Financial Statement Analysis- Homework Case – Computer Associates

Financial Statement Analysis- Homework Case – Computer Associates

Subject: Business    / Finance
Question
Accounting for Software Revenue Recognition
Is Computer Associates Being Too Aggressive?
Annual Revenues at Computer Associates (CA) dropped from $6.1 billion in 2000 to
$4.2 billion in 2001.
This case is designed to examine revenue recognition issues for software development
firms. The case includes the following information:
•
•
•
• Background on Software Revenue Recognition (AICPA Statement of Positions
97-2 and 98-9)
New York Times article describing CA’s accounting practices (4/29/2001).
CA’s press release describing its 2001 results (5/22/2001)
CA’s 2001 financial statement footnotes You are asked to read the materials, and answer the following questions:
1. Describe briefly how CA used to record software licenses and maintenance under
the “Old Business Model.” Assume that CA is selling a software package for
$1,000 where 60% is the license fee and 40% is for future technical support. The
support contract is for 10 years. What are the journal entries that CA is using to
record software licenses and maintenance under the “Old Business Model”?
Clearly state any assumptions you made.
2. Describe briefly how CA used to record software licenses and maintenance under
the “New Business Model.” Assume that CA is still selling a software package for
$1,000. What are the journal entries that CA is using to record software licenses
and maintenance under the “New Business Model”? Clearly state any
assumptions you made.
3. What differences, if any, exist in the timing of license and maintenance revenue
recognition under the two business models? What is the effect on net income and
cash flows?
4. The NYT article suggests that CA has been under pressure to buy new firms to
maintain sales growth. Will CA be under the same pressure under the new
business model? Provide a brief analysis of revenue growth for 2000-2001 based
on the GAAP (as reported) figures and the ‘Pro-Forma’ reported figures.
5. CA argues that its pro-forma results allow an analyst to look at the income
statement on a consistent basis over time and that the GAAP statements are
misleading. Is this true? Software Revenue Recognition (AICPA Statement of Position (SOP) 97-2)
In 1996, the AICPA issued Statement of Position (SOP) 97-2 to address the
recognition of software revenue. The statement requires that a portion of software
revenue be deferred when the software arrangement consists of “multiple elements,”
such as upgrades, add-ons, and other software enhancements. The deferral is
applicable even if the elements are only delivered on a “when and if available basis.”
SOP 98-9, Modification of SOP 97-2, With Respect to Certain Transactions
In 1998, AICPA issued Statement of Position (SOP) 98-9 changing the methodology
of attributing the fair value of undelivered elements. Document View Page 1 of 7 Databases selected: New York Times The Past May Haunt Computer Associates; [Chronology]
Alex Berenson. New York Times. (Late Edition (East Coast)). New York, N.Y.: Apr 29, 2001. pg. 3.1
Abstract (Summary) Along the way, Computer Associates has become a financial giant and made Mr. [Charles B. Wang] very rich. In the
fiscal year ended in March 2000, Computer Associates reported profits of $696 million on sales of $6.1 billion, five
times the sales and profits it posted a decade earlier. It has a market value of $20.3 billion, more than Nike or
Lockheed Martin. Mr. Wang, who came to the United States from China at the age of 8, owns shares and options
worth almost $1.1 billion, according to the company’s most recent proxy. Last year, Mr. Wang and Sanjay Kumar, the
company’s chief executive, bought the New York Islanders hockey team for $187.5 million.
In fact, while Computer Associates sometimes issues news releases highlighting Unicenter clients, it is hard to find
major companies using it. Those that Computer Associates has publicly identified include Bradlees, the discount chain
that is now being liquidated, and the New Pig Corporation, in Tipton, Pa., which Computer Associates calls ”a leading
provider of cleaning products and maintenance solutions for industrial facilities.”
Now Computer Associates has few targets left. Of remaining independent mainframe software companies, the only
ones of any size are Compuware and BMC. Both are smaller than Computer Associates, and mainframe users, who
say Computer Associates already has a monopoly in many products, would object if it tried to buy either one.
Full Text (3450 words) Copyright New York Times Company Apr 29, 2001
LOOMING above the Long Island Expressway in Islandia, N.Y., the steel-and-glass headquarters of Computer
Associates certainly looks solid.
