Major Case 3

MicroStrategy, Inc.

Background

MicroStrategy, Inc., incorporated in Wilmington, Delaware,in November 1989, has offices all over the United States and

around the world. Its headquarters are in McLean, Virginia.In its early years, the company provided software consulting services to assist customers in building custom softwaresystems to access, analyze, and use information contained in

large-scale, transaction-level databases. MicroStrategy beganconcentrating its efforts on the development and sale of datamining and decision support software and related productsduring 1994 and 1995.1A larger part of the companys revenues in 1996 resultedfrom software license sales. The company licensed its software through its direct sales force and through value-addedresellers and original equipment manufacturers (OEMs). Thetotal sales through the latter two avenues comprised morethan 25 percent of the companys total revenues. Since 1996,the company revenues have been derived primarily fromthree sources:

Product licenses

Fees for maintenance, technical support, and training

Consulting and development services

The company went public through an initial public offering (IPO) in June 1998. From the third quarter of 1998, thecompany began to take on a series of increasingly bigger andmore complicated transactions, including the sale of software, extensive software application development, and software consulting services.In 1998 the company began to develop an informationnetwork supported by the organizations software platform.Initially known as Telepath but later renamed Strategy.com.,the network delivers personalized finance, news, weather,traffic, travel, and entertainment information to individualsthrough cell phones, e-mail, and fax machines. For a fee, anentity could become a Strategy.com affiliate that could offerservice on a co-branded basis directly to its customers. Theaffiliate shared with MicroStrategy the subscription revenuesfrom users. By the end of 2004, MicroStrategy was the leading worldwide provider of business intelligence software.

The story of MicroStrategy reflects the larger problemsof the go-go years of the 1990s. The dream of many young entrepreneurs was to create a new software product or designa new Internet-based network and capitalize on the explosionin telecommunications network capacity and computer usage.Greed may have been the sustaining factor enabling themanipulation of stock value, as many chief executive officers(CEOs) and CFOs cashed in before the stock price tumbled.However, pressure to achieve financial analysts estimatesof earnings seems to have been the driving force behind thedecision to cook the books.

Restatement of Financial Statements

On March 20, 2000, MicroStrategy announced that it plannedto restate its financial results for the fiscal years 1998 and 1999. MicroStrategy stock, which had achieved a high of$333 per share, dropped over 60 percent of its value in one day, going from $260 per share to $86 per share on March 20.The stock price continued to decline in the following weeks. Soon after, MicroStrategy announced that it would alsorestate its fiscal 1997 financial results, and by April 13, 2000, the companys stock closed at $33 per share. The share pricewas quoted at its lowest price during the unraveling of the fraud $3.15 per share as of January 16, 2002.

The restatements (summarized in Table 1 ) reduced thecompanys revenues over the three-year period by about$65 million of the $312 million reported, or 21 percent.About 83 percent of these restated revenues were in 1999.

The companys main reporting failures were derived fromits early recognition of revenue arising from the misapplication of AICPAStatement of Position (SOP) 972. 2 The SECstates in the Accounting and Enforcement Release: This misapplication was in connection with multiple-element deals inwhich significant services or future products to be providedby the company were not separable from the up-front sale ofa license to the companys existing software products. Thecompany also restated revenues from arrangements in whichit had not properly executed contracts in the same fiscalperiod in which revenue was recorded from the deals.

The company 10-K annual report filed with the SEC forthe fiscal year ended December 31, 1998, states the followingin item number 7 of Management Discussion and Analysis(MD&A):

Our revenues are derived from two principal sources(i) product licenses and (ii) fees for maintenance, technicalsupport, education and consulting services (collectively,product support). Prior to January 1, 1998, we recognizedrevenue in accordance with Statement of Position 91-1,Software Revenue Recognition. Subsequent to December 31,1997, we began recognizing revenue in accordance withStatement of Position 97-2, Software Revenue Recognition. SOP 97-2 was amended on March 31, 1998 by SOP 98-4Deferral of the Effective Date of a Provision of SOP 97-2. In December 1998, the AICPA issued SOP 98-9 Modificationof SOP 97-2, Software Revenue Recognition, which amends SOP 98-4, and is effective after December 31, 1998.Management has assessed these new statements and believesthat their adoption will not have a material effect on the timingof our revenue recognition or cause changes to our revenuerecognition policies. Product license revenues are generallyrecognized upon the execution of a contract and shipmentof the related software product, provided that no significantcompany obligations remain outstanding and the resultingreceivable is deemed collectible by management. Maintenancerevenues are derived from customer support agreements generally entered into in connection with initial product licensesales and subsequent renewals. Fees for our maintenanceand support plans are recorded as deferred revenue whenbilled to the customer and recognized ratably over the termof the maintenance and support agreement, which is typicallyone year. Fees for our education and consulting services arerecognized at the time the services are performed.

