978-0077862213 Chapter 5 Case Computer Associates

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Case 5-1

Computer Associates

Computer Associates (CA) is a business consulting and software development company that designs,

markets, and licenses computer software products that allow businesses to efficiently run and manage

critical aspects of their information technology. CA’s stock trades on the New York Stock Exchange and is

registered pursuant to Section 12(b) of the Exchange Act, 15 U.S.C. §78l(b).

Between about the fourth quarter of fiscal year (FY) 1998 through the second quarter of FY2001,

CA engaged in a widespread practice that allowed for the premature recognition of revenue from software

licensing agreements. CA personnel recorded, into the just-elapsed fiscal quarter, revenue from software

contracts that were not finalized and signed by both CA and its customers until days or weeks after that

quarter ended. The reported revenue was improper because it violated GAAP, which required that license

agreements be fully executed by both CA and its customers by quarter end before recognizing revenue.

CA’s reported revenue and earnings per share appeared to meet or exceed Wall Street analysts’

expectations, when – in truth and fact – those results were based in part on revenue that CA recognized

prematurely and in violation of GAAP.

Audit Committee Investigation

In 2003, CA announced that the Audit Committee of its Board of Directors was conducting

an investigation into the timing of revenue recognition at the company. On April 26, 2004, CA filed

with the SEC a Form 8-K (“Form 8-K”) stating, among other things that:

“The Audit Committee’s investigation found accounting irregularities that led

to material misstatements of the Company’s financial reports for fiscal years

2000 and 2001, and prior periods. The effect of prior period errors which have

an impact on fiscal year 2000 have been considered as part of this restatement.

The Audit Committee believes that several factors contributed to the improper

recognition of revenue in these periods, including a practice of holding the

financial period open after the end of the fiscal quarters, providing customers

with contracts with preprinted signature dates, late countersignatures by

Company personnel, backdating of contracts, and not having sufficient

controls to ensure the proper accounting. In addition, the Audit Committee

found that certain former executives and other personnel were engaged in the

practice of “cleaning up” contracts by, among other things, removing fax time

stamps before providing agreements to the outside auditors. These same

executives and personnel also misled the Company‘s outside counsel, the

Audit Committee and its counsel and accounting advisers regarding these

accounting practices.”

Also in the Form 8-K, CA announced that it was restating over $2.2 billion in revenue that CA had

improperly recognized in FY2000 and FY2001.

Improper Revenue Recognition at CA

From at least the fourth quarter of FY1998 through the second quarter of FY2001, CA derived its income

primarily from licensing software and providing maintenance for that software. CA’s software operated

and maintained powerful “mainframe” computers, those generally used by businesses and other

organizations. Prior to October 2000, CA’s contract and licensing model involved entering into long-

term licensing contracts, some as long as seven years in duration. Under that business model, customers

paid an initial licensing fee for the software, plus subsequent licensing fees for the right to use the

software in subsequent years. In addition, customers paid CA for ongoing maintenance such as technical

support. Customers often entered into long-term contracts and spread out the licensing and maintenance

fees over the term of the contract.

For contracts under its pre-October 2000 business model, GAAP allowed CA to recognize all

the license revenue called for during the duration of the contract up front, during the fiscal quarter in

which the software was shipped and the contract was executed and final.

SOP 97-2, which the American Institute of Certified Public Accountants adopted in

October 1997,

requires the following before revenue can be recognized from a software sale:

evidence of an arrangement;

delivery;

fixed and determinable fees; and

ability to collect.

When a software company uses contracts requiring signatures by the software company and its

customer, then SOP 97-2 provides that both signatures – the software company and the customer – are

required as “evidence of an arrangement” before the software company may recognize revenue. During the

period in question all of CA’s license agreements required signatures by both CA and the customer.

Materially False Statements and Omissions in Filings with the SEC

During at least the fourth quarter of FY1998 through the second quarter of FY2001, CA violated

GAAP, including SOP 97-2, by backdating software contracts into prior fiscal quarters expired software

contracts that were not executed – and for which “evidence of an arrangement” did not exist – until a

subsequent quarter. This extended quarters practice resulted in CA’s premature recognition of revenue.

As a consequence, CA made material misrepresentations and omissions of fact concerning CA’s revenues

and earnings for the fourth quarter of FY1998 through the second quarter of FY2001 in various public

documents and in connection with the offer, purchase, and sale of securities. CA’s reported results for at

least the fourth quarter of FY1998 through the fourth quarter of FY2000 appeared to meet or exceed the

revenue and earnings estimates of outside analysts when, in fact, those reported results did not comply

with GAAP and were false and misleading.

In its Form 8-K, which was not an audited Restatement, CA admits that the extended quarters

practice resulted in CA prematurely recognizing substantial percentages of revenue for all quarters of

FY2000 and the first two quarters of FY2001. The following chart illustrates the impact of the premature

revenue recognition in each fiscal quarter:

Fiscal

Quarter

GAAP Value of

Revenue Properly

Recorded

GAAP Value

of Contracts

that CA Signed

After Quarter

End

GAAP Value

of Contracts

that Clients

Signed After

Quarter End

GAAP Value

of Revenue

Improperly

Accelerated and

Recorded

Percentage that

Properly Recorded

Revenue was

Inflated by

Improperly

Accelerated Revenue

FY2000

$977,165,281 $122,230,689 $122,604,030 $244,834,719 25%

FY2000

$1,047,256,904 $90,099,723 $467,643,373 $557,743,096 53%

FY2000

$1,239,902,741 $170,450,718 $401,646,541 $572,097,259 46%

FY2000

$1,748,131,031 $179,493,620 $199,375,348 $378,868,969 22%

FY2001

$1,135,600,000 $126,740,000 $15,660,000 $142,400,000 13%

FY2001

$1,462,040,000 $214,720,000 $4,240,000 $218,960,000 15%

The greatest amount of prematurely recognized revenue as a result of the extended quarters

practice occurred in FY2000, particularly in the third quarter, followed by the second, fourth and first

quarters of that fiscal year. If CA had not improperly recognized revenue in each of those fiscal

quarters, CA would not have met analysts’ revenue and earnings estimates.

