One Budget Surplus and an Order of Phantom Profits, Please

The following is a cautionary tale and is in no way designed to implicate the dozens of IT companies currently ducking for cover because of sloppy bookkeeping, wishful thinking, shady accounting work and flat-out deceptive financial practices.

I can recall it like it was yesterday, even though it was almost two years ago. I was working as a daily newspaper reporter on the state government beat in Virginia, a night-and-day change from Massachusetts. Things were great down South during the height of the Internet explosion and dot com boom. The state government had experienced three consecutive years of major revenue growth, so legislators cut taxes and spent most of its budget on education and transportation--two worthy goals but if you've ever been to Virginia, you'd know transportation is a lost cause (somewhere in Hades, I believe, condemned souls right now are sitting in gridlock traffic in Northern Virginia as well as the bowels of the "Big Dig" here in Boston). The General Assembly and former Gov. Jim Gilmore even decided to use most of the billions of dollars the commonwealth had received in the tobacco industry lawsuits on fixing highways instead of tobacco-related education and healthcare costs. How sadomasochistic of them. Things were so good, in fact, that everyone was using the "s" word.

Surplus. Honestly, a chill just ripped through me as I wrote that. Surplus is a dangerous word because whenever government officials or economists talk about a budget surplus, they're talking about a projection. An "educated" guess. Fuzzy math. A prediction. In other words, a budget surplus is like Santa Claus, Mickey Mouse, honest politicians and the Loch Ness Monster--something many people want to believe in, something that many people insist is true, but simply does not exist.

Virginia had projected a huge budget surplus, so much so the state increased its spending by more than 40 percent during the late 1990s while cutting taxes at the same time. Back in 1997, both the Democratic and Republican candidates for the governor's mansion ran on a tax-cutting platform that would return a large portion of the surplus to the people (Gilmore won because his camp patented the phrase "No Car Tax!" first and made a killing with campaign signs and bumper stickers). A tax cut was a noble effort, and I supported it, but I was always suspicious of this mythic surplus, which predicted billions in state revenue for the next five to 10 years. And I was worried that the size of the tax cut --which eliminated the personal property tax on automobiles--would be too much for a budget surplus that was not written in stone and heavily dependent on the stock market. I would ask members of the General Assembly if there was any kind of contingency plan in case the market crashed and the economy went south. They looked at me like I had just clucked like a chicken and asked them to marry me. No one considered the good times would end, and why would they? The Nasdaq was a juggernaut and jobs were falling out of the sky.

Well, in early 2000, just before I left Virginia to return to my home state and dive into the IT industry with full force, the budget surplus began to shrink. It shrunk some more as the year went on and by the following year, the dung had officially hit the air conditioner. The surplus was gone, and was replaced this year with a very real, very tangible deficit of approximately $1.5 billion, which is one of the largest state deficits in the country. Even if Virginia can cut that much this year, if the state doesn't reduce its budget by an additional $2 billion in the next two years, it will be in the red.

That is a reversal of fortune on an epic scale--kind of a like a lifelong slacker and underachieving rich kid becoming the most powerful man in the world. Government employees are going to take a harder beating than a pinata at Mike Tyson's birthday party. Education reform and transportation projects will see about as much daylight as an albino mole. And Virginians could even be faced with a tax increase.

This may not appear to have anything to do with the IT industry, but it does. First, Virginia gets a lot of its revenue through income taxes, which saw a jump in the late 90s because of the stock market. In fact, capital gains taxes surged during that period, most of which came from juicy stock options in the Northern Virginia technology sector, according to several reports. Why anyone would base a budget surplus projection on a handful of people trading huge volumes of stock is beyond me, but that's what Virginia did. It cost the state millions this year as officials cut the revenue forecast because of declining capital gains payments.

Second, Virginia's current Democratic governor is Mark Warner, an entrepreneur and one of the founding partners of Columbia Capital Corp., a technology venture capital fund in Alexandria, Va., that has funded companies such as Nextel, Affinity and XM Satellite Radio (yes, Columbia helps pay for those strange XM commercials on T.V. with David Bowie and Snoop Dog). So a young guy who rode the Internet wave and even helped create the aforementioned tech boom, which led to outrageous wealth and high-flying stocks, is now charged with reversing Virginia's deficit, which was in part caused by the irrational exuberance of the stock market and the phantom state budget surplus. If only Joseph Heller was still alive.

Third, and most importantly, Virginia is no different than much of corporate America and, unfortunately, the IT industry. The state bet its future on a lot of projections, faulty accounting, bad financial planning and just a flat-out reluctance, whether conscious or unconscious, to see the truth staring it in the face. We're seeing now that many corporations have dug themselves similar holes by overstating their value by playing loose with the numbers.

