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EUGENE SOLTES

A Letter from Prison

On February 14, 2008, Stephen Richards, inmate #71320-053 at Taft Federal Correctional Institution, completed a letter to Eugene Soltes, a student at the University of Chicago Booth School of Business. Richards was the former global head of sales at Computer Associates. Exhibit 1 provides the list of questions Soltes asked Richards. Exhibit 2 is a copy of the letter Soltes received in return.

________________________________________________________________________________________________________________
Professor Eugene Soltes prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2009, 2010, 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

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Computer Associates and Stephen Richards
Computer Associates International, Inc. (CA) began as a four-person start-up in 1976. Its founder, Charles Wang, sought to fill a growing need for mainframe computing software for IBM computers. Computer Associates offered a range of products, including database, application, and financial management software, to fulfill the computing needs of businesses.1 In 1988, soon after graduating from Avondale College in Australia, Stephen Richards joined CA's Sydney office. Within two years, Richards became manager of the Brisbane sales office. Richards impressed management, soon receiving a promotion to run the New Zealand office and then, two years later, the Australia office. By 1995, Richards was a leading regional figure for CA as the senior vice president of the Pacific region.2 Richards’ rise at CA paralleled the rapid growth of CA as a firm. During the 1980s and 1990s, CA acquired numerous competitors and firms producing complementary software products. By the late 1990s, CA had almost 18,000 employees and subsidiaries in nearly 100 countries. In April 1999, Richards caught the eye of CA President Sanjay Kumar and was promoted to lead one of Computer Associates’ North American regional offices with over 3,500 employees. Soon after, in April 2000, Richards was promoted to global head of sales.3 Richards’ growing responsibility and success was rewarded accordingly with a half-million dollar base salary and generous option compensation. For most software products that the CA sales team sold, clients purchased a license to use the product for a period of three to ten years. During the licensing period, CA provided software updates and technical support. Fees increased with the length of the contract, although each additional year of licensing was priced lower than the previous year to reflect software obsolescence. With even a small contract, the fees could amount to hundreds of thousands of dollars. When a license contract was finalized, CA allocated revenues to licensing fees and to usage and maintenance fees. Normally, at least 80% was allocated to the licensing fee. Under Generally Accepted Accounting Principles (GAAP), revenues from software licensing were recognized once a contract was signed, the software was delivered, and payment was reasonably assured. Once these three conditions were met, a software firm could recognize the entire value of the licensing fee as revenue. In accordance with GAAP, CA recorded the entire present value of the licensing contract in the quarter when the revenue recognition criteria were met. The immediate recognition of the entire value of multi-year software licenses in the quarter the contracts were finalized created numerous challenges for CA management. One analyst noted that “customers learned, or were advised by consultants, that the later into a quarter they waited to sign a contract, the more likely they were to get a better deal (bigger discounts, extended payment terms, free services, etc.). . . . Moreover, the bigger the deal, the more likely that the prospect would use such

1 For more information on Computer Associates, see Amy Hutton, “Computer Associates International,” HBS No. 102-061 (Boston: Harvard Business School Publishing, 2002) and Paul M. Healy and Krishna Palepu, “Computer Associates International, Inc.: Governance and Investor Communication Challenge,” HBS No. 103-107 (Boston: Harvard Business School Publishing, 2003). 2 Amanda Wells, “Rising Through the Ranks,” InfoTech Weekly, March 5, 2001. 3 Peter Griffin, “After Long Months, It’s Long Years,” New Zealand Herald, January 6, 2007.