After all, since 1976, Computer Associates has grown from a three-person start-up into the world’s fourth-largest
independent software company. Led by Charles B. Wang, its chairman and founder, it has bought hundreds of
smaller rivals, gaining a choke hold on an obscure but lucrative corner of the industry. Today, it has 18,000
employees and is the dominant supplier of mainframe utility software, the programs that help big computers run
smoothly.
Along the way, Computer Associates has become a financial giant and made Mr. Wang very rich. In the fiscal year
ended in March 2000, Computer Associates reported profits of $696 million on sales of $6.1 billion, five times the
sales and profits it posted a decade earlier. It has a market value of $20.3 billion, more than Nike or Lockheed Martin.
Mr. Wang, who came to the United States from China at the age of 8, owns shares and options worth almost $1.1
billion, according to the company’s most recent proxy. Last year, Mr. Wang and Sanjay Kumar, the company’s chief
executive, bought the New York Islanders hockey team for $187.5 million.
But much of the growth that has enriched Mr. Wang was a mirage, according to more than a dozen former employees
and independent industry analysts.
Computer Associates, they say, has used accounting tricks to systematically overstate its revenue and profits for
years. The practices were so widespread that employees joked that C.A. stood for ”Creative Accounting,” and that
March, June, September and December, when fiscal quarters end, had 35 days, giving the company extra time to
close sales and book revenue.
While reporting rising revenue and profits to Wall Street, Computer Associates has infuriated clients with high prices
and poor technical support. Its heavily marketed efforts to diversify out of the mainframe business have been a painful
failure, former employees and customers say. http://proquest.umi.com/pqdweb?index=2&sid=2&srchmode=1&vinst=PROD&fmt=3&st… 9/14/2007 Document View Page 2 of 7 Over the years, it has gained a reputation as a callous employer that dismisses workers without warning while top
executives take home eight- and sometimes nine-figure pay packages. And it has so angered I.B.M., which makes
most of the mainframes that its software supports, that I.B.M. is accusing Computer Associates of charging too much
for its products. I.B.M. is now developing its own rival software.
Now, Computer Associates’ past may have caught up with it.
The company declined to make Mr. Wang or Mr. Kumar available for comment and asked that questions about its
accounting practices be sent in writing. It then declined to answer more than a dozen questions sent by e-mail.
Big acquisitions were key to the accounting maneuvers, employees and analysts say. And after two decades of
buying competitors, Computer Associates has essentially exhausted the pool of takeover targets.
As measured by standard accounting rules, Computer Associates’ sales have fallen almost two-thirds over the last six
months. To cover that, the company has begun presenting its financial results in a way that confuses even the Wall
Street analysts who follow it.
The company’s stock has been strong this year. But within the information technology industry, its problems are no
secret. ”C.A.’s got a particular challenge ahead of them,” said William Snyder of the Meta Group, a 600-employee
consulting company that advises companies about information technology. ”They have two to three years to turn it
around.”
To be sure, complaints about Computer Associates’ prices and customer support have been around almost as long as
the company, and it has always outlasted its detractors. But if former employees’ claims are accurate, the company
faces a serious crisis.
These employees declined to speak for the record. The company has a well-deserved reputation for having a fierce
legal department. Since the beginning of 2000, it has been either a plaintiff or defendant in three dozen federal
lawsuits, on issues ranging from commission disputes to discrimination claims.
But, given anonymity, people who worked in sales, accounting and marketing units at Computer Associates explained
how the company inflated its reported revenues in a way that made it look as if new products were selling better than
they were. The company’s public financial statements support their claims, they said.
The proof, in other words, is in the numbers.
ON April 16, Computer Associates reported another banner quarter.
”New Business Model Rules; Q4 Rocks,” it said proudly in a news release outlining its results for the three months
ended March 31. The company appeared untouched by the slowdown in technology spending that has hurt other big
software companies like Oracle.
Computer Associates said that on a ”pro forma, pro rata” basis, its revenue had risen to $1.44 billion for the quarter,
from $1.39 billion in the period a year earlier. Profits were 47 cents a share, it said, up from 39 cents a share.
During a conference call later, Mr. Kumar, the chief executive, and Ira Zar, the chief financial officer, accepted
analysts’ congratulations.
