CORPORATE LAW AND PRACTICECourse Handbook Series

Number B-2052

Pocket MBAFall 2013:

Finance for Lawyers

Co-ChairsJames J. AgarPhilip J. BachEwa Knapik

Dana G. McFerranZiemowit T. Smulkowski

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IN THE MATTER OF COMPUTER ASSOCIATES INTERNATIONAL, INC.: A STUDY IN EARNINGS MANAGEMENT FRAUD

Daniel V. Dooley, Sr , CPA

PwC (Retired)

Reprinted from the PLI Course Handbook, Pocket MBA Summer 2013: Finance for Lawyers (Order #41744)

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.

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AFTERMATH

On April 24, 2006, the former Chief Executive Officer (“CEO”) of Computer Associates International, Inc. (“CA” or “Company”), Mr. Sanjay Kumar (“Kumar”), and CA’s former Senior Vice President and Head of Sales, Mr. Stephen Richards (“Richards”) each entered guilty pleas to eight felony counts of securities fraud, obstruction of justice and perjury which stemmed from one of the largest earnings management financial accounting and reporting frauds in the history of the U.S. securities market. Subsequently, Kumar was sentenced to serve twelve years (144 months) in prison (along with three years of supervised release) and pay an $8 million fine, and ordered to make a “restitution payment” of $798.6 million (to harmed investors); and Richards was sentenced to serve seven years (84 months) in prison (along with three years of supervised release), and ordered to make a “restitution payment” of $29.7 million. Previously, former CA General Counsel, Mr. Steven Woghin (“Woghin”), former CA Senior Vice President (“SVP”) – Finance, Mr. Lloyd Silverstein (“Silverstein”), former CA Chief Financial Officer (“CFO”), Mr. Ira Zar (“Zar”), former CA SVP – Business Development, Mr. Thomas Bennett (“Bennett), and former Vice President (“VP”)s – Finance, Messrs. David Rivard (“Rivard”) and David Kaplan (“Kaplan”) also entered guilty pleas to various felony counts relating to their roles in the CA securities fraud. Woghin – after pleading guilty to charges of securities fraud and obstruction of justice – was sentenced to one year (12 months, and a day) in prison, one year of home confinement (followed by three years of supervised release), Silverstein – who pled guilty to obstruction of justice – was sentenced to six months home confinement and three years of probation. Zar – who pled guilty to securities fraud and obstruction of justice – received a sentence of seven months in prison and seven months home confinement (followed by two years of supervised release). Bennett – who pled guilty to obstruction of justice – was sentenced to ten months home confinement and three years of probation. Messrs. Rivard and Kaplan – who each pled guilty to securities fraud and obstruc-tion of justice – received respective sentences of four months and six month of home confinement and three years of probation. These foregoing defendants also were ordered to make various amounts of “restitution payments” (to the harmed investors). In separate civil proceeding, all of these former members of CA’s senior management settled securities fraud charges by the U.S. Securities and Exchange Commission (“SEC”) – agreeing to settlements which barred them from serving as directors or officers of any public company, enjoined them from engaging in any

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future violations of U.S. securities laws or SEC rules and regulations, and required each to pay various amounts of fines and disgorgement sanctions; and also, Woghnin was disbarred from practice as an attorney.

CA, the Company, entered into a deferred prosecution agreement with the U.S. Department of Justice (“DOJ” and U.S. Attorney’s Office (“USAO”) – New York Eastern District (“E.D.”), and agreed – under settlements with the SEC and USAO – to pay $225 million in restitution to harmed investors, undertake various actions to improve controls and strengthen its compliance function, and retain an independent “monitor” responsible for overseeing and reporting on CA’s remedial actions. Between the fourth quarter of fiscal year 2000 and the first quarter of fiscal year 2001 – before the possibility of accounting irregularities was disclosed to the market – CA’s stock-price traded from highs of $75 to $ 63 per share, and the Company’s market capitalization ranged from $43 billion to $36 billion; in mid-2001 – after the market learned of possible accounting irregularities at CA – the stock-price plunged by 43 percent (a loss of market capitalization of $15 billion, or more). Today CA’s stock trades at about $25 per share, about one-third of its high-point when the Company’s senior management was engaging in earning management fraud. While no accurate calculation of the actual damages – caused by the fraud and disclosures of misconduct by the then senior management of CA and the true results of CA’s operations - has been made, it is very likely that investors’ losses – resulting from this earnings management fraud – were in the billions of dollars.

