SEC Investigating Microsoft Practices -- Earnings Manipulated, Former Employee Contends

Microsoft disclosed yesterday that the Securities and Exchange Commission is investigating possible accounting improprieties at the software giant.

Chief Financial Officer Greg Maffei told analysts and reporters the SEC is probing allegations that Microsoft uses its financial reserves to manipulate its quarterly results. The investigation stems from allegations by former Microsoft auditor Charles Pancerzewski, who settled a wrongful-termination suit against the company last year.

"We are cooperating with the SEC fully," Maffei said.

Pancerzewski's core accusation was that Microsoft used its deep financial reserves to smooth its earnings performance. The company, he said, manipulated its books by shifting earnings from stellar quarters into its reserves, then dipping into that pot during sluggish quarters. That way results appear more stable, and stability is what Wall Street rewards.

Maffei didn't mention Pancerzewski's claims, but he said that an article in The Wall Street Journal in January, recounting the case, had triggered the investigation.

"We don't know everything that the SEC is looking into," Maffei said.

Pancerzewski's wife said her husband, who is a Mukilteo city councilman, was traveling yesterday and unavailable. But his lawyer, Jerry McNaul, said Pancerzewski has talked to SEC investigators.

"I can confirm that the SEC has contacted Charlie Pancerzewski and that Charlie has cooperated with the SEC," McNaul said.

That cooperation has included being interviewed by investigators and handing over a substantial volume of records about Microsoft's practices, McNaul said.

SEC spokesman Duncan King declined to confirm or deny the existence of an investigation. But Maffei said the investigation began several months ago, and sources said it is being handled by the SEC's Washington, D.C., office.

Last fall, Pancerzewski and Microsoft settled the wrongful-termination case, filed in 1997, without disclosing terms. Pancerzewski, who audited Microsoft's business practices and reviewed acquisitions, contended that Microsoft fired him after he raised the issue of the company's accounting practices with his bosses. Pancerzewski, 59, also accused the company of age discrimination, but that charge was dismissed.

E-mail presented as evidence

During a hearing last summer, Pancerzewski's lawyers cited e-mail from his boss, then-Chief Financial Officer Mike Brown, to Microsoft Chairman Bill Gates on maintaining smooth earnings.

"I believe we should do all we can to smooth our earnings and keep a steady state earnings model," Brown wrote, according to a court transcript. "While a strategy is to use it (earnings) to increase volatility and then capitalize (on) the volatility, I think in the long run employees, stockholders and our corporate destiny are best served by smoothness."

Pancerzewski's lawyer, Peter Vial, used that e-mail in court to suggest that Microsoft knew it was breaking the law.

"The CFO to whom Charlie was reporting his concerns about illegality was the biggest advocate for the very illegality that was going on," Vial argued in court a year ago.

Microsoft said that Brown's remarks were made in the context of reporting results in accordance with generally accepted accounting principles, or GAAP, which are the rules and procedures that govern accounting practices.

"We report earnings, based on GAAP and SEC regulations, to reflect the business fundamentals, and Wall Street expectations do not drive what we report," Microsoft spokeswoman Caroline Boren said.

Microsoft declined to comment on Pancerzewski's claims. Microsoft Chief Operating Officer Bob Herbold, though, was effusive in praising Pancerzewski in a letter he wrote last summer leading up to the settlement.

"Nothing related to your departure altered Microsoft's high regard for you as an individual and as an effective auditor, and Microsoft and your colleagues and former supervisors at the company deeply regret any adverse effect that your leaving the company may have had on your reputation," Herbold wrote.

It's unclear what effect the SEC investigation will have. The SEC recently launched a nationwide review of accounting practices. Yesterday, it settled an earnings-manipulation case against W.R. Grace & Co. of Boca Raton, Fla. The SEC had accused Grace of dipping into reserves to boost results so that they met corporate targets.

"This case makes plain that we will not tolerate efforts to play fast and loose with the accounting rules to meet earnings targets," said Richard Walker, director of the SEC's Division of Enforcement.

Because the SEC is reviewing accounting practices, articles in publications such as The Wall Street Journal raising allegations of improprieties are going to trigger investigations, said Joseph Grundfest, a Stanford University law professor and former SEC commissioner.

"You will get a visit from the SEC. The SEC reads newspapers," Grundfest said. "That doesn't mean Microsoft has done anything wrong. There is a reasonable probability that it means nothing."

Accountants often disagree about accounting rules, Grundfest said.

"These are often judgment calls," he said. "Many people have the idea that accounting is an exact science. It's not."

The effect on Wall Street may also be muted. Microsoft has long been a Wall Street darling, so even if Microsoft did shift reserves from one quarter into another, investors will likely believe the motivation was simply to provide a smoother picture of its results, said Bill Epifanio, an analyst with J.P. Morgan in New York.

Investors aren't going to get too upset about that. Besides, Microsoft has more pressing matters to attend to, such as an ongoing antitrust trial.

"Like them or not, Microsoft has demonstrated a consistent history of conservative accounting," Epifanio said. "I can't at this point get too excited about this. I have a DOJ (Department of Justice) trial going on."

Revenue reporting changed

Separately, Microsoft announced changes in the way it will recognize revenue on its balance sheet.

Previously, Microsoft stretched out the revenue it receives from new-product sales because the technical support and product updates that go along with those sales tend to be delivered over time. New accounting rules require Microsoft to report more of that revenue upfront.

The impact will be modest, though, adding about a penny a share to analyst estimates in the fourth quarter, which ended yesterday, and another penny a share for the fiscal year that begins today.

Jay Greene's phone message number is 206-464-3287. His e-mail address is: