J2 Global Communications Trying to Hide Accounting Errors

J2 Global Communications (NasdaqGS: JCOM ), better known as eFax, is under fire. Yesterday, Sam Antar tore into the company for an accounting gimmick that the company (and its auditors) had to know was wrong. The issue involves revenue and deferred revenue.

In the 10-Q for the first quarter of 2011, J2 reported an upgrade to its accounting system. The new system gave J2 the ability to properly calculate unearned revenue from annual contracts with customers:

In the first quarter of 2011, the Company made a change in estimate regarding the remaining service obligations to its annual eFax subscribers. As a result of system upgrades, the Company is now basing the estimate on the actual remaining service obligations to these customers. As a result of this change, the Company recorded a one-time, non-cash increase to deferred revenue of $10.3 million with an equal offset to revenues. This change in estimate reduced net income by approximately $7.6 million, net of tax, and reduced basic and diluted earnings per share for the three months ended 03/31/11 by $0.17 and $0.16, respectively.

What this says is that in the past, J2 had improperly calculated its deferred revenues, meaning that earned revenues were overstated.

Unfortunately, J2 improperly characterized this as a “change in estimate.” This is not a change in estimate. It is actually the correction of an error. The method of estimating deferred revenues never changed. J2 simply did the calculation wrong in the past. Now they’re correcting it, but trying to hide the error by calling it a “change in estimate.”

Gradient Analytics first called attention to this issue, stating:

…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results. The distinction between a change in estimate and a correction of an error is important in that it may have implications for an evaluation of the effectiveness of internal controls.

Under U.S. GAAP, a change in accounting estimate occurs when new information or additional experience causes a company to change its estimate of an amount that is subject to uncertainty, such as future warranty obligations or the useful life of an asset. In contrast, errors result from mathematical mistakes in applying accounting principles or oversight, or misuse of facts that existed when preparing financial statements. In the case of JCOM, if the remaining service obligation for eFax customers can be determined with certainty, as is implied by the disclosure in the firm’s 10-Q it would appear to us to be a result of oversight of facts existing at the time of financial statement preparation. That is, the disclosure appears to indicate that the company’s internal control systems were not able to determine the remaining service obligation, despite the fact that the remaining service obligation was important both to revenue recognition and to customers who depend on accurate billing on their accounts and accurate tracking of remaining services they are owed. Furthermore, if the firm’s legacy system could not properly identify or track the underlying facts and figures required to properly value deferred revenue, as implied by the disclosure in the Q1 2011 10Q, it would appear to indicate a deficiency in internal control before Q1 2011.

Investor relations justified the characterization as a “change in estimate” to Gradient by explaining that the new accounting system allowed the company to do a more accurate measurement of the deferred revenues. Unfortunately for J2, that’s still not a change in estimate. That’s a correction of an error. The same estimate is being made, it’s just being done correctly now.

Sam Antar gives a more basic explanation:

I’ll try to explain the situation involving j2 Global’s accounting issues in simple terms. A person could not count the fingers on his right hand without a calculator. He looked at his right hand and estimated that he had four fingers. After that person bought a calculator, he realized that there are actually five fingers on this right hand instead of four.

Is the one finger adjustment a change in estimate or an error under accounting rules? In such a case, the actual amount of fingers already existed, was not subject to uncertainty, and did not come about because of new information. Therefore, the adjustment should not be a change in estimate under accounting rules. The person made a mathematical error. The miscounting of fingers arose from an oversight or misuse of facts at the time they were counted. If he couldn’t count his fingers, he should have used a calculator to count them. Therefore, the adjustment should be considered an accounting error. The same logic appears to apply to adjustments made by j2 Global to deferred revenues, revenues, and net income.

J2 Global is trying to hide the fact that its internal controls were not sufficient in the past to detect an error in calculating deferred revenues. Instead of reporting this accounting error, management is trying to fool investors into believing that is has come up with a new way of estimating deferred revenues. This is dishonest.

Management tries to brush the issue under the rug by explaining that the adjustment of $10.3 million isn’t material when compared to revenues over the last 13 years. This analysis of materiality is incomplete. Materiality does not only apply to a quantitative analysis. It also must be applied to a qualitative analysis. And in this case, J2 has failed miserably at covering up the true nature of the adjustment, and that cover-up in and of itself would seem to make the issue material.

Why does eFax management care so much about pretending this is a change in estimate? If it is an error correction, the company must go back and restate financials under SFAS 154:

Correction of errors. As under APB 20, the correction of an error, which may be a change from one non-GAAP method to GAAP, or a bookkeeping correction, is shown as a restatement. Error corrections are distinguished from changes in GAAP, which are considered retrospective applications. Thus, although error corrections, like changes in principles, are reflected by restating comparative financial statements along with a prior-period adjustment to the opening retained earnings balance, the term “restatement” is reserved for error changes. SFAS 154 retains accounting for error corrections as in APB 20; there is no exception due to impracticability.

Sorry J2, but you’ve made an even bigger mess. Instead of just correcting your accounting error by the book, you were dishonest in your characterization of the situation. You still need to go back and restate prior years’ financial statements, and now you also need to explain to the market why you improperly called this a change in estimate.

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