EARNINGS MANAGEMENT

What CA and its former management engaged in was improper earnings management – in which they intentionally violated GAAP to report false and misleading financial information in the Company’s financial statements and quarterly reports. Such misstatements were done through misapplying GAAP for revenue recognition, specifically, by prematurely recording and reporting sales in periods earlier than when the amounts actually were earned and realizable as income.. In so doing, the then-management of CA was able to achieve revenue and earnings forecasts and present to the market the “appearance” that CA was achieving its revenues and earnings predictions and sustaining its growth projections. By “borrowing” revenue and income amounts from future accounting periods, the Company and its management were able to present to the market (and Company shareholders, and financial analysts) the “picture” of a successful and highly-profitable company; for the years 1999 and 2000 (and their

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quarters), as well as what likely was all of the reporting periods in the 1990s, this “picture” was a false one.

Earnings management can involve legitimate choices made and actions taken by management regarding transactions, the timing of events, and alternative accounting treatments permitted by GAAP. For example: as long as the transaction is recognized and reported in the correct period, management legitimately may choose whether to complete a sale in the current period or defer the transaction to a future accounting period; or, management may decide whether (and in which period) to incur certain discretionary expenses. However, as it has come to be used and understood, the term “earnings management” denotes illegitimate activities and accounting treatments done to create the “appearance” of controlled, disciplined growth of revenues and earnings – when, in fact, all that is happening is that transactions and accounting entries are being manipulated and misstated. Such improper earnings management has been described by the Panel on Audit Effectiveness (the “O’Malley Panel”) of the Public Oversight Board (“POB”) as follows:

[I]ntentionally recognizing or measuring transactions and other events and circumstances in the wrong accounting period or recording fictitious transactions – both of which constitute fraud.

Other descriptions of improper earnings management (cited by the O’Malley Panel) have been given by Accounting Professor Katherine Schipper (“Schipper”), and Accounting Professors Paul M. Healy and James M. Wahlen (“Healy and Wahlen”) in their separate Accounting Horizons articles, respectively, “Commentary on Earnings Management,” and “A Review of Earnings Management Literature and its Implications for Standard Setting,” as follows:

[E]rnings management really means “disclosure management’ in the sense of purposeful intervention in the external reporting process, with the intent of obtaining private gain (as opposed to, say, merely facilitating the neutral opera-tion of the [reporting] process).

Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.

However it is described, such improper earnings management reflects certain common characteristics – it is a species of financial fraud, there is intent to misstate amounts in reported financial information and mislead users of such information, and the timing and measurement of amounts are accounted for and reported in violation of GAAP.

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CA’S EARNINGS MANAGEMENT SCHEME

According to statements made by Kumar and other defendants, the improper earnings management practices at CA had been going on for many years, possibly throughout all of the 1990s, before such practices were discontinued in fiscal 2001 and the fraud was disclosed in fiscal 2002. After CA’s Audit Committee conducted an internal corporate investigation in fiscal 2003, the Company restated previously issued quarterly reports from the fourth quarter of fiscal 1998 through the second quarter of fiscal 2001, and restated the previously issued annual financial statements for the fiscal years ended March 31, 1999 and 2000. Because of the “timing” nature of misstatements occurring prior to January 1, 1998 (that is, otherwise valid amounts of sales revenues being prematurely recognized), the prior-period effects of any misstatements occurring in fiscal years 1990 through 1997 (and the first through third quarters of fiscal year 1999) had “reversed” and no longer materially affected the financial statements for the three years ended March 31, 2001 or the quarterly reports relating thereto. In other words, although only the then-outstanding financial statements and quarterly reports for fiscal years 1999 and 2000 required restatement, the findings developed in the course of the various investigations – the first internal corporate investigation by CA management, the independent investigation conducted by the Company’s Audit Committee, and the separate investigation by the SEC – as well as admissions made by Kumar and other defendants, all indicate that the earnings management fraud at CA went on throughout the 1990s (and possibly even during the late 1980s). Hence, in order to understand fully the earnings management schemes at CA, it is necessary to start at “the beginning.”

