Premature Revenue Recognition in the Software Industry

Team 105: Qin Li, Zhuting Meng, Xue Shao, Yang

Yang, Jie Yin

 

AgendaAccounting Issue & Relevant Regulations

Case Studies of Three Software Companies

Technical Analyses (CAR, Jones Model, Ratio)

Auditing Guideline

Prediction

Conclusion

Motivation

The software industry employs more than 2 million people in the US in 2013

The contribution of software industry to GDP up to $361 billion in 2013

The economic and technical characters of the software industry make  revenue recognition become a very complex issue

Premature Earning Recognition Premature revenue means revenue is

recognized for a legitimate sale in a period prior to that called for GAAP

Mostly frequently used earnings management trick for publicly traded software company

Case 1: Computer Associates International, Inc.

BackgroundA Fortune 500 companyOne of the world’s largest software companies

Fraud Scheme: prematurely reported $2.2 billion in revenue from software contracts (1999-2000)Recognized revenue from contracts that were not

executed

ConsequencesStock price dropped over 43%8 executives pleaded guilty

Case 2: MicroStrategy, Inc.Background

Founded in 1989A provider of software consulting services

Fraud Scheme involved multiple-element transactionsPrematurely recognized revenue from the service element

ConsequencesOn Mar. 20, 2000, announced to restate for FY 1998 and

1999Stock price dropped over 60%

Product

Element

Service

Element

Multiple Element Transac

tion

Revenue Recognition for Product Element in Multiple-Element Transactions

Recognize revenue from the product element only if: Product element is

separable from service element

Revenue from the service element is deducted

Case 3: Lucent Technologies, Inc.

BackgroundFormed in 1996 as an AT&T spin-offDesigns and provides systems, services, and software

Fraud Scheme: aggressive accounting practicesBooked revenues before they have been earned or

become realized Eg: A $135 million transaction with Winstar Communications

included credits toward future purchases of products and services

ConsequencesOn Nov. 21, 2000, announced to restate its financialsStock price dropped about 16%

Technical Analyses--- CAR

CAR(-1,1) CAR(-1,0) CAR(0,1)

Computer Associates International Inc. -0.282240225 0.026346423 -0.283624073

MicroStrategy Inc. -0.121581858 -0.075054234 -0.065964426

Lucent Technologies -0.10422436 -0.13871302 -0.123126804

Technical Analyses--- Discretionary Accruals (Jones Model)

  

Computer Associate Inc.Year Normal Accruals Discretionary Accruals

2 Years before Fraud Year(s)1998 -0.09559 -0.05558

1999 -0.10781 -0.44736

Fraud Year(s)2000 -0.11285 0.193602

2001 -0.16637 0.43441

1 Year After 2002 -0.12891 -0.02812

Technical Analyses--- Discretionary Accruals (Jones Model)

  

Lucent TechnologiesYear Normal Accruals Discretionary Accruals

2 Years before Fraud Year(s)1997 -0.0621 0.434057

1998 -0.01663 0.108237

Fraud Year(s)1999 0.139746 -0.40812

2000 0.035513 1.477886

1 Year After 2001 -0.2203 0.905154

Technical Analyses--- Discretionary Accruals (Jones Model)

  

MicroStrategy Inc.

Year Normal Accruals Discretionary Accruals

2 Years before Fraud Year(s)1997 -0.37173 0.412103

1998 0.290238 0.485201

Fraud Year(s) 1999 -0.40915 0.323971 

1 Year After 2000 -0.85313 0.854915

1997 1998 1999 2000 2001 20020

0.2

0.4

0.6

0.8

1

Discretionary Accruals --- MicroStrategy Inc.

Technical Analyses--- Ratio

Auditing GuidelinesTechnical Analysis

High residualsAbnormal ratios compared with the industry avg

Other important stepsCheck the footnote that contains revenue

recognition policyWatch accounts receivableCheck other balance sheet accounts to find cover-

up actsConsider physical capacity

Prediction--- VERAMARK TECHNOLOGIES INC

High residuals Higher AR/TA ratio growth than Industry AverageYear Residuals

2009 -0.03642

2010 2.614737

2011 -1.39678

2012 0.047285 2009 2010 2011 20120.1

0.13

0.16

0.19

AR/TA

VERA Industry

ConclusionSoftware industry

Premature revenue recognition

The Jones model and ratio analysisUseful for auditors to detect premature revenue

recognition in software industry

Thank you!