”Today really is a great day for us at Computer Associates,” Mr. Kumar said.
He attributed the company’s strong pro forma results to a new software licensing model that it unveiled with great
fanfare on Oct. 25. The company promised that its ”new business model” would allow it to offer customers more
flexible contract terms, including month-to-month licenses.
In addition, the new model would help Computer Associates by giving it a more predictable revenue stream, the
company said. Previously, it struggled each quarter to close enough large deals to meet Wall Street’s expectations
and discounted its software heavily as the end of each quarter approached. http://proquest.umi.com/pqdweb?index=2&sid=2&srchmode=1&vinst=PROD&fmt=3&st… 9/14/2007 Document View Page 3 of 7 ”The new business model turned out to be a competitive advantage for us,” Mr. Kumar said in the conference call.
Wall Street agreed. Over the next three days, the company’s stock soared $7.41, to $37, a gain of 25 percent. After
falling steeply from its January 2000 high of $75 to $18.13 in December, the stock has rebounded strongly this year,
closing on Friday at $35.25.
But the last line of the April 16 news release told a different story.
There, Computer Associates reported its revenue and income according to ”generally accepted accounting
principles,” the standard that companies are required to use in filings with the Securities and Exchange Commission
to calculate results. By those rules, revenue fell almost 60 percent, to $732 million, from $1.91 billion. After earning a
profit of $1.13 a share, or about $700 million, last year, the company lost 29 cents a share, or about $175 million, this
year.
The divergence followed an equally big gap in the company’s quarter ended Dec. 31. For that period, the company
reported pro forma revenue of $1.4 billion and profits of $247 million, while by the stricter standards it had revenue of
$783 million and a loss of $342 million.
Computer Associates is not the only company to highlight pro forma results — which offer investors an alternative,
usually more favorable, way to look at results — and to play down standard figures. Even so, its last two quarterly
reports were extraordinary. Many companies that make use of pro forma accounting offer a detailed road map
connecting those figures to standard results. Computer Associates did not. Nor have analysts been able to decipher
how the company is reporting its numbers.
”The pro formas are very difficult to fathom,” said Norma Schroder of Gartner Dataquest, a leading technology
consulting firm. ”I’ve spent many hours with the financial statements, and I’m still having problems understanding it.”
The company says its pro forma numbers more accurately reflect its results now that it has changed its licensing
terms. But customers and competitors say the company continues to use old sales tactics and to offer old contract
terms.
”I have not heard anything that we would be paying monthly,” said Andy Olivenbaum, who is negotiating a new
license for Florida’s Northeast Regional Data Center, which processes records for the state.
”Certainly out in the field they’re still selling the way they always sold,” said Bob Beauchamp, president and chief
executive of BMC Software, a rival mainframe software company. ”To my knowledge, we have not run into this,
quote, new model.”
Former employees and analysts have a very different explanation for the company’s effort to focus Wall Street on its
”new business model.” After years of inflating revenue and profits, Computer Associates has finally run out of
accounting maneuvers, they say. Now, they add, it hopes to persuade analysts to ignore its standard accounting
results while it unravels the mess it has created.
UNDERSTANDING how Computer Associates is said to have pumped up its revenue requires a bit of background
about the way software is sold. Big software companies usually offer clients software for a large initial fee that enables
them to use it for a year, followed by annual fees to continue using it and receive product upgrades and technical
support. The annual fees are usually 15 to 20 percent of the first year’s fee. Customers can also sign a long-term
contract and spread the initial fee, plus the annual fees, over the term of the contract. The fees increase along with
the power of the computers used to run the software.
For accounting purposes, the crucial issue that determines whether Computer Associates, or any software company,
can immediately book the fees as revenue is whether the fees are classified as license or maintenance charges.
(When the fees are supposed to be paid is nearly irrelevant, accounting experts say.)
If the fees are called maintenance, then accounting rules require software companies to book them a little at a time
over the life of the contract. But if they are considered license fees, then under some circumstances the companies
can book them immediately, even if they are to be paid over a period of many years.