“The Beginning”

CA was incorporated in 1974 by its co-founders, Mr. Charles B. Wang (Wang”) and Mr. Russell Artzt (“Artzt”) and commenced operations in 1976. Headquartered in Islandia, New York, since its inception the Company’s principal business has been to provide business-to-business (“B2B”) software solutions for main-frame computers and servers – including operating systems’ software, data base management software, computer security products, and systems’ management applications. In 1981, CA completed its initial public offering (“IPO”) of its stock to the public, was listed on the New York Stock Exchange (“NYSE”) and became an SEC registrant, subject to U.S. securities laws and the rules and regulations of the SEC.

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During the 1980’s, through a series of strategic mergers and acquisitions (including the acquisition in 1987 of its main competitor, UCCEL) and from organic growth and product-development, CA became one of the largest independent providers of business (main-frame and servers) software solutions, and it expanded into a global software company. From the Company’s inception through 2000, when he resigned his management position, Wang served as chairman of the board and CA’s CEO. Kumar joined the Company in 1987, with the acquisition UCCEL, and served as VP-Planning in 1988-1989, SVP-Planning through 1992, Executive Vice President (“EVP”)-Operation in 1993, President and Chief Operating Officer (“COO”) from 1993 through 2000, President and CEO from 2000 through 2002, and chairman of the board and President and CEO from November 2002 (when Wang resigned as CA’s chairman of the board) through April 2004 when Kumar resigned, effective June 2004, from all of his positions at CA. Zar joined the Company in 1982, became CA’s VP-Finance in 1994, and was promoted to EVP and CFO in 1998; he was relieved of his duties and resigned from all positions with CA in April 2004. Richards joined the Company in 1988, became SVP-Sales in 1998, and was promoted to EVP-Sales and Head of Global Sales in 2000; he was relieved of his duties and resigned from all positions with the Company in April 2004, effective June 2004. Woghin joined the Company in 1992, became VP-Legal in 1993, and became SVP and General Counsel in 1995; he was relieved of his duties and resigned from all positions with the Company in April 2004, effective June 2004.

It appears likely that Kumar, Richards, Zar, and Woghin were aware of, if not participated directly in, the earnings management fraud throughout the 1990’s and through the second quarter of fiscal 2001. Although Wang never was charged with any crimes, nor named as a participant in any illegal acts, Kumar and other defendants have alleged that the improper earnings management schemes at CA extend back to when Wang was CA’s CEO. Other defendants who pled guilty to various securities fraud and/or obstruction of justice charges – Silverstein, Bennett, Rivard, and Kaplan – also appear to have been aware of, if not participated directly in, this fraud during some, if not all, of their times of employment with CA. From the findings of the various investigations, it also is likely that many other CA employees (“good soldiers”) assisted in, and were aware of, the improper earnings management schemes: these included many members (employees and

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“middle-management”) of CA’s sales force, and various employees and “middle-management” of the Company’s accounting department.

In beginning to use improper accounting and reporting practices to manage earnings, members of management were motivated by personal gain – from bonuses and awards of stock-options based on performance and meeting revenue and earnings and share-price targets; however they also were challenged in meeting revenue and earnings targets by the nature of CA’s business and its sales relationships with customers. From its inception and through mid-year fiscal 2001, the Company’s business and accounting model was to recognize software sales revenues (reduced for a small portion deferred for future “maintenance” services) immediately upon recognition of the sales arrangement, as earned revenue. However, it was (and still is) the nature of the software industry that customers tend to negotiate “deals” with software providers all the way up to, and even after, the end of accounting periods. The customers know that the public-listed sellers are pressured to record sales, recognize revenues and report earnings for each and every quarter. Therefor the buyers hold off, and negotiate hard, to obtain the best “deals” possible – using the looming close of the accounting period as a negotiating lever. On the sellers’ side, the pressures to complete a sales transactions come from management (who “drive” the marketing and sales activities), and from the personal gains these employees might realize – in terms of commissions, bonuses, and stock-option awards – if they “make the numbers” and consummate the sales transactions (in the specified accounting periods). The tension between software buyers’ and sellers’ motivations and needs often led to “last-minute” deals, either being closed and con-summated at or very near the end of the periods, or being executed sometime immediately after the close of such periods.

