Critics say EAI, manager of several city schools, fools investors with accounting

December 19, 1993|By Ian Johnson | Ian Johnson,New York Bureau

NEW YORK -- How did a struggling $3 million consulting firm like Education Alternatives Inc. transform itself almost overnight into a $30 million company that has been the toast of Wall Street?

In part, through unusual accounting practices that boost revenue, according to experts and a survey of similar companies.

EAI, which runs nine public schools in Baltimore and provides limited services at two others, uses an accounting method that artificially inflates revenue and can mislead unsophisticated investors, critics say. Half the revenue booked by EAI is only nominally under its control and immediately reverts to the city school board, they say. That gives the impression that EAI is expanding rapidly, when in fact the company has signed just one new contract.

And that may have helped drive up EAI's stock price and market value.

"It's such a nonsensical thing for this company to be valued so highly," said Howard M. Schilit, a finance professor at American University in Washington and author of a book on corporate accounting practices.

"It hasn't earned all this revenue, because it returns much of it to the school board. Almost no other company books its revenues like EAI."

EAI officials and its defenders on Wall Street say the accounting practices are justified, because it is a unique company that provides unique services.

"No one has operated in this industry [education] before," said EAI's chief executive, John Golle. "There is no other way for us to book our revenues."

The dispute over EAI's accounting methods is more than a fight over a few columns of numbers. At its heart is whether investors are being misled into buying EAI stock at high prices.

EAI notes its accounting practice in government filings, including stock prospectuses. But few investors had looked closely at the company until its stock began to rocket over the past year. Now the company's method of booking revenue has become a topic of intense debate among investors, educators and accountants.

Several large shareholders, for example, recently sold EAI stock after concluding that its accounting methods were suspect. And the two latest EAI contracts in Baltimore have drawn even more fire because they seem to give the company greater leeway to book revenue that has little to do with its job in the schools.

EAI's Baltimore contracts call for the company to receive a set amount of money for each pupil at the nine schools it runs. In the last school year, that was $5,549 per pupil, for a total of $26.7 million.

This year, EAI will receive $5,918 per pupil at those schools; the total value of the contract is expected to be about $28 million. On top of that comes $5,918 for each pupil in two new schools, at which EAI agreed this month to take over maintenance and some other services. That deal will add $8.9 million to EAI's revenue.

Using last year's figures for the original nine schools under management, EAI received $26.7 million in an escrow account.

The company was required to return $3.4 million to the school board immediately for administrative services like registration and busing. The $3.4 million would not change if the company operated the schools more efficiently.

The company also had to immediately return about $12 million in salary money so the board could pay teacher salaries. That left $11.3 million, from the original $26.7 million, for EAI to spend.

The numbers aren't in question -- just how EAI accounted for them. EAI's critics say the company should have booked just $11.3 million -- or restructured the contract in line with those used by other management service companies. Instead, EAI booked the full $26.7 million -- including the $3.4 million in administrative expenses and the $12 million in teacher salaries.

This boosted company revenue from $3 million in 1992 to $30 million this year and helped trigger a stampede for the company's stock. Even allowing for recent declines in the stock's price, it increased from $9, when the contract with Baltimore was signed in mid-1992, to $35.25 Friday.

EAI's rationale for booking the full $26.7 million, Mr. Golle says, is that it must control every dollar to be able to spend efficiently. Receiving only part of the money would not allow EAI to run the schools at optimum efficiency.

"Until you control the whole dollar, you can't make returns," he said.

But according to the contract, EAI has no control over the $3.4 million, which must be returned to the school board. EAI officials say they negotiated this amount -- making the school board, in effect, a subcontractor that EAI hires to do administrative chores.

Teachers' salaries

The rationale is similar for the teachers' salaries, which are set by a contract between the school board and teachers' union. EAI has no control over the amount they are paid.

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