The following is a chart which shows the impact of the extended quarters practice on CA’s

earnings per share in the four quarters of FY2000 and the extent of the material misstatements and

misrepresentations in the Forms 10-Q and Form 10-K that CA filed with the SEC which reported each

quarterly result, and related public statements made by CA:

Quarter

Total Revenue

Properly

Recorded

Total

Revenue

Improperly

Recorded

Analyst earnings

per share

(“EPS”)

Estimate

Announced

EPS

without

Improper

Revenue

Overstatement

of EPS

FY2000

$977 million $244 million $.47 $.49 $.29 $.20

FY2000

$1.047 billion $557 million $.59 $.60 $.05 $.55

FY2000

$1.240 billion $572 million $.90 $.91 $.31 $.60

FY2000

$1.748 billion $378 million $1.13 $1.13 $.82 $.31

A Systemic and Intentional Practice

The premature recognition of revenue at CA during at least the fourth quarter of FY1998

through the second quarter of FY2001 was the result of a systemic, intentional practice by certain CA

personnel. To implement and conceal this extended quarters practice, CA personnel employed a variety

of improper techniques, many of which rendered the company’s books and records false and misleading

including:

Some employees at CA called the extended quarters practice the “35-day month” practice,

because generally most quarters were extended by at least 3 business days, although some

quarterly extensions lasted longer.

Sometimes, CA had its customers execute contracts bearing preprinted dates from the just

expired quarter even though the customer did not actually sign the contract until days or weeks

into the new quarter.

CA substantially stopped prematurely recognizing revenue for software contracts signed after quarter end

by CA’s customers during the first quarter of FY2001 (quarter ended June 30, 2000). That quarter, CA

missed its Wall Street earnings estimates. CA issued a press release on July 3, 2000, stating that it would

miss the analysts’ estimates, specifically citing the fact that the company did not complete several large

contracts that they had hoped to conclude before the close of the quarter. This was only the second time

in CA’s then recent history that CA missed Wall Street’s estimates. The next trading day, July 5, 2000,

CA’s stock dropped over 43 percent from $51.12 to $28.50, as the market reacted to the news.

CA continued to prematurely recognize revenue from contracts that CA signed after quarter

end (although, with a few exceptions, the customer did sign contract by quarter end) for the first two

quarters of FY2001, after which that practice substantially stopped.

Legal Matters Resolved

In September 2004, CA agreed to pay $225 million in restitution to shareholders to settle the civil case

brought by the SEC and to defer criminal charges by the U.S. Department of Justice. At the same time, a

federal grand jury brought criminal charges against former CA chairman and CEO Sanjay Kumar. Kumar

resigned in April 2004 following an investigation into securities fraud and obstruction of justice at CA. A

federal grand jury in Brooklyn indicted him on fraud charges on September 22, 2004. Kumar pled guilty to

obstruction of justice and securities fraud charges on April 24, 2006. On November 2, 2006, he was

sentenced to 12 years in prison and fined $8 million for his role in the massive accounting fraud at CA.

Kumar is currently housed at the Federal Correctional Institution in Miami, Florida, with a projected

release date of January 25, 2018.

Questions

1. Analyze each revenue recognition technique identified in the audit committee investigation

and explain whether each technique violates revenue recognition rules in accounting.

Evaluate the practices followed by CA from an ethical perspective.

The audit committee investigation found and reported the following revenue recognition problems: (1) a

practice of holding the financial period open after the end of the fiscal quarters, (2) providing customers

with contracts with preprinted signature dates, (3) late countersignatures by Company personnel, (4)

backdating of contracts, and (5) not having sufficient controls to ensure the proper accounting. The first

four problems have the effect of moving the revenue recognition to an earlier quarter than the contract

was legally executed; this early revenue recognition was to meet analysts’ expectations. GAAP, pre-

October 2000, allowed revenue recognition of all software license revenue due during the duration of

2. CA executives were not accused of reporting nonexistent deals or hiding major flaws in the

business. The contracts that were backdated by a few days were real. Was this really a crime

or should it fall under the heading of no harm, no foul? Be sure to use ethical reasoning in

responding to the question.

The actions by CA were dishonest and did cause harm to shareholders, all investors, creditors, employees,

suppliers, and the reputation of the company and CEO, Sanjay Kumar. Although the contracts were real and

only the timing of the revenue recognition was affected, the acts were dishonest because they were intended

3. In her “Seven Signs of Ethical Collapse” that were discussed in Chapter 3, Marianne

Jennings listed “pressure to maintain the numbers” as the number one sign. How can a

company like CA resist such pressure?

In the late 1990s all software companies were under pressure to make the numbers. The dot.com companies

in the 1990s had found angel investors and then went public. The market expectations of being a publicly-

owned company and pressure to “make the numbers” affected many companies and led them to manipulate

the financial statements. In this environment, it was easy for the companies to rationalize that “all the