Early-on, possibly from the 1980’s and very likely during the 1990’s, CA’s management began to deal with this situation of signifi-cant sales transactions sometimes occurring just after the end of accounting periods by prematurely recognizing such revenue amounts – in the current accounting and reporting periods instead of the subse-quent periods, when the transactions actually were consummated. In those “early days,” CA’s management had several reasons to “ratio-nalize” such premature revenue recognition and improper earnings management practices – including the following: (1) In the 1980s, and early 1990’s (up to the promulgation in 1991,

effective for financial statements issued after March 15,1992, of American Institute of Certified Public Accountants (“AICPA”)

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Statement of Position (“SOP”) 91-1, Software Revenue Recogni-tion), GAAP and prevalent accounting practices relating to software revenue recognition were not well-defined, nor were they “standardized” – thus, different software companies, and their managements, applied varying accounting practices regarding when software sales revenues were recognizable as income;

(2) Also, CA was under competitive and market pressures to “make the numbers” – to support and increase the Company’s stock-price and market capitalization, and thereby facilitate more strategic acquisitions to accomplish the Company’s growth plans;

(3) And, in these early, “go-go days” of the software industry, personal fortunes were to be made – from bonuses and stock-options tied to performance – by “making the numbers” and delivering to the market superior results (for example, in 1999 Wang and Kumar received stock-options awards, based on the performance of CA’s stock-price through 2005, valued at $651 million and $326 million, respectively).

From “Trickle” to a “Waterfall”

At first CA management simply “advanced” the recording of sales revenues, from future periods (when the transactions actually were consummated) to current periods (when the amounts were needed to “make the numbers” and achieve forecasts of revenues and earnings growth). The sales were real and the amounts were reasonably assured of collection; only the “timing” was off. In some quarters CA met sales and earnings targets without management needing to prematurely rec-ognize any sales transactions. And, at least starting out, when man-agement did need to resort to improper revenue recognition in order to “manage” earnings, the numbers of affected transactions were relatively few and the amounts, while material, were relatively small. By holding open the books for five or so (sometime up to seven) business days after the ends of quarters, late-executed revenue arrangements could be identified and “held in reserve;” and management could assess whether properly recognizable revenues met the quarterly revenue and earnings targets, or whether it was necessary to “borrow” some amounts from the groups of late-executed contracts. In the “early days,” the fraud scheme was not that complicated and it mainly involved four key elements:

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(1) Close monitoring of selling activities – especially nearing the end of each quarterly accounting period – so that management knew: (a) what sales were “in,” (b) what potential revenue arrangements remained outstanding and still being negotiated, and (c) what amounts might still be needed to “make the numbers;”

(2) Advanced planning for the possibility of needing to use (i.e., “borrow”) any late-executed revenue arrangements – which, depending on the customer (and the customer’s willingness to “cooperate”), usually involved (a) using “no-date” contracts, or (b) getting the customer’s representative to improperly “back-date” the contract, or (c) getting the customer to agree to leave the execution dating blank (to be “back-dated” by a CA representative);

(3) Dealing with the dating of deliveries of the products involved in any late-executed revenue arrangements – because many of such products were delivered “electronically,” this could be handled either (a) by “shipping” the products to customers before the end of the quarters, even though the sales transactions had not yet been consummated, or (b) by altering CA’s internal records pertaining to product deliveries; and, should there be circumstances where evidence (e.g., hard-copy documentation) of delivery/ customer receipt was required, such documentation could be dealt with in the same manner as was done to back-date revenue arrangements (see 2 above);

(4) Collusion with customers – which might include: (a) having the customers’ representatives agree to back-date documents (or leave the applicable documents un-dated, to then be back-dated by CA representatives), (b) getting the customers’ applicable representa-tives to conceal their own involvement in and/or knowledge of any back-dating involving their arrangements with CA, and (c) if needed, getting the customers’ applicable representatives to misrepresent – to CA’s independent auditors, on any confirmation requests they might receive – the execution dates of the subject arrangements