Virginia was banking on high income taxes and capital gains to keep the dream alive, and when that started to dry up, Gilmore essentially turned a blind eye. He refused to drop his car tax cut, which is admirable perhaps from a campaign promise perspective but outrageously stupid considering the state was staring at a deficit. Originally, ridding the state of the car tax would have cost more than $500 million over several years. This year alone, the state is paying $800 million to reduce the car tax by more than half. When the car tax has been completely eliminated in a few years, it could cost the state as much as three times the original advertised price.

Still, Gilmore would not cave in. Even his own Republican troops in the General Assembly argued it was time to freeze the tax cut, at least until the recession ended. There was a rare budget deadlock with the General Assembly last year because of the car tax plan, and Gilmore was even accused by legislators on both sides of the fence of inflating state revenue and delaying income tax refunds to balance the budget.

I know this is sounding familiar, and it should. Is Gilmore the Kenneth Lay of government? Absolutely not. Gilmore and his administration had good intentions, which was to use the surplus to pay back taxpayers and improve schools and highways, whereas I doubt Lay and his executive team at Enron ever had a scrupulous motive. But they say the road to hell is paved with good intentions (either that or with the gridlock traffic of Northern Virginia), and Gilmore and his administration have no excuse--they saw the flood coming but did nothing to evacuate the village and instead build aqueducts leading right up to the front door.

I fear the number of publicly traded IT companies out there that have fallen into the same trap is higher than we realize. After all, this industry is responsible for the dot com phenomenon, which allowed companies that weren't making ANY money to spend venture capital on moronic Super Bowl ads. We've already seen some high-profile disasters that, while nowhere near the scale of Enron, have certainly disillusioned investors. Ariba is one example. The company declared itself the first Internet B2B software company to reach profitability in January of last year and predicted revenue of $180 million for the second quarter. But by the time April rolled around, the company admitted that Q2 revenue was going to be about $90 million and that it was facing an operating loss. How does that happen? How does a company project a profit for investors only to come back in less than three months to say they can only deliver half of what they predicted?

Ariba is hardly alone, although I must state that to my knowledge the company was never the target of a federal investigation regarding securities fraud. The number of companies that have been wildly off the mark in their earnings reports is greater than any of us like to admit. Everyone blames it on the recession, but I believe that faulty financial management and dishonest record-keeping contributed heavily to the situation. I'm not going to start rolling out the names of all the troubled IT companies that are being probed by the federal government. You can make your own determination of whether their problems were isolated incidents due to boneheaded mistakes or if they were part a bigger corporate culture of lawlessness.

The problem is, I suspect, that sloppy accounting practices and corner cutting has become a standard in our industry. Financial officers and executives look for any legal method to get the quarterly reports to swing their way, even going as far as counting business deals that haven't even been signed off. It's called legal and institutionalized deception, and it gets worse, too, as we've seen. Once you start to manipulate the numbers a little here and there, it leads to outright fibbing. Fibbing leads to little white lies, which then lead to bigger and more damaging lies. Before you know it, your business records have more inaccuracies than the visa of a Latino baseball player and you find yourself squarely in scandalous congressional hearings and the hall of infamy of U.S. business history.

They say the numbers don't lie, but that's just not accurate. If this job has taught me anything, it's that people can make numbers into whatever they want, especially when it comes to dollar signs. Companies can defer revenue for a quarter, say they're on a run rate for profitability without any actual proof, trumpet one-time charges and expenses, spin off overseas subsidiaries to bear the brunt of all their losses--anything to inflate success or, worse, distort the true picture of financial instability. I'd really like to live in this world. Hey, boss, I've got a strong pipeline of killer stories in the works, but I can't disclose any details!

Some people probably think I'm overreacting to all of this, and these probably also probably think that:

Bill Clinton was the greatest Democratic president of the 20th Century.

The classic documentary "Roger and Me" was some sort of elaborate, fictional hoax to smear General Motors.

Michael Douglas got a bad rap in "Wall Street."

It's all so sad, too. There are a number of signs that at the very least the economy has stabilized, and at best the country is climbing out of the recession. But the stock market is a Herculean obstacle that's preventing a speedier recovery. We shouldn't be surprised if consumer confidence continues to fall in the U.S., as it did last month according to the Conference Board. If Americans can't trust even the most well-known and respected corporations in this country, how can we expect them to invest? And if IT firms can't put their faith in one another to do honest business, how can we possibly reclaim the glory days.

All is not lost, of course. Virginia will recover, just as Ariba has bounced back. But we must learn from the mistakes of the past. The cycle will surely repeat itself if we don't stop betting the future on outrageously optimistic budget surplus and fudging the numbers. Our national economy will not heal until our government and business leaders start taking a long, hard look in the mirror. It's time for a reality check.

Now repeat after me. One plus one equals two...