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delaying tactics.”4 Consequently, a significant portion of CA revenue was commonly booked during the final week of the quarter. Each quarter, management set internal sales targets. With a “sales-driven culture,” sales associates were under immense pressure to hit these sales targets. The sales associates were also incentivized by commissions that were tied to these targets. Those sales associates who met or exceeded their sales targets were richly rewarded. It was not uncommon for a successful sales associate to receive over a million dollars in compensation.5 Despite the challenges and pressures, CA prospered during the 1990s. Computer Associates reported that 95% of Fortune 500 companies used CA software and that CA trailed only Microsoft and Oracle in total sales in the software industry. In addition, Fortune magazine named Computer Associates one of America’s “most admired” companies. When asked about his job by a reporter, Richards said, “I love my job. It’s fantastic.”6

Allegations against Computer Associates
Over time, management found it increasingly difficult to accurately forecast revenues and earnings each quarter. In some cases, management found itself unable to warn analysts about unexpected shortfalls in revenue until the quarter was over. In July 2000, CA announced that its financial results for the first quarter of 2001 would “be less than current Wall Street estimates.”7 Computer Associates management noted that “several large contracts, previously expected to close in the final day of the quarter,” contributed to this shortfall.8 In response, CA’s stock fell by 42%. On April 29, 2001, the New York Times published an article that suggested CA management had employed overly aggressive accounting practices to boost earnings. The article said “the practices were so widespread that employees joked that C.A. stood for ‘Creative Accounting.’”9 However, aggressive financial reporting was not an uncommon charge for a rapidly growing and successful firm like CA. Numerous pieces of evidence suggested that earnings management—the managerial use of discretion to influence reported earnings—was a widespread corporate practice (Exhibit 3). In response to the New York Times article, CA issued an eight-page response which, among other things, defended its accounting practices. In this April 30, 2001, response, CA wrote that its auditor, KPMG LLP, reasserted “that the financial statements were presented, in all material respects, in accordance with generally accepted accounting principles.”10

4 Deutsche Bank Equity Research, “Computer Associates,” November 9, 2000. 5 Griffin, “After Long Months.” 6 Wells, “Rising Through the Ranks.” 7 Computer Associates press release, July 3, 2000. 8 Laura Johannes, “Computer Associates Says Latest Results Will Be Hurt by Delays in Big Contracts,” Wall Street Journal, July

5, 2000.
9 Alex Berenson, “The Past May Haunt Computer Associates,” New York Times, April 21, 2001. 10 Computer Associates, Form 8-K, April 20, 2001.

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DOJ and SEC Investigation
Despite public reassurances from CA that their accounting procedures followed GAAP, the allegations drew the attention of federal investigators at the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC). Kumar reassured concerned board members that the claims against the firm were unfounded. Nevertheless, CA’s board enlisted the firm’s general counsel, Steven Woghin, to examine the allegations. Preliminary discussions with individual managers and the available documentation did not seem to support claims against the firm. However, in July 2003, federal investigators expressed dissatisfaction with CA’s internal investigation of the allegations. Faced with this criticism, CA’s board hired the prestigious law firm Sullivan & Cromwell to investigate more aggressively. Attorneys and forensic accountants carefully combed through employee computers and Woghin provided attorneys with twenty-three boxes of documents that were originally missing. Within three months, the team of investigators found sufficient evidence to implicate the firm’s CFO, Ira Zar, of facilitating the backdating of some contracts. On October 7, 2003, Walter P. Schuetze, director and chairman of the audit committee, called the board together to announce that there was definitive evidence that CA employees had backdated some contracts. The following day, the firm issued a press release that stated CA “found that a number of software contracts . . . appear to have been signed after the end of the quarter in which revenues associated with such contracts had been recognized. Those revenues should have been recognized in the quarter in which the contract was signed . . . at the same time, the committee has found no evidence to suggest that the revenues and cash flows associated with these contracts were not genuine. The contracts were valid, products were delivered, and the cash was received.”11 However, due to the improper recognition of revenues, three executives were forced to resign, including Zar and two of his subordinates. Although Kumar, Richards, and other executives denied any involvement in the backdating during meetings with attorneys from Sullivan & Cromwell, federal prosecutors strongly believed that other senior officers were also culpable. If prosecutors were correct and management was obstructing the investigation by misleading investigators, CA as a firm could be indicted for serious wrongdoing.12 The attorneys redoubled their efforts, with a focus on Kumar and other senior management. Eventually, in April 2004, the attorneys discovered a number of e-mail exchanges that implicated Kumar and later Richards. On April 26, 2004, Richards resigned from Computer Associates, and by September, the SEC filed a formal complaint against Richards. In the complaint, the prosecutors alleged that Richards, as global head of sales at Computer Associates, facilitated the extension of the fiscal quarter, allowed subordinates to obtain contracts after the quarter end, and failed to alert the finance and accounting departments about contracts that may have been backdated. The complaint also detailed how the misreporting affected revenues and earnings during the 2000 and 2001 fiscal years (Exhibit 4). The complaint alleged that this misconduct occurred between the fourth quarter of 1998 and the second quarter of 2001. Along with Richards, six other executives of Computer Associates were indicted on similar charges. This included CA’s general counsel, Woghin, who later admitted that he coached executives to mislead investigators.

