A Letter From Prison

A Letter from Prison Written Analysis of the Case I.

Summary of the Case A student of the University of Chicago, Booth School of Business, Eugene Soltes, made a

list of questions to Stephen Richards, a former global head of sales at Computer Associates, about his opinion on the allegations against Computer Associates that happened during the year 2000s. Computer Associates International, Inc. (CA) began in 1976, and was established by Charles Wang, who wanted to feel a growing need for mainframe computing software for IBM computers. CA offered variety of products that includes database, application, and financial management software. Most of the software products are sold by the sales team to clients who purchase a license to use the product for a period between three to ten years. CA also provides software updates and technical support to its clients during the period of licensing. The fee of licensing charged by the CA to the clients increases with the length of the contract, as well as each additional licensing year was priced lower as compared to the previous year in order to reflect software obsolesces. The CA distributes the revenues obtained from the clients to licensing fees as well as to usage and maintenance fees once the contract of the license between the company and the client is finalized. At least 80% of the revenue is allocated to the licensing fee. Generally, under GAAP, revenues from software licensing were recognized once a contract was signed, the software was delivered, and payment was reasonably assured. Once all of the three conditions are 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. CA has a “sales-driven culture” that sales associates were under immense pressure to meet the sales targets. Each quarter, management sets internal sales targets for the sales team. Sales associates who met or exceeded their sales targets were handsomely rewarded with the sales incentives are given to the immune pressure to meet these targets. In the early 2000s, the management found it hard to accurately forecast revenues and earnings for each quarter in the year, and found that they are unable to warn the analysts about the unexpected shortfalls in revenue. There is allegation about fraud within the company by few executives of the CA. The CA had greatly implemented the approach of aggressive accounting practices in order to boost the earnings. But evidences proved that the company is applying all the accounting practices in accordance with GAAP. This

allegation got the attention of the federal investigators at the DOJ and SEC who showed dissatisfaction with the internal investigation of the company. The company faced much criticism that deeply affected their status. So, the company hired a prestigious law firm in order to investigate more aggressively. It is determined from the investigation that the few employees of the CA, Ira Zar who is the CFO and his subordinates, had backdated some of the contracts. in addition It also appeared that the revenues related to such contracts had been recognized after the end of the quarter which must be recognized in the quarter in which the contract has been signed. The investigators redoubled their efforts in investigating focusing on President Sanjay Kumar and other senior management. In the complaint, the prosecutors alleged that Richards smoothed the progress of the extension of the fiscal quarter, allowed subordinates to obtain contracts after the quarter end, and failed to inform the finance and accounting department about the backdated contracts. The complaint also contains how misreporting affected revenues and earnings. On April 2006, Richards pleaded guilty and was sentenced to seven years in the Taft Federal Correctional Institution in California. II.

Statement of the Problem The pressure being imposed by the executives of Computer Associates, Inc. to meet

market expectations has led the employees of the entity to rely more on aggressive means of accounting for revenues. Although the entity has initially regarded such reporting as a strategy to improve performance (at least in the financial statement level), in the long run, the line between legal and illegal reporting has become blurry. Such circumstance has later resulted to legal cases and suits for the entity. Considering the above factors, what change in policy could facilitate reporting of true performance (earnings) while mitigating the probable losses involving stakeholder’s (investors, shareholders, creditors, and employees) interests in the long run? III. 1.) 2.) 3.) 4.)

Objectives: To be able to amend existing policies ( e.g. compensation and accounting practices) To reduce pressure for committing fraudulent activities To report true earnings To be able to maintain stakeholder (investors, shareholders, creditors, and employees) relationships

5.) Improve entity performance despite the possible losses involved with the chosen alternative. IV. Areas for Consideration A. SWOT Matrix STRENGHTS

INTERNAL

1. Competitive employees 2. Established and known company 3. Right compensation (employees are motivated to work harder) 4. Goal-oriented 5. Sales driven culture

EXTERNAL

OPPORTUNITIES 1. Many subsidiaries 2. Market for products 3. Product development

WEAKNESSES 1. Most boards have no enough involvement 2. Most boards lack a strong background 3. Fraud vulnerability 4. Sales driven culture

THREATS 1. Investors’ reliance on analysts’ estimates 2. Competitors 3. Stakeholder relationship

B. Analysis of SWOT Computer Associates was among the most aggressive company when it comes to its pursuit of goals. Because of its considerable success, CA became a well –established and known company and was even featured in Fortune magazine and described as one of America’s “most admired” companies. With a “sales- driven culture”, sales associates were under immense pressure to hit these sales targets. This kind of culture has both advantage and disadvantage. The employees are very competitive in this kind of environment but due to the immense pressure, which is one of the legs of a fraud triangle, the company is very vulnerable to fraud.

Most Boards lack a strong background in the market place they represent and since they are too far removed from the day to day aspects of the business they struggle to add value on the strategic aspects of the business. Given that CA is a very big company that has a lot of subsidiaries in nearly 100 countries, it has a lot of opportunities in which the company can enjoy like a larger share in the market, and a lot of resources that can be used to make a research and development for the new and existing products. In this line of business competition is very intense because of many complementary products available in the market and because of the demand for products is very elastic and dynamic. A possible threat in the company is the investors’ reliance on analysts’ estimates rather than the direct communication with the company. Relying solely on information that the analyst provided can be detrimental to the company, especially when market expectations set by the outside parties are not met by the company. Existing and potential investors may pull- out/ backout their investments when such situation will occur. V.

