Darktrace, the cybersecurity company, has lost a quarter of a billion pounds from its valuation after an aggressive US short-seller claimed the company engages in fraudulent accounting.
Quintessential Capital Management (QCM), a New York-based asset management firm, alleged that Darktrace engages in “channel stuffing” and other fraudulent practices designed to artificially inflate its sales figures.
So-called “channel stuffing” is when a company strikes fake sales contracts with commercial partners immediately before a deadline such as the end of the financial year. After the deadline passes, goods “sold” under the fake contract are quietly returned.
In a 70-page report published on Tuesday, QCM’s founder Gabriel Grego claimed that Darktrace was “shifting tomorrow’s revenues into today’s books”.
The problem for Darktrace here is that it is somewhat believable. For the accusations – they are just that for any lawyers reading – about Autonomy are that such accounting went on. And if Mike Lynch is involved then do such habits repeat?
Note what is being said here. Absolutely not that the two firms will share practices. Nor even that Autonomy did channel stuff. Only that folk out here might believe the Autonomy claim and then go on to believe the Darktrace one.
So it’s an easy short to make.
As an aside, I wrote a little stock market piece elsewhere saying that Darktrace lumbered under something of a cloud. That there was a certain belief that perhaps they shined up their revenues a bit too much. Not that they did, just that some might believe they did, this therefore explaining their low – for the reported revenue growth numbers – P/E ratio.
I got an email from a financial PR type insisting that this was absolutely not so etc. Which, as I pointed out to him, isn’t exactly a refutation of the claim that Darktrace thinks a lot about beliefs about its numbers. Because a PR email about a squib of a piece with a few hundred readers doesn’t, in fact, refute the idea that Darktrace worries about financial PR now, does it?
I never had dealing with them but I have seen other US firms do it. In order to get the best price I liked to negotiate major purchases for a little before the sellers accounting year end. You got very good deals that way as they saw it as the chance to revive flagging targets. Our bean counters however would always delay the purchase till after the vendors year end. What I did see happen is the the firm producing the goods would “sell” them to a random distributer just before financial year end and we would then be instructed to finish the purchase by buying from them a few weeks later.
The “markets” really have a thing about Lynch but, remarkably, have never really managed to get anything to stick. Even in the aftermath of the HP takeover, when HP wrote off the investment in Autonomy and those noted financial experts at the Guardian became even more self-righteous than usual, Deloittes seemed to be on Lynch’s side. I imagine he must have farted in the presence of some financial notable. He really does seem to have the knack of annoying the usual parties
Presumably channel-stuffing only works as a one-off boost, right? Once the channel is stuffed, you can’t repeat the trick. So it probably doesn’t matter that much.
Autonomy’s bigger trick was conflating hardware and software sales, making it look as though they were selling billions in highly profitable software, when actually it was just millions in software alongside billions in low-margin hardware.
I’m gonna go out on a limb here and suggest that any business willing to fabricate sales (however ‘temporarily’) to hit a number is probably doing all sorts of other stuff you wouldn’t like.
Up to and potentially including the legendary “warehouses full of fake IT stock that are actually bricks” trick.
No idea if Darktrace does any of this, mind. The idea of channel stuffing just sets my spider senses tingling: a well run business would sack you on the spot for that. Cutting an early invoice on a nod and a wink from the customer is one thing, booking dodgy transactions as legitimate business is what I’d tend to think of as “fraud”.
The not-well-run subsidiary of my better-run employer was found to be bringing forward the following year’s income for short-term improvement to its results. The entire board of the subsidiary was summarily dismissed.
@Andrew M
Yes it only works once, but it does matter. It matters a lot. The salesman meets his target so gets his bonus rather than being fired. The area sales manager gets his cut of the bonus and the board members renumerate themselves nicely for meeting predictions and not having angry shareholders. Yes it makes the following year harder but who is to say they will still be there by next year end.
Worked for a fortune 500 FMCG company and this was rife despite repeated threats of dismissal for any salesman colluding with customers to do it. The sales figures looked like a saw tooth, with the few days following the month end sometimes even showing negative revenue.
A company I knew managed it for 2 or 3 years, before getting caught. The European MD ( Swiss German ) was at the heart of it and it took a major audit by the US mother to discover it.
The company was being sold to Oracle, hence the audit, I think otherwise the Board wouldn’t have given a stuff.
If it’s in any way material, how does any half competent auditor not pick up on the (necessary) post balance sheet credit notes?
@PF
From an accounting perspective it’s the date that the sale was made that counts, not the actual date that the payment hits the bank account.
Tax is just the same. Capital gains on shares are counted from the trade date not the settlement date. As such you get a lot of transactions just before the end on the financial year even though settlement might be in the following tax year.
Not the date of sale, but the date the goods or services are provided. If sale date is in advance of that then it’s deferred income on the balance sheet.
The accountants should be telling the sales types to wind their necks in.
AndyF
Yes, sure, invoices (or “provided” per Isi3) rather than cash. A 101 check is to look post-balance sheet and see if stuff’s then getting reversed (for example, credit notes for invoices). That’s a big red flag. Sales/GM are obvious ones because (in a non-asset business) it’s where large numbers are. As I say, if auditors aren’t alert for things as basic as that…
Isi3: “wind their necks in”. Yes quite – should never get as far as an audit!
It can be complicated due to revenue recognition rules where dates and certain pieces of paper matter, a customer asking you to not ship something for a couple of weeks as they are behind on another phase of the project can scupper legitimate timing on transactions unless you have the right paperwork needed to acknowledge the sale and defer transfer, same with stuff in transit that gets delayed or not booked in by the customer so you get paperwork dated a day after the period end.
Once people figure out they can massage legitimate transactions that are just small but crucial timing differences then there’s a danger someone takes it further
US GAAP is still very box ticking so it’s possible for auditors to sign off as long as you have the right paperwork
One other method is I sell you a load of software and you sell me a load of hardware which nets off as we both have a customer who wants both, but after the sales period, that way we bring the sale forward in time.