11 Computer Associates press release, October 8, 2003. 12 Charles Forelle and Joann S.Lublin, “In CA Probe: Recovered E-mails, Surprise Cache of Documents,” Wall Street Journal,

September 24, 2004.

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On April 24, 2006, Richards pleaded guilty and was sentenced to seven years in the Taft Federal Correctional Institution in California. Reflecting on the situation, Richards stated he felt that there was an important difference between Computer Associates and other well-publicized corporate scandals: “WorldCom bankrupt, Enron bankrupt, Adelphia bankrupt, it’s a radically different environment to those. There were no shell companies where liabilities were hidden or liabilities converted into assets or any of that kind of stuff. This was simply a timing issue of a deal coming in and being recognized two or three days earlier as opposed to two or three days later.”13

13 Stephen Richards, interview by Peter Griffin, “After Long Months, It’s Long Years,” New Zealand Herald, January 6, 2007.

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Exhibit 1

Questions for Stephen Richards

1. 2. 3. 4. 5. 6. 7. 8. 9.

Can you describe how your performance at Computer Associates was measured and the challenges you faced in trying to achieve your performance goals? How did these forces influence you, other managers, and your board’s decision making? What effect did these goals have on your success at the firm? Can you discuss the management of earnings and financial performance? Did you feel that this managerial flexibility led to more severe problems? What role did compensation play in your decision making? How do you think the growth in option compensation may have affected decision making? Are there any additional forces that shaped your decision making? Do you believe that you will be able to participate in business in the future?

10. How have the events affected you socially? 11. Do you have any additional thoughts that would be insightful to help understand the dilemmas and challenges faced by managers and by those who are not yet managers?

Source:

Casewriter.

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Exhibit 2

Letter from Stephen Richards

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Exhibit 2 (continued)

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Exhibit 2 (continued)

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Exhibit 2 (continued)

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Exhibit 2 (continued)

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Exhibit 2 (continued)

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Exhibit 2 (continued)

Source:

Letter from Stephen Richards to Eugene Soltes.

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Exhibit 3

Earnings Management

Description
Earnings management is the managerial use of discretion to influence reported earnings. Numerous other phrases, including “aggressive accounting,” “financial statement management,” and “income smoothing,” are often used to describe earnings management. The practice arises from flexibility in accounting choices and management’s ability to time and change real business decisions. Within the accrual accounting system, managers have significant discretion with their firms’ accounting choices. Management has the ability to make choices that can opportunistically lead to higher or lower reported earnings. Examples of accounting estimates that can be understated or overstated include: – – – – – Provision for bad debt Size of an allowance for uncollectible accounts Need and size for inventory write-downs Useful life and salvage value for depreciation Rate of return expected on pension assets

Management can also make real business decisions with the primary objective of manipulating reported earnings (i.e., “real earnings management”). Unlike actions taken within the accounting system, these choices affect both earnings and the underlying cash flows of the firm. Examples of real earnings management include: – – – Decelerating research and development Postponing advertising expenditures Changing a product release date

Frequency
In a speech titled “The ‘Numbers Game,’” the former chairman of the SEC, Arthur Levitt, described the practice of earnings management as “widespread.” He noted that the practice “has swelled in a market that is unforgiving of companies that miss their estimates.”a Several pieces of academic evidence provide support that earnings management is pervasive among publicly traded firms.