By categorizing fees as related to licenses, instead of maintenance, Computer Associates could inflate its revenues in
any given quarter, at the expense of future quarters. And, subject to outside auditors’ approval, it had considerable
discretion over whether to classify fees as license or maintenance. http://proquest.umi.com/pqdweb?index=2&sid=2&srchmode=1&vinst=PROD&fmt=3&st… 9/14/2007 Document View Page 4 of 7 For at least a decade, the company has taken full advantage of that discretion, former employees say. When
Computer Associates bought other software vendors, it would try to persuade their existing customers to ”reroll,” or
extend, their license and maintenance agreements for as long as 10 years. It then classified most of the fees from the
extended agreements as new license revenue and booked it immediately.
Other software companies are more conservative in the way they split license and maintenance fees. For example,
BMC Software classifies all the fees it charges after the first year of long-term contracts as maintenance fees, and
books them over time.
”There’s a dirty little truth about the mainframe business,” said a former Computer Associates executive who worked
in its interBiz division. ”There’s not a whole lot of new mainframes going in, so a lot of what’s being booked as new
revenue is taking an existing contract that’s expiring and adding years on to it. It’s rerolling a contract.”
More than a dozen other former employees confirmed that account. ”What C.A.’s going to do is say, ‘We’re going to
give you a long-term deal here,’ ” another former executive said. ”They hire young, cute girls to basically resell
maintenance contracts.”
Sometimes, that tactic backfired. George Allen Papapetrou, a systems programmer for the school board of Alachua
County, Fla., recalled that about six years ago, the company sent a saleswoman who was ”a very attractive young
woman, but she knew nothing about mainframes.” Mr. Papapetrou added, ”Most of us are geeky-type people, so we’ll
appreciate the looks, but we certainly don’t appreciate the lack of knowledge. I felt sorry for her.”
REROLLS were not Computer Associates’ only accounting maneuver, former employees and analysts say. Wall
Street, which knew mainframes were steadily losing market share to ”client server” systems made by companies like
Sun Microsystems, wanted the company to prove it could compete in that arena. In that battle, Computer Associates’
most important software product was Unicenter, later called Unicenter TNG, which in theory lets companies map and
control their entire computer infrastructure.
Computer Associates had difficulty winning clients for Unicenter. In part, its problems stemmed from its history of
buying smaller companies, firing their support staffs and raising fees for customers who wanted to buy more powerful
computers. Those moves increased revenue and profits but alienated customers.
”I don’t think it’s any secret that a lot of us, especially in mainframe stuff, are not C.A. fans,” said Doug Fuerst, a
software consultant in Brooklyn whose clients have included big financial services companies. At technology
conferences, when people were asked if they were trying to drop ”one or more C.A. products, probably 95 percent of
the hands go up in the room,” he said.
Mr. Papapetrou said the Alachua school board now uses nine Computer Associates programs, compared with 13 four
years ago, paying about $20,000 a year, down from $30,000. ”We’ve been steadily trying to eliminate C.A. products,”
he said.
Unicenter has another drawback. Its complexity makes it difficult to install, and most companies are not able to
operate it successfully, said Donna Scott, a Gartner analyst. Both inside and outside Computer Associates, Unicenter
is derisively called ”shelfware,” or software that is bought but never used.
In fact, while Computer Associates sometimes issues news releases highlighting Unicenter clients, it is hard to find
major companies using it. Those that Computer Associates has publicly identified include Bradlees, the discount
chain that is now being liquidated, and the New Pig Corporation, in Tipton, Pa., which Computer Associates calls ”a
leading provider of cleaning products and maintenance solutions for industrial facilities.”
Unicenter and Jasmine ii, another product that Computer Associates has advertised heavily, ”are pretty hard to find in
the wild,” said Herbert VanHook, senior vice president at the Meta Group.
Yet Computer Associates has steadily reported increases in its Unicenter revenue. In fiscal 1999, it said in an S.E.C.
filing that Unicenter accounted for one-fourth of its overall revenue. By last year, Unicenter and other nonmainframe
products accounted for half the company’s overall contract revenue, it said.
It may appear paradoxical that customers would pay for software that did not work. The explanation, former
employees and analysts say, is that the company often offered Unicenter free in the maintenance rerolls it offered. In
deals called ”wrap and rolls,” it would then allocate a portion of the revenue to Unicenter, enabling it to show sales http://proquest.umi.com/pqdweb?index=2&sid=2&srchmode=1&vinst=PROD&fmt=3&st… 9/14/2007 Document View Page 5 of 7 growth to Wall Street.