Somewhat surprisingly, over the years that Company management operated their earnings management fraud, the evidence shows they had no trouble enlisting the “cooperation” of many of CA’s customers. For some customers and their representatives, it made no difference to them whether CA back-dated their arrangement by a few days, and it was understood that “going along” with such back-dating was included in the bargain. Of course, there also were a number of CA

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employees who had to conspire with Company management – salesper-sons who closed the late-executed revenue arrangements (and knew that they were being back-dated), members of the accounting department who knew that the revenue arrangements were received after the end of the period (and who knew or suspected that the datings were false), sales management, who helped orchestrate the scheme, and others; these “good soldiers” participated in the scheme for their own personal gain, or out of “loyalty” to the Company and CA senior management, and – for some – they did not view what was done as being wrong.

During the mid-1990s CA senior management forecasts of revenue and income growth and quarterly earnings targets grew more aggressive – driven in large part by the Company’s performance-based compensation plan (and 1995 stock-price targets which, if met, would trigger enormous stock awards for Wang, Kumar, and other members of senior management). And, to achieve these aggressive growth, earnings and stock-price targets, senior management found itself having to resort to improper earnings management and revenue recognition fraud in more and more quarters – until eventually it was became a year-round practice. This was the result of two circums-tances – the aforementioned aggressive revenue and earnings targets being set by management, and the fact that demand (that is the “true” market demand) for CA’s products actually was slowing. Hence, each successive quarter in order to keep up “appearances” – to the market, investors and financial analysts – that CA was meeting its aggressive growth and profitability targets (and thereby drive up the Company’s stock-price), senior management involved in the fraud had to “borrow” ever more amounts of subsequent quarters revenues. But then, by prematurely recognizing such “borrowed” revenues to “make the numbers for each current quarter, management was digging a deeper and deeper “hole” for each succeeding quarter. The combination of quarter-over-quarter increased revenue and earnings targets and starting out each successive quarter deeper and deeper in the “hole” caused by greater and greater amounts of revenue “borrowings” eventually exhausted the “supply” of late-executed revenue arrange-ments available in the five-to-seven business days after the end of a quarter. Not only had the initial “trickle” of misstated, prematurely recognized, revenue transactions become a “waterfall,” but also the original scheme was running out of sufficient numbers and amounts of revenue arrangements to “borrow” in support of management’s improper earnings management scheme.

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By the end of fiscal 2000, CA’s senior management fraudsters, running out of a “fuel source” to drive their premature revenue recognition fraud, tried to get off the quarterly treadmill. In early fiscal 2001 CA disclosed that it was changing its business and accounting model to essentially defer all software sales revenues amounts – to be recognized ratably over the terms of the agreements. Management hoped that the sudden decline in revenues and earnings (which actually would be due to discontinuing the improper earnings management premature revenue recognition scheme) could be tied instead to the change in the Company’s business model and accounting method. However, by mid fiscal 2001 things had gotten too far gone: CA and its officers was named in a third-party private securities litigation class action which alleged, among other claims, that CA had improperly overstated revenues by at least $500 million by misapplying revenue recognition GAAP. Taking notice of the private securities litigation claims, the Staff of the SEC opened their own investigation into CA’s revenue accounting practices. Then, when CA did change its business model and revenue accounting method, in the third quarter of fiscal 2001, and revenues and earnings plunged, the market’s and investors’ reaction was markedly sudden and dramatic (in a single trading day the Company’s stock-price dropped by 43 percent). It was the beginning of the end: throughout 2001 and 2002 the various investigations – internal corporate, Audit Committee, and SEC – poured through years of CA’s sales revenue transactions, closely examined revenue arrangements’ documentation and support, reviewed thousands of the Company’s e-mails (both internal and between CA employees and customer representatives), and conducted interviews of CA employees (including senior management). Ultimately, the Audit Committee’s independent investigation and the SEC’s investigation found that members of CA’s senior management and a number of other employees had been violating GAAP for many years and that the Company’s quarterly report for the fourth quarter of fiscal 1998, annul financial statements and quarterly reports for fiscal years 1999 and 2000, and quarterly reports for the first and second quarter of fiscal 2001 all required restatements.