Survey evidence of accounting choice and real earnings management: A survey of 312 CFOs and financial executives found that 59% would forgo a project with a positive net present value (NPV) if undertaking the project would cause their firm to fall short of the analyst consensus forecast. Eighty percent of the executives would choose to decrease discretionary spending (e.g., R&D or advertising) to hit a desired target. In addition, nearly 25% agreed that their firm might draw down on reserves previously set aside, postpone taking an accounting charge, or repurchase common shares to achieve the desired earnings target.b Large sample evidence of the tendency for firms to marginally meet or exceed analyst benchmarks: Figure A shows a histogram of annual earnings surprises. The earnings surprise is the difference between a firm’s reported earnings-per-share (EPS) and the analyst’s forecasted EPS.

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The figure shows that the number of firms narrowly beating expectations (.01) significantly exceeds the number of firms narrowly missing expectations (-.01). This evidence suggests that managers may be managing earnings to marginally meet or exceed analyst expectations.c Figure A

Large sample evidence of earnings smoothing: An unexpectedly large number of firms report consistent strings of earnings increases in spite of fluctuations in economic conditions and changes in the business cycle. One study examined data from the early 1960s to 2004 and found that 746 firms reported increasing EPS for at least 20 consecutive quarters. In addition, when operating income was low, firms had a higher tendency to report more positive special items.d Similarly, when operating income was high, firms had a tendency to report more negative special items.e

aArthur Levitt, “The ‘Numbers Game,’” Speech given at the NYU Center for Law and Business, September 28, 1998. bJohn R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,”

Journal of Accounting and Economics, 40 (2005), 3-73. cSanjeev Bhojraj, Paul Hribar, Marc Picconi, and John McInnis, “Making Sense of Cents: An Examination of Firms that

Marginally Miss or Beat Analyst Forecasts,” Journal of Finance, 64 (2009), 2361-2388. dSpecial items are charges that are infrequent or unusual in nature. Accounting Principles Board Opinion No. 30 (Reporting

the Results of Operations). eJames N. Myers, Linda A. Myers, and Douglas J. Skinner, “Earnings Momentum and Earnings Management,” Journal of

Accounting, Auditing and Finance, 22 (2007), 249-284.

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Exhibit 4

Effect of Earnings Management at Computer Associates

Fiscal Quarter Q1, FY2000 Q2, FY2000 Q3, FY2000 Q4, FY2000 Q1, FY2001 Q2, FY2001

GAAP Value of Revenue Properly Recorded $977,165,281 $1,047,256,904 $1,239,902,741 $1,748,131,031 $1,135,600,000 $1,462,040,000

GAAP Value of Contracts that CA Signed After Quarter End $122,230,689 $90,099,723 $170,450,718 $179,493,620 $126,740,000 $214,720,000

GAAP Value of Contracts that Clients Signed After Quarter End $122,604,030 $467,643,373 $401,646,541 $199,375,348 $15,660,000 $4,240,000

GAAP Value of Revenue Improperly Accelerated and Recorded $244,834,719 $557,743,096 $572,097,259 $378,868,969 $142,400,000 $218,960,000

Percentage that Properly Recorded Revenue Was Inflated by Improperly Accelerated Revenue 25% 53% 46% 22% 13% 15%

Fiscal Quarter Q1, FY2000 Q2, FY2000 Q3, FY2000 Q4, FY2000

Total Revenue Properly Recorded $977,165,281 $1,047,256,904 $1,239,902,741 $1,748,131,031

Total Revenue Improperly Recorded $244,834,719 $557,743,096 $572,097,259 $378,868,969

Analyst EPS Estimate $0.47 $0.59 $0.90 $1.13

Announced EPS $0.49 $0.60 $0.91 $1.13

EPS without Improperly Recognized Revenue $0.29 $0.05 $0.31 $0.82

Source:

SEC v. Sanjay Kumar and Stephen Richards, 04 Civ. 4104 (E.D.N.Y.)(Glasser, I.L.), September 21, 2004.

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