In the last century, one could walk into a building and see plant and equipment. That’s not possible in today’s knowledge/service-based economy. Assets are “soft,” even invisible. The result is that we are forced to trust the validity of published numbers. However, given the deceptions that occurred with Enron and WorldCom, we know it is risky. It’s often revealed in bear markets. Computer Sciences was the first software fraud to be charged with a false statement of profits (2.8B) in 2006. The next major fraud will once again be in software. But this time it could impact the entire technology sector.

Today almost all technology companies use the word “adjusted” or the phrase “non-GAAP” in reporting financials. Retrospectively, fraud often happens to what previously had been a highly respected company. This occurred in 1973 with Stanley Goldblum and Equity Funding. It was among the 10 largest life insurance companies and the fastest growing. All institutional accounts in Boston, except Mass. Investors Trust, owned the stock. The M.I.T.’s portfolio manager’s response as to why he didn’t own the stock was, “I met him.” That’s a very different experience than today’s Zoom call.

GAAP, as you may know, is the acronym for generally accepted accounting principles. The first time I encountered the non-GAAP “concept” was over 30 years ago. At the time, I was working for a small investment banking firm which had made its reputation by bringing Microsoft public in 1976. Early one morning – 7:30 AM – I heard an analyst use the words “non-GAAP” in relation to a company’s reported earnings. Puzzled I asked, “What’s that?” The analyst then explained how non-reoccurring charges were eliminated to give investors a better understanding of the underlying business.  

The analyst was the firm’s technology analyst. At the time I naively thought, “Well, I guess, that makes sense.” Later it occurred to me it would be as though I had said to myself, I would have more money if I didn’t have to pay the nonrecurring expense for my four children’s freshman year in college. But then, of course, there’s sophomore year. To my frustration, I realized that there are always non-“reoccurring” expenses in life. Thirty plus years later, I still feel the same way. What amazes me about the technology sector is that it seemingly has more “children” going to college than any other sector.

The original concept of non-GAAP was well intended. Twice I have struggled through accounting classes in my attempt to understand what, I believe, is an arcane artistic methodology. But it is undeniably a process that has been abused over the past 30 plus years.  Most recently by a wannabe technology company called WeWork. At its apex it had a private market valuation of $47 billion. But its fame came from its egregious non-GAAP accounting. Example: “Community Adjusted EBITDA.” What is that? It’s the virtual elimination of expenses. Currently WeWork is a SPAC now worth “just” $6 billion.

So how do you protect yourself in a world that uses Zoom from future Stanley Goldblums? Without physical contact with executives, it is imperative to have a strong sell discipline. This is especially true in this knowledge/service-based economy. In 2021 there were 68 new software IPOs. Most have cloud-based contracts and are currently profitless. Revenue recognition was the issue in the Computer Sciences software fraud in 2006. At that time all software was front entered as a sale. The next fraud will also be revenue recognition. But this time the business will be back ended with cloud leasing contracts and undoubtedly each company will treat revenue recognition differently using non-GAAP.