VIOLATING GAAP

Under AICPA SOP 91-1, and its successor authoritative pronouncement, AICPA SOP 97-2, Software Revenue Recognition, and under Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting

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Concept (“CON”) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, paragraphs 83-84, “Revenues and Gains,” there are four revenue recognition criteria which are particularly relevant to the revenue accounting situation at CA – these are: (1) An arrangement must exist and be enforceable, between buyer and

seller; (2) The amounts being recognized as revenue must have been earned

(that is, the seller must have done substantially all that was required under the arrangement, to be entitled to the benefits represented by such revenue transactions);

(3) The goods (products or merchandise) must have been delivered or the services rendered by seller to buyer;

(4) The amounts must be realized or their realizability must be probable (i.e., reasonably assured) of collection in the ordinary course,

Absent these foregoing criteria being met on or before the end of an accounting period, the subject revenues may not be recognized and rec-orded in that period.

Violating GAAP by Back-Dating Revenue Arrangements and Sales Transactions

Evidence of the timing of a revenue transaction usually is provided by the date affixed to related documents such as the revenue contract, sales invoice, or sales receipt. “Best evidence” is that which is provided by third-party (i.e., customer/ buyer) dating – in the case of software revenue arrangements, the date affixed to the revenue contract by the customer representative. In respect of CA and its sales transactions with customers, the affected sales transactions (at least those which mattered) were large, the terms were relatively detailed (and often complex), and the Company’s customary practice was to rely on written agreements (i.e., contracts). Such arrangement documents were expected to be signed by the customers’ authorized representa-tives, and were considered to be important legal documents – which needed to be reflect the date of their execution. Other types of “dating” – providing either direct evidence or supporting an inference – might be: (i) dates affixed to transmittals of the executed documents, (ii) correspondence (especially from the buyer) indicating when a particular revenue contract was executed, (iii) internal (i.e., CA-generated) dating of receipt of executed revenue contracts, (iv) internal company records of the selling and sales arrangement negotiating

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“history,” or (v) other circumstances surrounding the sales trans-actions – such as customer payment in advance of the period-end in question, the date of delivery of the product(s) to the customer (although, see “Violating GAAP by Back-Dating Deliveries” below), or subsequent confirmation, to CA’s independent auditors in response to their confirmation inquiries, of what the customer/ buyer purports to be the date on which the contract was executed and the transaction was executed (however, see “Customer Collusion” below). Taken together this “best evidence” and other direct or inferential evidence, of the dates on which revenue arrangements were executed and sales transactions were consummated, should support (or not) management’s assertions – regarding revenue cut-off and when revenues were earned and realizable in conformity with GAAP.

As described above, members of CA’s senior management and certain Company employees manipulated the dating or revenue arrange-ments and sales transactions (i.e., “back-dated” the supporting docu-ments and other evidence) by either: (a) colluding with customers’ representatives – to have them falsely-date such documents; (b) relying on so-called “no-date” contracts and other documents; (c) having customers not date such documents (so that CA representatives later could affix false dates thereto); and/or (d) alter transaction dates (particularly in respect of transmittal documents, computer records, and correspondence). After the fraud scheme went into “full gear” (and throughout the period 1998-2001), the senior management fraudsters established a “war-room,” operated immediately after each quarter-end, where they and selected employees (“good soldiers”) worked non-stop to manipulate the documentation of the dates when revenue transactions were consummated. Ahead of each quarter-end accounting close, management fraudsters would make preparations to facilitate back-dating – including: coordination with CA salespersons, coordina-tion with the possible customers’ representatives (to enlist their “cooperation”), confection of “no-date” revenue contract documents, creation of false information in Company records relating to the selling and transaction negotiating “history” of the revenue arrange-ments likely to be late-executed, and destruction or concealment of information which might “give the lie” to management’s assertions of when sales transactions actually occurred. By-and-far, the foregoing fraudulent activities were the most frequently-used methods of prematurely recognizing revenues and violating GAAP in respect of revenue recognition for CA’s software sales. By falsely-dating the execution and consummation dates of otherwise legitimate sales

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revenue transactions, CA’s senior management fraudsters accomplished their main method of prematurely recognizing revenues and facilitating the Company’s improper earnings management scheme.