The majority of MicroStrategys sales closed in the finaldays of the fiscal period, which is common in the software industry and was as stated by the company in its 10-K. Thefollowing is an excerpt from the companys 10-K for the fiscal year December 31, 1998:

The sales cycle for our products may span nine months ormore. Historically, we have recognized a substantial portionof our revenues in the last month of a quarter, with theserevenues frequently concentrated in the last two weeks ofa quarter. Even minor delays in booking orders may have asignificant adverse impact on revenues for a particular quarter

To the extent that delays are incurred in connection withorders of significant size, the impact will be correspondingly greater. Moreover, we currently operate with virtually noorder backlog because our software products typically are shipped shortly after orders are received. Product licenserevenues in any quarter are substantially dependent on orders booked and shipped in that quarter. As a result of these andother factors, our quarterly results have varied significantly in the past and are likely to fluctuate significantly in thefuture. Accordingly, we believe that quarter-to-quarter comparisons of our results of operations are not necessarilyindicative of the results to be expected for any future period

SEC Investigation and Proceedings

According to the SEC investigation, the problems forMicroStrategy began at the time of its IPO in June 1998and continued through the announced restatement in March2000. The software company materially overstated its revenues and earnings contrary to GAAP. The companys internal revenue recognition policy in effect during the relevanttime period stated that the company recognized revenue inaccordance withSOP 97-2. The company, however, had notcomplied withSOP 97-2, instead recognizing revenue earlierthan allowed under GAAP.The closing of a majority of the companys sales in the finaldays of the fiscal period resulted in the contracts departmentreceiving numerous contracts signed by customers that needed(according to company policy) to be signed by MicroStrategy aswell. To realize the desired quarterly financial results, the company held open, until after the close of the quarter, contracts thathad been signed by customers but had not yet been signed bythe company. After the company determined the desired financialresults, the unsigned contracts were signed and given an effectivedate in the last month of the prior quarter. In some instances, the contracts were signed without affixing a date, allowing the company to assign a date at a later time. GAAP and MicroStrategysown accounting policies required the signature of both the company and the customer prior to recognizing revenue.

SEC regulations that were violated by MicroStrategyincluded reporting provisions, recordkeeping requirements,and the internal control provisions. The company wasrequired to cease and desist from committing any further violations of the relevant rules, as well as take steps to complywith the rules already violated.

Role of the Auditor

The auditor of MicroStrategy in 1996 was Coopers & Lybrand,and Warren Martin was the engagement partner. After Coopers merged with Price Waterhouse and became knownas PricewaterhouseCoopers (PwC), Martin continued as theengagement partner until April 2000. The SEC filed administrative proceedings against him on August 8, 2003, and suspendedhim from practicing before the commission for two years.3

Martin was in charge of the audit of MicroStrategy during the period of restatement and was directly responsiblefor the unqualified (i.e., unmodified) opinions issued on thecompanys inaccurate financial statements. The SEC chargedhim with a variety of violations of professional standards ofpractice, including lacking an attitude of professional skepticism, failing to obtain sufficient evidence to support revenuerecognition, and demonstrating a lack of due care in carryingout professional responsibilities.

Role of Officers of the Company

The following officers came under investigation by the SEC:Michael Saylor, cofounder and CEO; Mark Lynch, the CFO;and Sanjeev Bansal, cofounder and chief operating officer(COO). The SEC filed administrative proceedings againstSaylor, Lynch, and Bansal on December 14, 2000, charging that MicroStrategy materially overstated its revenuesand earnings from the sales of software and informationservices contrary to GAAP. Two other officials were citedfor their role in drafting the revenue recognition policies thatviolated GAAPAntoinette Parsons, the corporate controller and director of finance and accounting and vice president of finance; and Stacy Hamm, an accounting managerwho reported to Parsons.4 The SEC considered that all theseofficers should have been aware of the revenue recognitionpolicies of the company. Lynch, as the CFO, had the responsibility to ensure the truthfulness of MicroStrategys financial reports, and he signed the companys periodic reports tothe SEC. Saylor also signed the periodic reports.

The CEO, CFO, and COO paid approximately $10 millionin disgorgement used to repay investors who were affected by this fraud, another $1 million in penalties, and they agreed to acease-and-desist order regarding violations of reporting, bookkeeping, and internal controls. The controller and the accounting manager agreed to a cease-and-desist order that prohibitedthem from violating Rules 13a and 13b of the Securities andExchange Act. In a separate action, Lynch was denied the rightto practice before the commission for three years.

On June 8, 2005, the SEC reinstated Lynchs right toappear before the commission as an accountant. Lynchagreed to have his work reviewed by the independent auditcommittee of any company for which he works.

Post-Restatement Through 2004

MicroStrategy discontinued its Strategy.com business in 2001.It now has a single platform for business intelligence as its core business. Total revenues consist of revenues derived fromthe sale of product licenses and product support and other services, including technical support, education, and consultingservices. The companys international market is rapidly developing, and it has positive earnings from operations since 2002.

