This document presents an analysis of accounting issues and revenue recognition practices in the software industry. It summarizes three case studies of software companies (Computer Associates, MicroStrategy, and Lucent Technologies) that engaged in premature revenue recognition. It then outlines technical analyses using the CAR model, Jones model, and ratios to detect discretionary accruals and abnormal revenue recognition. Guidelines for auditing software companies focus on these technical analyses and examining revenue recognition policies, accounts receivable, and other financial statement accounts. Veramark Technologies is predicted to need further auditing based on its residuals and higher than average accounts receivable to total assets growth rate.

1. Team 105:
Qin Li, Zhuting Meng, Xue Shao, Yang Yang, Jie Yin

2. Agenda
 Accounting Issue & Relevant Regulations
 Case Studies of Three Software Companies
 Technical Analyses (CAR, Jones Model, Ratio)
 Auditing Guideline
 Prediction
 Conclusion

3. 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

4. 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

5. Case 1: Computer Associates International, Inc.
 Background
 A Fortune 500 company
 One 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
 Consequences
 Stock price dropped over 43%
 8 executives pleaded guilty

6. Case 2: MicroStrategy, Inc.
 Background
 Founded in 1989
 A provider of software consulting services
 Fraud Scheme involved multiple-element transactions
 Prematurely recognized revenue from the service element
 Consequences
 On Mar. 20, 2000, announced to restate for FY 1998 and 1999
 Stock price dropped over 60%

7. Revenue Recognition for Product Element
in Multiple-Element Transactions
Product
Element
Service
Element
Multiple
Element
Transaction
Recognize revenue from the
product element only if:
 Product element is separable
from service element
 Revenue from the service
element is deducted

8. Case 3: Lucent Technologies, Inc.
 Background
 Formed in 1996 as an AT&T spin-off
 Designs and provides systems, services, and software
 Fraud Scheme: aggressive accounting practices
 Booked 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
 Consequences
 On Nov. 21, 2000, announced to restate its financials
 Stock price dropped about 16%

9. 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

10. 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

11. Technical Analyses
--- Discretionary Accruals (Jones Model)
Lucent Technologies
Year 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

12. 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
1
0.8
0.6
0.4
0.2
0
Discretionary Accruals ---
MicroStrategy Inc.
1997 1998 1999 2000

13. Technical Analyses
--- Ratio

14. Auditing Guidelines
 Technical Analysis
 High residuals
 Abnormal ratios compared with the industry avg
 Other important steps
 Check the footnote that contains revenue recognition policy
 Watch accounts receivable
 Check other balance sheet accounts to find cover-up acts
 Consider physical capacity

15. Prediction--- VERAMARK TECHNOLOGIES INC
 High residuals  Higher AR/TA ratio growth
than Industry Average
Year Residuals
2009 -0.03642
2010 2.614737
2011 -1.39678
2012 0.047285
0.19
0.16
0.13
0.1
AR/TA
2009 2010 2011 2012
VERA Industry

16. Conclusion
 Software industry
 Premature revenue recognition
 The Jones model and ratio analysis
 Useful for auditors to detect premature revenue recognition
in software industry