Daily Journal Accused of Incorrect Accounting
The company has been accused of incorrectly accounting for software development costs by an activist investor seeking board seats and a consulting contract.
Daily Journal Corporation announced that an activist investor has accused the company of incorrectly accounting for software development costs at its Journal Technologies subsidiary. Longtime readers may recall my detailed report on Daily Journal published two years ago as well as more recent articles about potential uncertainty at the company following Charlie Munger’s death.
Mr. Munger’s long history with the company sparked the interest of many Berkshire Hathaway shareholders and other investors. Although I have never owned shares of Daily Journal, I have followed the company for more than fifteen years. Unsurprisingly, the company was run in a highly unconventional manner with Mr. Munger serving as Chairman for decades alongside longtime CEO Gerald Salzman who recently passed away at the age of 86, only a few years after retiring from the company. Given Mr. Munger’s insistence on the highest levels of integrity, accusations of accounting irregularities should be viewed with skepticism.
Steven Myhill-Jones, the current CEO who was selected by Mr. Munger, presented his thoughts on the controversy in a note submitted with the announcement. The activist investor, Alexander E. Parker, has accused the company of improperly accounting for software development costs. In a series of letters initiated on July 14, Mr. Parker became increasingly insistent that his firm should be engaged on a consulting basis to rectify the problems. In addition, he demanded two board seats.
Mr. Parker claims that he can “unlock” $160 million of value. In exchange for his consulting services, Mr. Parker’s firm would be awarded up to $24 million of Daily Journal stock should the company’s market value rise by up to $160 million for any reason. When Daily Journal opted to hire another consultant to evaluate its accounting methodology, Mr. Parker reported the company to the Securities and Exchange Commission.
The substance of Mr. Parker’s complaint is hardly news to longtime readers of Daily Journal’s filings. I noted the company’s accounting policy regarding software development costs several times in my 2023 report.
Daily Journal opts to expense software development costs rather than capitalizing such costs. This has the effect of increasing current period expenses, thereby reducing current period net income. If the company instead capitalizes all or part of software development costs, the funds spent would appear as an asset on the balance sheet amortized over the useful life of the software. Initially, an accounting change involving capitalizing software development costs would boost earnings and book value. Presumably, this is why Mr. Parker believes that $160 million of “value” can be “unlocked.”
But the idea that informed investors do not already understand Daily Journal’s policy on this matter and would suddenly revalue the company by $160 million simply due to an accounting change seems like an absurdity. Conservative accounting is one of the hallmarks of Charlie Munger’s legacy. As Mr. Myhill-Jones pointed out in his email to Mr. Parker on July 18, the key point in making an expense vs. capitalization decision involves when the software reaches “technological feasibility.” Mr. Myhill-Jones asserts that the nature of Daily Journal’s process means that technological feasibility is reached concurrent with general release of software which obviates the need to capitalize costs.
It appears that little has changed regarding this accounting standard since I was involved in providing input on “technological feasibility” in my research and development role at a small private software company in the mid to late 2000s. I was responsible for vertical market software applications, like Daily Journal’s products, and my experience was that the process was highly iterative and required close consultation with clients before “technological feasibility” could be determined. Often, that nearly coincided with production release of software. As a result, conservatism on capitalization decisions was simply common sense.
The opposite approach of aggressively capitalizing software costs often leads to write downs. Daily Journal is no stranger to this problem. When the company acquired its software businesses in the late 1990s, it came with capitalized costs. This policy was apparently continued in 2000 and a large write down occurred in 2001, as discussed in my report:
“In addition to capitalized costs of $3 million recognized at the time of the acquisition, Daily Journal invested $6.9 million in fiscal 2000 to develop the software product. In fiscal 2001, an additional $8.1 million was invested in software development. In April 2001, management discovered that the software was not functioning properly. In the fiscal 2001 10-K, management reported ‘the software development project was both seriously flawed and seriously behind schedule … and was, therefore, of virtually zero commercial value. As a result, the company wrote off and expensed in fiscal 2001 capitalized software development costs aggregating $15,048,000.’”
I think Charlie Munger fully supported the conservative accounting policy regarding the current expensing of software development costs and any knowledgeable shareholder who bothers to read the company’s filings has known about the policy for years. From the materials that Daily Journal released, Mr. Parker’s campaign against the company is full of demands (including seeking to dictate the timing of board meetings and other company deliberations) that hardly seem reasonable. I doubt he will gain any traction with the company’s shareholders if he launches a proxy campaign.
Like so many others, I greatly miss Charlie Munger’s wit and wisdom. I can only imagine the zingers that he would come up with if he was able to comment on this accounting controversy. Come to think of it, we can probably ask “AI” to predict what he would say!
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No position in Daily Journal Corporation.