For the year ended December 31, 2004, the MD&A identified its revenue recognition policy as described in Exhibit 1 .In its early years, MicroStrategy stated its revenue recognition policy in a single paragraph, saying that it followedthe relevant accounting policies. Now the company providesa detailed analysis in its MD&A, as well as the notes to financial statements. The company has implemented all therequirements of the SEC. PwC continues as the auditors for MicroStrategy, and the firm has given an unqualified (i.e.,unmodified) opinion on both the companys financial statements and its internal control report under SOX.Investors sued MicroStrategy and PwC in 2000, afterthe software maker retracted two years of audited financialresults and its stock price plunged by 62 percent in a singleday, wiping out billions of dollars in shareholder wealth.

A report filed in court by the plaintiffs said the auditfirm consistently violated its responsibility to maintainan appearance of independence. It cites e-mail evidenceof a PwC auditor seeking a job at MicroStrategy while hewas the senior manager on the team that reviewed the companys accounting. PwC also received money for resellingMicroStrategy software and recommending it to other clients.The accounting firm was working on setting up a businessventure with its audit client, according to the plaintiffs report.

Steven G. Silber, a PwC spokesman, said the companydenies all of their allegations about our independence and the work we performed. He added: While we believe our defenseagainst the class-action claim was strong and compelling, weultimately made a business decision to settle in order to avoidthe further costs and uncertainties of litigation.

MicroStrategys chief of staff, Paul N. Zolfaghari, saidin a statement that PwC auditors have consistently assured us that they have been in full compliance with all applicableauditor independence requirements.On May 8, 2011, PwC agreed to pay $55 million to settle a class action lawsuit alleging that it defrauded investorsin MicroStrategy Inc. by approving financial reports thatinflated the earnings and revenue of the company.6 Exhibit 1 Revenue Recognition MicroStrategys software revenue recognition policies are in accordance with the American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended. In the case of software arrangements that require significant production, modification or customization of software, we follow the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We also follow the guidance provided by SEC Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, and SAB No. 104, Revenue Recognition, which provide guidance on the recognition, presentation and disclosure of revenue in the financial statements filed with the SEC.

We recognize revenue from sales of software licenses to end users or resellers upon persuasive evidence of an arrangement, as provided by agreements or contracts executed by both parties, delivery of the software and determination that collection of a fixed or determinable fee is reasonably assured. When the fees for software upgrades and enhancements, technical support, consulting and education are bundled with the license fee, they are unbundled using our objective evidence of the fair value of the elements represented by our customary pricing for each element in separate transactions. If such evidence of fair value exists for all undelivered elements and there is no such evidence of fairvalue established for delivered elements, revenue is first allocated to the elements where evidence of fair value has beenestablished and the residual amount is allocated to the delivered elements. If evidence of fair value for any undeliveredelement of an arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence offair value exists for undelivered elements or until all elements of the arrangement are delivered, subject to certain limitedexceptions set forth in SOP 97-2.

When a software license arrangement requires us to provide significant production, customization or modification of the software, or when the customer considers these services essential to the functionality of the software product, both the product license revenue and consulting services revenue are recognized using the percentage of completion method. Under percentage of completion accounting, both product license and consulting services revenue are recognized as work progresses based upon labor hours incurred. Any expected losses on contracts in progress are expensed in the period in which the losses become probable and reasonably estimable. Contracts accounted for under the percentage of completion method were immaterial for the years ended December 31, 2004, 2003, and 2002.

If an arrangement includes acceptance criteria, revenue is not recognized until we can objectively demonstrate that the software or service can meet the acceptance criteria, or the acceptance period lapses, whichever occurs earlier. If a software license arrangement obligates us to deliver specified future products or upgrades, the revenue is recognized when the specified future product or upgrades are delivered, or when the obligation to deliver specified future products expires, whichever occurs earlier. If a software license arrangement obligates us to deliver unspecified future products, then revenue is recognized on the subscription basis, ratably over the term of the contract. License revenue derived from sales to resellers or OEMs who purchase our products for future resale is recognized upon sufficient evidence that the products have been sold to the ultimate end users provided all other revenue recognition criteria have been met.

Technical support revenue, included in product support and other services revenue, is derived from providing technical support and software updates and upgrades to customers. Technical support revenue is recognized ratably over the term of the contract, which in most cases is one year. Revenue from consulting and education services is recognized as the services are performed.

Amounts collected prior to satisfying the above revenue recognition criteria are included in deferred revenue and advance payments in the accompanying consolidated balance sheets. Questions 1. Evaluate the accounting decisions made by MicroStrategyfrom an earnings management perspective. What was the company trying to accomplish through the use of theseaccounting techniques? How did its decisions lead the

company down the proverbial ethical slippery slope?

2. What motivated MicroStrategy and its management toengage in this fraud? Use the pressure and incentive side of the fraud triangle to help in answering the question.How would you characterize the companys actions in this regard with respect to ethical behavior, including aconsideration of Kohlbergs stages of moral development?

3. Why is independence considered to be the bedrock ofauditor responsibilities? Do you believe PwC and its professionals violated independence requirements in Rule101 of the AICPA Code of Professional Conduct? Why or why not? Include in your discussion any threats toindependence that existed .