Their Faith's in the Numbers

CA confident of vindication in accounting controversy

Mark Harrington

March 4, 2002

ON A CLEAR OCTOBER MORNING in New York two years ago, Sanjay Kumar stood before a gathering of Wall Street analysts at The Plaza hotel to trot out his "new business model."

Kumar, then only several months on the job as chief executive of Computer Associates, spoke with conviction and intelligence as he explained that CA would begin charging for its software the way power companies charge for electricity - month to month. It would institute a new "pro-forma pro-rata" accounting method to accompany the new business model, resulting in significant changes to the way investors view its operating results. Comparing the old numbers to the new, he said, would be like comparing "apples to rib-eye steaks."

When he finished his presentation, Kumar showed admirable patience walking analysts and reporters through many questions.

It's a job that continues.

And one that is not getting any easier.

In the face of two federal probes into its accounting practices, Computer Associates last month said it is standing by its controversial accounting methods. It's a bold statement of conviction given all the company has endured over the past two years.

"While we'd be the first to admit that we could always do better in terms of explaining our shift to ratable accounting...it is clear that accounting professionals agree that our GAAP-compliant ratable accounting is an appropriate and transparent methodology," Kumar said last month in a conference call confirming the federal probes.

It's not the first time the new accounting methods have plagued the Islandia company. (Indeed, the day Kumar introduced the new business model, a New York Times story critical of its accounting ran under the startling headline, "Computer Associates Still Lacks Credibility.")

An expensive proxy battle last year by Texas tycoon Sam Wyly, who ridiculed the company for its "phony" accounting, took sharp aim at the pro-forma accounting methods. CA fended off Wyly's efforts, at a cost of more than $10 million.

Last April, The Times accused the company of using "accounting gimmicks" to mask "a mirage" of past revenue growth. Pro-forma, the paper charged, was a means to disguise the revenue falloff. A day after the story appeared, Kumar held an early morning conference call that made no direct reference to the Times story, focusing instead on a detailed explanation of its new accounting.

Last week, CA shareholder Jack McBride filed a suit accusing CA of securities fraud through a scheme to hide "a disastrous drop in revenue." CA blasted the suit, based largely on the Times story, as a "cobbled together" effort that used media reports that are inaccurate or misleading...We intend to defend ourselves vigorously," the company said.

While it will be up to federal authorities and the courts to determine the veracity of the claims about CA's accounting, one lesson for any company pondering a complex accounting change is clear: Keep it simple.

Forget for a minute the possible implications of the federal probes and the shareholder suit. The fact that a company's accounting could be debated in investment circles raises red flags, observers say.

"There are only two possible reasons why experienced analysts wouldn't be able to understand a company's financial reports," said Gary Lutin, an investment banker at Lutin & Co., who tracked the company during last year's proxy fight. "One is that management doesn't have the information needed to understand the business themselves. The other is that management has the information but doesn't want to show it to investors."

In a conference call with analysts in January 2001, it became clear that Wall Street analysts, even those closest to CA, were having problems relating the new numbers to those they'd relied on in the past. Past results under generally accepted accounting principles sank under the new business model. That was because CA created a new line item called residual value, where it pooled future subscription revenues. But new pro-forma numbers, which assumed that CA and its recently acquired companies had been operating under the new model for years, drew skepticism because CA had, in fact, not been operating under that model for several years.

"The real issue is management's continuing failure to provide financial reports that satisfy accepted standards," Lutin said. "I can't think of any reason why CA's management would continue presenting pro-forma numbers without reconciliations to GAAP [numbers], or why CA's directors would tolerate it."

But CA has gone out of its way over the past year to stress GAAP numbers first, and to present pro-forma figures as a "supplemental" view of its business.

Those who track CA suggest the ride of the past year is one investors should get used to.

"For better or worse, controversy is not new to CA," securities firm SG Cowen said in an eyebrow-raising report last week. "Over the past 15 years, we've seen the stock fall sharply from time to time due to either weak fundamentals or accounting/perception problems. And while we'd rather not go through the anguish, each of these declines has created a significant buying opportunity ... "

Assuming in this latest case the company is guilty only of gross misunderstanding, it appears Kumar and the company will nevertheless continue to have a lot of explaining to do.