Violating GAAP by Back-Dating Deliveries

In the case of CA, most of the “deliveries” of software products were accomplished electronically or by physical deliveries of software discs. Hence, delivery-dates were based on what the Company’s computers showed, or what shipping documents (e.g. way-bills or bills of lading or shipping-advices), showed – in their datings. Because under GAAP the deliveries of the “sold” products had to happen on or before the end of the accounting period, CA conducted the fraud by manipulating and altering the delivery-dates of the products sold in the back-dated revenue transactions. Due to the nature of much of CA’s software products – merely delivering the software, whether by electronic means of through physical shipment did not change the economic substance of the transaction – in order to effectively use the software, the customer had to: (i) close the deal (otherwise, CA would cancel the licenses), and (ii) eventually agree to the negotiated deal terms – of implementation and installation of the software, and of price and payment, and – most importantly, of “maintenance” of the purchased software products. CA’s customers had little or no reason to object to “delivery” (or representing the occurrence of “delivery”) of CA software products in advance of when they actually consummated revenue arrangements – because they stood to lose nothing, and by “cooperating” with CA’s ploys they gained additional negotiating “leverage” (that they used to get better pricing from CA).

The nature of CA’s software products for sale has much to do with the habit of CA’s senior management’s fraud: (a) owing to the complex-ities of such software (and its arrangements), customers could not “renege” on sales agreements – either consummated or contingently approved; (b) owing to the ease of “delivery” and the fact that CA’s software products were critical to customers’ software systems – customers were inclined to “ignore” delivery-dates, and accept CA’s assertions of when “delivery” occurred; and (c) owing to the fact that CA’s negotiating practices included “side-agreements” (mostly oral) with customers for them to falsify the datings of arrangements and deliveries of products – it was more likely that customers would corroborate the false assertions, about executions of revenue contacts, and the delivery dates of sold software products, that were made by CA management.

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Violating GAAP by Recording Revenue Amounts Not Yet Realizable

If, at the end of an accounting period (e.g., quarter-end), there was no enforceable agreement (and the customer could “walk-away” from the deal), then there was no obligation of the customer to pay the seller the amounts being recognized and recorded as revenues. By definition, sales transactions not yet consummated do not require the potential buyers to make payments to the sellers; hence, as of the end of the subject accounting period the amounts were not realizable.

Concealing the Misconduct and Violations of GAAP

CA’s concealment started with its senior management fraudsters lying to the Company’s directors, and independent auditors, and others (including the SE C) regarding the Company’s revenue recognition practices, the actual results of operations, and the support for and documentation of specific revenue transactions. These lies by CA senior management fraudsters included: signing and issuing false “manage-ment representation letters” provided to the Company’s independent auditors, making false assertions to the Company’s directors and independent auditors – regarding the Company’s procedures and practices regarding revenue recognition, and also falsely asserting that they were unaware of any violations of GAAP or material misstate-ments of the Company’s financial statements. Concealment activities extended much further – orchestrated by senior management (and aided and abetted by other CA employees): the sales department and account-ing department (and likely the contact administration department) were “silent” about what they knew (or suspected) regarding improper revenue accounting and premature revenue recognition; many employees directly involved in the fraudulent activities concealed their roles and lied about their activities; and senior management and CA employees actively engaged in falsifying documents and concealing evidence. In the “first-round” of interviews by representatives of the Audit Committee and of the SEC, virtually every member of CA management or CA employee lied about their knowledge of the fraud, their involvement in fraud-related misconduct, and their activities in furtherance of the Company’s misstatements of its financial reports. Other elements of the concealment” by CA senior management fraudsters included; (a) enlisting customers to falsely create or corroborate information that CA used to account for revenue transactions; (b) collaborating with customers’ representatives regarding

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the false assertions and misrepresentations made by CA management – as to the timing of revenue transactions; and (c) upon occasion, requesting customers to respond to confirmation inquiries issued by CA’s independent auditors, regarding the datings of revenue transactions – by falsely confirming the dates of revenue transactions. Concealment also included – among other things: alteration or falsification of internal CA documents, manipulation of CA’s account-ing records, and omission of significant facts relating to the subject revenue transactions.

