, Saylor insists that he has dug in for the long haul and that he'll stay hands-on. ''I have a lot of work to do during the next decade,'' Saylor says, ''to make sure that all the constituencies that depend on us find their trust returned.'' The SEC hopes that at the top of the list are the shareholders who rely on the impartiality of MicroStrategy's audits.

By Christopher H. Schmitt and Paula Dwyer in Washington

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