1. In the end, Success Factors investors were not hurt by this alleged improper accounting because SAP paid such a high premium to acquire the firm, which helped SAP jump-start its cloud computing business. Was anyone hurt by this alleged improper accounting and, if so, who and how?

2. Should management encourage the reporting of non-GAAP financial measures that may be useful to investors? Why or why not?

3. What sort of measures should the management teams of service companies put in place to ensure that there is no improper accounting of multiyear contracts?

SuccessFactors is a U.S. multinational company that provides cloud-based human resources-related software applications. Under its “software-as-a-service” business model, the company provides software resources to subscribers who access them via the Internet for a fee. Annual revenue for the firm was $206 million in 2010.

SuccessFactors spreads its costs over a large number of subscribers to keep its subscription rates low and generate income. Subscribers, in turn, rely on SuccessFactors to manage their data and software in a secure and reliable manner. Subscribers avoid large capital out lays for computing equipment and eliminate the costs associated with the purchase of hardware and software and the hiring of numerous computer operations and support people. SuccessFactors has not been profitable—incurring losses in each fiscal period since its inception in 2001, with a loss of $12.5 million for 2010 and an accumulated deficit of $231.3 million. Nevertheless, SAP paid $3.4 billion (over 10 times its 2011 revenue of $327 million)to acquire SuccessFactors in early 2012. (This number compares very unfavorably with the median price—three times revenue—paid in the 32 software mergers that occurred in NorthAmerica in the five years prior to SAP’s purchase of SuccessFactors.)SAP was willing to pay such a premium to gain significant market share and expertise in the rapidly growing human resources software-as-a-service arena. At the time, SuccessFactors had a customer base of some 15 million subscription seat licenses spread across 3,500 customers.

As with many companies, SuccessFactors supplemented the financial results that it reported in accordance with GAAP (generally accepted accounting principles that form the basisfor financial reporting), with non-GAAP financial measures. The manner in which such non-GAAP measures are defined and calculated differ from company to company.One of these non-GAAP financial measures was a measure called“backlog.” SuccessFactors, and many other cloud computing service firms, invoice subscribers on an annual basis even if the term of the subscription agreement is longer than one year. Amounts that have been invoiced, but that have not yet been recognized as revenue, are recorded as deferred revenue. SuccessFactors reported the portion of the total contract value not yet invoiced as backlog. SuccessFactorshad a backlog of about $90 million at the end of 2007 compared with a backlog of $43 million at the end of 2006—an increase the company attributed to an upsurge in new contracts and customers. In 2009, SuccessFactors stopped reporting this backlog figure, and the omission caught the eye of the SEC. When the agency inquired about why the company was no longer reporting this figure, SuccessFactors responded that it felt investors did not consider this figure useful.

In the third quarter of 2010, Success Factors stated that it had adopted a 2009 SEC rule that limited the manner in which revenue could be reported on multiyear contracts. However,in its 2011 annual report, filed just after SAP announced its intent to acquire the firm, but before the deal was finalized, SuccessFactors admitted that its accounting controls suffered from “a material weakness” and that its “internal control over financial reporting was not effective as of December 31, 2011.” Indeed, a SuccessFactors salesperson turned whistle-blower claimed that from 2009 to 2011, accounting controls at SuccessFactors were so weak that sales people were able to improperly rewrite existing multiyear contracts as new contracts to earn additional commissions. If true, this would also accelerate revenue, making the company look more financially sound, while also reducing the backlog number. SAP investigated these claims with an examination conducted by an outside law firm and found no merit to the claims.