”Sometimes the deals that were made, if you’re using these products, we’re going to throw in this for free,” Ms. Scott
said. ”It doesn’t mean it’s going to get implemented.”
All of this explains a puzzling trend in Computer Associates’ financial statements. At most big software companies,
maintenance fees account for more than one-quarter of overall revenue. For example, SAP, which has just passed
Computer Associates to become the third-largest independent software company, reported maintenance revenue of
485 million euros, or about $440 million, nearly one-third of its overall revenue, for the three months ended March 31.
And, not surprisingly, maintenance fees generally rise along with license fees.
Indeed, several years ago, Computer Associates’ company results were in line with industry standards. In 1992, it
reported maintenance fees of $585 million, about 39 percent of its overall revenue of $1.51 billion. The next year,
overall revenue climbed 22 percent, to $1.84 billion, while maintenance revenue rose 15 percent, to $672 million.
Then something changed. Over the next seven years, overall revenue skyrocketed, as the company made several
major acquisitions. In fiscal 2000, its overall revenues reached $6.1 billion, more than triple the level seven years
earlier.
Yet over the same period, maintenance revenue grew only 30 percent, to $877 million. As a result, in fiscal 2000,
maintenance accounted for only 14 percent of revenue.
Put another way, Computer Associates’ maintenance rose only $200 million in seven years, even though two
companies it bought over that span — Legent and Sterling Software — had each reported more than $200 million in
maintenance revenue in the last year they were independent.
IT is not clear whether the way Computer Associates prepared its financial statements broke any accounting rules.
Both Ernst & Young, which audited the company until 1999, and KPMG, its current auditor, declined comment on
Computer Associates’ practices.
But there is no doubt that rerolls and wrap-and-rolls shifted future fees into current reported revenue, pumping up the
present at the expense of the future. And once the company had rerolled an old contract, it could not reroll it again for
several years. So to keep reporting growth, employees say, the company needed to find a steady supply of new
contracts to turn over.
So the company began buying ever-bigger companies. In 1995, it bought Legent for $1.8 billion in cash, at the time
the largest takeover in the history of the software business. The next year, it acquired Cheyenne Software for $1.2
billion in cash. In July 1999, Computer Associates bought Platinum for $3.5 billion in cash. And last year, it picked up
Sterling for $4 billion, its biggest acquisition yet.
Now Computer Associates has few targets left. Of remaining independent mainframe software companies, the only
ones of any size are Compuware and BMC. Both are smaller than Computer Associates, and mainframe users, who
say Computer Associates already has a monopoly in many products, would object if it tried to buy either one.
Its core franchise, meanwhile, faces a powerful challenge from I.B.M., which says Computer Associates is hurting its
sales of new mainframes. Computer Associates’ fees rise as its clients install faster computers, so a company that
buys new I.B.M. hardware must also pay much higher fees for software that is sometimes decades old.
Other software vendors also raise fees when clients install new hardware, but Computer Associates’ price increases
are excessive, I.B.M. asserts, especially since the company provides little support. After years of asking Computer
Associates to cut prices, I.B.M. has decided to develop its own utilities and compete head to head.
”In the last three years we’ve been systematically upping our investments,” said Steve Mills, head of I.B.M.’s software
unit, which has annual sales of $13 billion. ”This is our business that they are damaging.”
JUST before midnight on Monday, July 3, 2000, as most Wall Street analysts were enjoying a four-day holiday
weekend, Computer Associates announced that its revenues and profits would fall far short of expectations. On
Wednesday, July 5, when stock markets reopened for trading, angry investors sent its stock down $21.63, or 42
percent, to $29.50. The sell-off shaved more than $12 billion from Computer Associates’ market value. http://proquest.umi.com/pqdweb?index=2&sid=2&srchmode=1&vinst=PROD&fmt=3&st… 9/14/2007 Document View Page 6 of 7 Three months later, the company announced plans to switch to its ”new business model” and discouraged analysts
from judging its results by standard accounting rules.
So far, Wall Street has complied. But as other companies have found, inv…