GAAP is applied on the basis of management assertions, and represented facts, regarding transactions and economic events. By falsifying and misrepresenting facts and concealing material information – in connection with their accounting for revenue transactions, CA’s management intentionally violated GAAP. GAAP is applied based on promulgated concepts, principles and rules – spelled out in the accounting literature of the FASB and AICPA. By ignoring the specific prohibitions of GAAP, against recognizing revenue before it has been earned and is realizable, and before the subject transactions were consummated, the Company’s management intentionally violated the GAAP principles regarding revenue recognition, in general, and software revenue recognition – as such applied to CA.

REVENUE MISSTATEMENTS DURING FISCAL YEARS 1998 – 2001

The amounts of misstatements alleged in the SEC’s Complaint were based on the findings developed by PricewaterhouseCoopers LLP (“PwC”), the forensic accountants engaged by the Audit Committee of CA and its special counsel, Sullivan & Cromwell (“S&C”). These findings also served as the basis for restatements made by the Company in respect of its previously-issued financial statements for fiscal years 1999 and 2000, and quarterly reports for those years and the fourth quarter of fiscal year 1998 and first and second quarter of fiscal year 2001. The amounts from these two sources have reconcilable differences – for tax effects, the related adjustments to balance sheet accounts, and some additional correcting entries discovered subsequent to the findings included in the Audit Committee’s report of investigation; however, for purposes of this case study, the amounts affecting revenue recognition are substantially the same.

Not all amounts found to have been misstated in one or more particular quarters were misstatements for the respective years. This is because of the “timing” (i.e., premature revenue recognition) nature of

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the misstated amounts, resulting in amounts incorrectly recorded and reporting in one quarterly period “reversing” – and becoming properly reported in the subsequent period(s). Hence, the quarterly misstatement amounts reported below will not sum to the total amounts of misstatements affecting the respective years.

Overstatement of Reported Revenues – Fiscal 1998-2001 (Quarters and Fiscal Years, $ in millions – pre-tax)

FY 1998 FY 1999 FY 2000 FY 2001 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Quarterly 47 135 293 386 346 245 558 572 379 142 219

Annual 47 346 379

The misstatements as percentages of reported revenues in the respective quarters ranged from: 1998- 3%; 1999 – 15% to 40%; 2000 – 22% to 53%; and 2001 – 13% to 15%. (all of which were material to the respective quarters reported results of operations).

CONCLUSION

In the end, the costs to shareholders of CA management’s earnings management revenue recognition fraud scheme included: the loss of over half of CA’s market capitalization – through a sudden stock-price drop of over 40 percent and then further declines; the costs of settlements of private securities class actions – and related legal expenses; the substantial costs of CA’s internal corporate investigation and the independent investigation conducted by the Audit Committee of the Company’s Board of Directors; unrecovered amounts advanced to employees (e.g., Kumar, Richards, et al. to pay for their civil and criminal defenses; and the costs of paying for the SEC-appointed “monitor,” and undertaking extensive remedial actions to improve Company controls and procedures. Less quantifiable, but likely more damaging in the longer-term – to the Company and its shareholders and stakeholders – were: the loss of reputation; the nearly three year loss of business focus – while the Company and its management were “under siege;” and the serious disruption of the organization - resulting from the resignations and terminations of once-key employees. All of it was for nothing (if not less than nothing). The stock-price which management cheated and schemed to grow came crashing down. The hundreds of millions of dollars that management gained in bonuses and stock awards – based on their improper accounting, misreporting of results of operations, and manipulation of CA’s stock price - ended up being taken by the federal government (or paid over to

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private securities litigation plaintiffs). The senior management positions of the co-conspirators – as well as their professional credentials, reputations, and future prospects of working in business – are gone. And, these various senior management fraudsters now are convicted felons. The concealments and falsehoods were wide-spread. The violations and circumventions of Company policies and internal controls were systematic. And, the “tone at the top” at CA was corrupt and it pervaded the organization with an atmosphere of fraud and deceit. Essentially, the company that CA became – during the 1990s and early 2000s – was “built” on a pack of financial accounting and reporting lies. And, CA’s then-senior management who reached the pinnacle of success – and earned historically-high amounts of compensation in the process – did so by defrauding shareholders and stakeholders, and investors and the market.

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