1) Auditor opinion
Sapiens’ financial statements were audited by Kost, Forer,Gabbay & Kasierer, an Israeli accounting firm, which is a member of Ernst & Young Global. The audit was conducted according to the standards of the Public Company Accounting Oversight Board (PCAOB) established in the US following the Sarbanes Oxley Act of 2002.
The audit report is clean with one reference to Note 2j on the adoption of new accounting rules – Statement of Financial Accounting Standard (SFAS) 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets.
Sapiens recorded $204,000 impairment of goodwill, prior to adoption of FAS no.142, which indicated that the company might write off future years' impairment during the current year.
Similarly, the company recognized impairment loss of long-lived assets in the amount of $519,000 in 2001, which could also be thought as Shifting Future Expenses to Current Period. 2) Discontinuity of earning around zero
The widely accepted explanation for this phenomenon is that companies facing a small negative earnings figure adopt more aggressive accounting estimates raising earnings above the zero mark. Sapiens’ reported quarterly earnings of $0.01 for the 4th quarter of 2003, and this could be thought as an indicator of earning management. A small positive earnings figure could mislead the investors and banks, reduce the cost of transaction and the financing cost for the company.
3) Disclosures on debt covenants
Sapiens disclosed that during 2003, the company did not fulfill the debt covenant, pertaining to maintenance of cumulative, quarterly earnings at certain level, but received waivers from the banks. However, whether the company could continue to fulfill these covenants still remains uncertain. Trying to avoid violation of covenants provides the motivation of earning and cash flow management to the company.
2. Assessment of Sapiens' accruals management
1) Depreciation and Amortization
Depreciation and amortization expenses of all above assets decreased heavily from 2001 to 2003. This phenomenon indicates that the company may have tried to shift current expenses to later period by decreasing current year's depreciation/amortization expenses and failing write off worthless assets as well. As a result, the profits of 2002 and 2003 were increased artificially.
2)R&D and Capitalization of computer software development costs
Compared to the previous two years, net R&D expense in 2003 decreased to $3.7 million in 2003 due to the higher capitalization rate employed in 2003.However, the net capitalized costs increased year by year from 2001 to 2003 given that total R&D spending decreased from $11 million in 2001 to $9.4 million in 2002 and to $8.3 million in 2003.
By increasing capitalization rate improperly, the company could shift current expenses in 2003 to later period, therefore increase the profit of 2003.
3) Revenue Recognition – Unbilled Receivables
Compared with 2002, The unbilled receivables increased in 2003 in terms of the absolute amount and percentage of the total trade receivables. This indicates that the company may have recognized revenue aggressively by increasing unbilled receivables. Usually, analysts consider growth in ‘Unbilled Receivables’ a red flag indicating revenue shifting.
On December 2003, Sapiens issued convertible bonds for $16.193 million after its results for the 3rd quarter of 2003 had been published in November 2003. However, Sapiens chose not to disclose changes in ‘Unbilled Receivables’ in the quarterly financial statements. Hence, investors could observe this amount only in the annual financial statements of 2003 which would published in June 2004. Therefore, investors couldn't observe the increase of unbilled receivables before Sapiens' bond issuing.
4)Factoring, days of receivables and allowance for bad debts