Alternative courses of Action

1.) Reduce pressure for fraud and decrease compensation expense This change in policy would include the re-establishment of the commission policy in the entity. Instead of having a sales basis compensation plan (which is limitless), the entity would instead set a limit to the compensation to be received. Compensation would then be set to not exceed the basic salary of employees. If Computer Associates, Inc. will decrease the compensation expense then the objectives previously identified will be met. First, the group has made it a point to reduce the pressure (both internal and external) existing in the company. It is to be emphasized that backdating of revenues would be eliminated and the pressure concerning the meeting of analysts’ forecasts would be reduced. Not that the entity would completely ignore the market forecast but instead would use it as a guide to improve entity performance. Second, true earnings would be reported and stakeholder relationship would be maintained. Even if market expectations are not met, the entity would prioritize true financial reporting than stakeholder’s interest. This may seem unethical at

first but, in the long run reporting manipulated earnings would mislead investors and eventually affect their future decisions. Third, this alternative poses an opportunity to eventually increase revenue in the long run. The market expectation would still be critical in this circumstance not that it would set the actual goal that should be met but rather it would be the goal that would help the entity assess whether its performance is consistent and improving. 2.) Reduce pressure for fraud and utilize entity resources Computer Associates’ operations currently offer a range of products, including database, application, and financial management software, to fulfill the computing needs of businesses. It is evident in exhibit 4 that without earnings management, the earning of the company is fluctuating. However, they should take note that the entity is still earning. Therefore, the entity could use this established market of their current products as basis for improving future performance. The objectives identified are also met using this alternative. However, instead of reducing the compensation expense, we direct the entity’s effort to utilizing the entity’s current resources. First, in this alternative, fraud is also reduced. It is to be emphasized that backdating of revenues would be eliminated and the pressure concerning the meeting of analysts’ forecasts would be reduced. As with the first alternative, the forecasted market expectation will only serve as a guide. Second, true earnings would also be reported and stakeholder relationship would be maintained. Third, this alternative poses an opportunity to eventually increase sales in the long run. In this alternative, the entity will develop the current products and possibly market them to new classes of customers. In this way, the entity could show that there’s still an intention to improve performance so as to meet the target, but not actually to the point of manipulating earnings to achieve the expectations of third parties. 3.) Reduce pressure for fraud and offer IT services This alternative has met the objectives just like the other alternatives. There is a need to reduce pressure for fraud so that the management won’t resort to fraudulent means like backdating just so they can meet market expectation. Not that the entity would completely ignore the market forecast but instead would use it as a guide to improve entity performance. True earnings would be reported and stakeholder relationship would be maintained. The third

alternative also suggests CA to offer IT Service Management. . Offering this kind of service will increase CA’s revenue, as well as increasing its versatility as a software business. VI. Recommendation Through weighing the advantages and disadvantages of each alternative, we therefore recommend alternative 3, which is to reduce pressure for fraud and offer IT Service Management. Before giving the specifics of the chosen alternative, we present the following reasons why the other alternatives were not chosen: The first alternative is not chosen because decreasing compensation expense, meaning, decreasing or limiting the compensation (such as bonus) to be received by employees can actually lead to employees being less motivated to reach sales target. Even though reducing compensation expense leads to greater profit, this can be offset by the decreasing sales caused by employees who are less motivated to meet sales target. Employees will become less concerned about meeting the needed sales, it will eventually lead to decreased/decreasing sales. On the other hand, though alternative 2 addresses the former problem identified in the 1st ACA, this alternative also involves some other areas of concern. As a software company, the risk of developing new software products, considering their nature, is risky. The market for these products is limited and is threatened by the existence of bigger competitors. (Microsoft and Oracle). Furthermore, we can't deny the fact that technology comes in many similar forms. A lot of companies sell the same software with just small differences in components or processes. If the goal is to improve performance though an increase in revenues, then selling or developing products which are not unique rom other sellers, will prove to be ineffective in reaching the said objective in the long run. The following are the details of the chosen alternative: It is to be noted that each alternative has something in common and that is to reduce pressure for fraud. There is a need to reduce pressure for fraud so that the management won’t resort to fraudulent means like backdating just so they can meet market expectation. Means such as backdating do not reflect true earnings of the entity, can give the wrong impression about the entity and misinform the current clients and investors, and potential clients and investors about the true performance of CA. How do we reduce pressure for fraud?

Instead of using market expectation as their basis for its performance, the entity should just focus on using market expectation as their guide to improve their performance. Thus, even if market expectations are not met, the entity should still prioritize true financial reporting so that investors are not misled. If they do not meet market expectation, they should use it as their drive to do better and improve their performance. Another way to reduce pressure for fraud is to reduce opportunity for fraud. How to reduce opportunity for fraud? The most effective way is to amend their existing fraud policies by implementing effective means of preventing and detecting fraud. One way is to set up punishment for people who commit fraud, no matter their position in the company. Those people who will be proven to commit fraud can be suspended or terminated. They can also establish a hotline which can be used for anonymous tips regarding any fraudulent activity. This will make employees deter from committing fraud, thus reducing opportunity for fraud. The third alternative also suggests CA to offer IT Service Management. IT Service Management is, by definition, a strategic approach to designing, delivering, managing and improving the way information technology is used within an organization. The goal of IT Service Management is to ensure that the right processes, people and technology are in place so that the organization can meet its business goals. Offering this kind of service will increase CA’s revenue, as well as increasing its versatility as a software business. Since CA is in the business of creating software, it can be assumed that offering IT service management will not be so much of a problem for them since it is within their expertise. Another advantage of this is, when customers will purchase in the future, it is highly probable that they will also choose CA for IT service management. This can lead to stronger customer relationship and loyalty. Their current and potential customers will not feel the need to look for another company who offers IT service management because CA will already offer it. Furthermore, the new market of customers may compensate for the risks involved in the production of software alone. Through implementing this alternative, the entity will be able to expand and attract new customers and eventually earn revenue that may increase performance in the long run.