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How serious was the fraud at Computer Associates?

Knowledge@Wharton examines whether the software maker's offense really constituted a crime or should it fall under the heading of no-harm, no-foul?

How serious was the fraud at Computer Associates?
From Knowledge@Wharton
Special to CNET News.com
October 13, 2004, 12:00 PM PDT

The $3.3 billion securities fraud case against Computer Associates has been called the last of the big Enron-era cases, involving alleged practices termed "the 35-day month," "the three-day window" and the "flash period." Certainly, there are some parallels: Each case involved a multi-billion dollar fraud that required participation by a wide group of top executives and others further down.

But the cases of the Houston energy-trading firm and the Islandia, N.Y., software giant are also different. Enron executives engaged in an extraordinarily complex hoax, creating a raft of outside businesses that could be used to conceal the firm's mammoth debt. Computer Associates executives are accused of something far more prosaic: keeping the books open a few days after the end of the reporting period so revenue could be counted a quarter earlier than it ought to have been.

Computer Associates executives are 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?

It is indeed a serious offense, says Scott Richardson, professor of accounting at Wharton. "While it appears innocuous to say it is revenue one day early, this type of practice allows companies to draw on future earnings to deliver earnings and revenue growth, to help justify high (price-to-earnings) multiples," he notes, adding: "Clearly, while this appears innocuous, the consequences are far from that."

Documents filed by the SEC and Justice Department show that the timing of infractions at Computer Associations required the participation not just of a few top executives but of many people.
Late in September, the company agreed to pay $225 million in restitution to shareholders to settle a civil case brought by the Securities and Exchange Commission 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 Computer Associates chairman and CEO Sanjay Kumar and the firm's former head of worldwide sales, Stephen Richards. Both men were forced to resign in April, about two years after the scandal broke. They have denied wrongdoing. A number of other executives were implicated as well.

In announcing the settlement, Mark K. Schonfeld, director of the SEC's Northeast Regional Office, boiled the case down to its essence: "Like a team that plays on after the final whistle has blown, Computer Associates kept scoring until it had all the points it needed to make every quarter look like a win."

The SEC said the scheme began in 1998, possibly earlier, and continued through September 2000. In all, the company prematurely reported $3.3 billion in revenue from 363 software contracts. This violated Generally Accepted Accounting Principles, or GAAP, which state that revenue should not be counted until both parties have properly signed a contract. During the four quarters of fiscal 2000, for example, the practice improperly inflated revenues by 25 percent, 53 percent, 46 percent and 22 percent, respectively. The SEC said the goal was to meet or beat per-share earnings estimates of Wall Street analysts, a key to keeping a company's stock price rising.

The most extreme incident was the second quarter of 2000, when the company reported $557 million in revenue beyond the $1.05 billion it could properly claim. The company thus reported 60 cents in earnings per share, beating the consensus Wall Street forecast of 59 cents. Without the padded revenue, earnings would have been a mere 5 cents per share and the stock price might well have fallen.

The victims in the case were the shareholders who were led to believe the company was more profitable than it was, Richardson says. They paid more than they should have for the stock, or kept in when, had they known the truth, they would have sold. These shareholders suffered enormous losses once the practices were revealed. When the company stopped the practice at the end of the first quarter of 2001, it fell short of the Wall Street earnings estimate and the share price fell by more than 43 percent in a single day. Shares currently trade around $27, down from more than $71 early in 2000.

There was another class of victims as well--employees. Late in September, the company said it would trim its workforce by 800 people, or 5 percent, in order to pay the $225 million settlement.

Richardson notes that companies are not required to keep mum about revenues received after a reporting period ends. These "order backlogs" can be detailed in quarterly reports so long as they are not in the quarter's revenue and earnings calculations.

Fixation on numbers
In theory, investors should care little whether a deal is signed by the end of the quarter or a few days later, so long as the details are accurately reported. But in practice, investors tend to focus on the quarterly revenue and earnings targets. "People, for whatever reason, are fixating on certain numbers in the financial statement. If it's not in the quarter, it's not as good," Richardson says.

At Computer Associates and many other companies, big portions of executives' compensation depend on meeting specific goals. Inflated figures meant Computer Associates executives were paid more than they should have been--extra compensation that came from shareholders' pockets.

Moreover, executives at Computer Associates were big shareholders themselves, and many held enormous blocks of stock options. They therefore had a big financial stake in the share price, and thus an incentive to inflate results. "There will always be cases where incentives to manage earnings are particularly acute for a given firm at a given time, and if you have an unethical management, they will push the envelope," Richardson says. Indeed, he adds, improper timing of revenue recognition is "by far the most common" reason companies are forced to restate earnings.

While outside auditors are sometimes blamed for not catching the practice, auditors must rely on data from their clients, and timing infractions can be very hard to spot, according to Richardson. Investigators say Computer Associates simply backdated contracts, so that auditors would see that the paperwork confirmed the company's claims.

Richardson argues that boards of directors and their compensation committees in particular should be careful not to inadvertently give executives incentives to cook the books. An executive sitting on a huge block of options about to vest may well get "a very myopic focus" about meeting analysts' revenue and earnings projections, he said, noting that directors should be especially vigilant at such times.

Richardson does not believe the Computer Associates case and others like it point to the need for regulatory reform. The accounting flexibility available to public companies is necessary, he notes, even though it makes some breaches hard to detect. "Everything in the financial statements is a result of choice--of some exercise of financial discretion. If you eliminate choice, statements will be meaningless."

The best way to address cases like that of Computer Associates is through rigorous enforcement of existing rules and severe punishment for violators, he suggests.

Documents filed by the SEC and Justice Department show that the timing of infractions at Computer Associations required the participation not just of a few top executives but of many people, including lower level people in sales. The government also alleges top executives clearly knew what they were doing was wrong and went to great lengths to cover up. Obstruction of justice is among the charges against Kumar and Richards.

How does a clearly improper practice become so firmly rooted? In many cases, says Thomas W. Dunfee, professor of legal studies and ethics at Wharton, "the organization's values have evolved in such a way that they are perverse when they are objectively viewed from outside...Sometimes you have companies that start getting an adversarial view of the world." In addition, Dunfee notes, studies have shown that "people who have been with an organization longer tend to see the organization's values as compatible with theirs.

"I don't think that anybody actually sets out to establish evil norms," he adds. "It's just that they develop ways of looking at things where they frame issues in a way that ultimately becomes more and more incompatible with the outside world."

A healthy company can minimize the risk of this downward slide by encouraging and protecting whistleblowers, Dunfee suggests. That way, problems are addressed internally--well before they become big enough to drag the entire company over the cliff.

 
To read more articles like this one, visit Knowledge@Wharton.

All materials copyright © 2004 of the Wharton School of the University of Pennsylvania.

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