In October 2000 Computer Associates proclaimed a new business model, which featured a new accounting as its centerpiece. As with other enterprises that created all sorts of pro forma earnings during the last five years or so, Computer Associates produced a New Accounting that just happened to generate better results than GAAP. The reader's problem then and now is whether these numbers are better for the shareholders than good old-fashioned GAAP numbers.

The public finally obtained a chance to contrast the two systems on May 22, 2001, when Computer Associates issued a press release showing the results on a pro forma basis. Fourth quarter 2001 earnings were $274 million as compared with the previous year's fourth quarter earnings of $207 million; annual income for fiscal year 2001 was $951 million and $787 million for fiscal year 2000. Let's now check on the GAAP income figures. Fourth quarter earnings are $(410) million contrasted with an earlier $392 million; annual income for fiscal year 2001 and 2000 was $(591) and $696 million, respectively. The difference between the two sets of numbers is staggering. Clearly, GAAP shows reasons for concern, while the pro forma numbers indicate causes for celebration. The signals are plainly inconsistent with each -- so which do we believe?

 

Managers published the document, "How Our New Business Model Delivers Value to Customers, Shareholders, and Employees" in an attempt to explain and defend the New Accounting. They say, "Historically, CA recognized the present value of license revenues at the time a contract was signed and the product delivered while recognizing maintenance revenues and financing fees in monthly installments over the contract term. Under ratable recognition, all fees are recognized in equal monthly installments over the length of the contract." The effects are clear: earnings are more conservatively stated, inducing a downward bias on earnings volatility. In addition, the company would report a residual value on the balance sheet to approximate the value created by Computer Associates.

 

This New Accounting appears more appropriate than its previous overly aggressive approach to revenue recognition. On that score I think the New Accounting might be better. However, it seems to artificially smooth the earnings process and thereby reduce the standard deviation of earnings. In short, it is an attempt to look like a safe investment. The balance sheet effect appears, for this residual value is labeled incorrectly -- it really is nothing more than deferred revenue. Further, the deferred revenue should discount the future cash flows but does not.

 

Worse, given the fact that Computer Associates changed in accounting method, it should say so in its 2001 10-K and provide adequate disclosures for an investor to assess the impact of this New Accounting. Management incorrectly does not account for this as a change in accounting principle.

 

Worst of all, there exists the possibility of Computer Associate's recycling revenues. (Alex Berenson also notes the possibility of the recounting of revenue in his book The Number.) While I hope the auditor would catch this, other events from 2000-2002 make me apprehensive.

 

My trepidation results from one critical observation -- the New Accounting provided a means for managers at Computer Associates to receive over a billion dollars in stock options! Did executives at this business enterprise really create so much economic value that they deserved one billion U.S. dollars in compensation for services rendered? I doubt it.

The most telling statistic of all is free cash flow. Always remember that to validate the quality of earnings, one simply estimates free cash flow. Somehow, investors have gotten away from this simple dictum. In the case of Computer Associates, the free cash flow numbers are $1,096 million in 1999, $4,515 million in 2000, but only $5 million in 2001. Clearly, the New Accounting does not constitute better accounting.

 

Whatever the problems in 2000, I suggest that the SEC also examine the New Accounting that Computer Associates concocted in 2001. It seems amiss to me.

 

By the way, this example is one of the reasons that I started 2001 with about 100% of my investments in equities but moved to 0% by mid-year.

 

It's nice to be right now and then.

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle.