Revenue Recognition Fraud or Error The Case of MicroStrategy, Inc.

By
Sudha Krishnan
Assistant Professor
Loyola Marymount University
Hilton Center for Business
One LMU Drive, MS 8385
Los Angeles, CA 90045

Tel: (310) 338 7409

Fax: (310) 338 3000

Email: skrishna@lmu.edu

My thanks to Wendy Pfeifle from the MBA program for excellent research
assistantship and to Dr. Alan Cherry of Loyola Marymount University for all the
encouragement.
Revenue Recognition Fraud or Error The Case of MicroStrategy, Inc.

Abstract

This is a part of series of cases on revenue recognition issues identified from the popular press as
well as the SEC enforcement actions. These cases can be used both at the undergraduate and at
the MBA level.

This specific case deals with MicroStrategy, Inc., a software company listed on NASDAQ. Since
the company came out with an initial public offering (IPO) in June 1998, it has always been
identified as a successful growing company with positive net income. On March 20, 2000, the
company announced that it would restate its financial statements since its IPO. This
announcement caused its share price to fall 60% in one day.

The case summarizes the timeline of actions taken by the company management and identifies
the issues relating to revenue recognition policies under generally accepted accounting
principles.
Background

MicroStrategy Inc., incorporated in Wilmington, Delaware in November 1989, has

offices all over the United States, as well as, around the world. Its headquarters is located in

McLean, Virginia. The companys principal business in the early years encompassed providing

software consulting services to assist customers in building custom software systems to access,

analyze, and use information contained in large-scale transaction- level databases. MicroStrategy

began concentrating its efforts on the development and sale of data mining and decision support

software and related products during 1994 and 1995.

A greater part of the revenues in 1996 resulted from software license sales. The company

licensed its software through its direct sales force and through value- added re-sellers and

original equipment manufacturers. By 1997 sales through the latter two methods, sometimes

known as channel partners, represented more than 25% of the companys total revenues. Since

1996, the company revenues have been derived primarily from three sources:

Product licenses
Fees for maintenance, technical support and training
Consulting and development services

The company went public through and initial public offering in June 1998. From the third quarter

of 1998, the company began to take on a series of increasingly bigger and more complicated

transactions involving the sale of software, as well as, extensive software application

development and consulting services. The company began to develop, in 1998, an information

network supported by the organizations software platform. Initially known as Telepath, but

now known as Strategy.com. This network would convey personalized finance, news, weather,

traffic, travel, and entertainment information to individuals through cell phones e- mail and fax
machines. Today, MicroStrategy is a leading worldwide provider of business intelligence

software.

Restatement of Financials and its Impact

A Financial Executives International Research Foundation survey found that 464

companies had restated their earnings in the last three years, more than in the prior 10 years

combined. One of the companies on that list is MicroStrategy.

On March 20, 2000, MicroStrategy announced that it planned to 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% of its value in one day, dropping from $260 per share to close

at $86 per share on March 20th. The stock price continued to decline in the following weeks.

Soon after, MicroStrategy announced that it would also restate its fiscal 1997 financial results,

and by April 13, 2000 the companys stock closed at $33 per share.

Figure 1 Chart MicroStrategy, Inc. January 2000-January 2002

 These restatements (summarized in Table 1) reduced the companys revenues over the

three-year period by about $66 million of the $365 million reported. About $54 million, or 80%,

of these restated revenues were in 1999. The companys main reporting failures were derived

from its premature recognition of revenue arising from the misapplication of AICPA Statement

of Position 97-2. This misapplication was in connection with multiple-element deals in which

significant services or future products to be provided by the company were not separable from

the up-front sale of a license to the companys existing software products. Additional

restatements resulted from deals in which the company had not properly executed contracts in

the same fiscal period in which revenue was recorded from the deals, as well as other accounting

errors.

Table 1 Impact of Restatement on Revenue and Net Income

Revenue Net Income
(In thousands)
Reporting period Original Restated Original Restated

Year ended:
December 31, 1997 53,557 52,551 121 (885)

Quarter ended:
March 31, 1998 19,895 19,160 542 (193)
June 30, 1998 23,790 21,138 942 (1,133)
September 30, 27,014 25,960 1,928 2,055
1998
December 31, 1998 35,731 29,231 2,766 (2,984)

Year ended:

December 31, 1998 106,430 95,489 6,178 (2,255)

Quarter ended:
March 31, 1999 35,784 29,322 1,859 (3,804)
June 30, 1999 45,638 40,465 3,211 (3)
September 30, 54,555 35,309 3,794 (12,774)
1999
December 31, 1999 69,352 46,162 3,756 (17,162)

Year ended:
December 31, 1999 205,329 151,258 12,620 (33,743)
Company reports

The company 10K for the fiscal year ended December 31, 1998 states the following:

Our revenues are derived from two principal sources (i) product licenses and (ii) fees for
maintenance, technical support, education and consulting services (collectively, "product
support"). Prior to January 1, 1998, we recognized revenue in accordance with Statement
of Position 91-1, "Software Revenue Recognition." Subsequent to December 31, 1997,
we began recognizing revenue in accordance with Statement of Position 97-2, "Software
Revenue Recognition." SOP 97-2 was amended on March 31, 1998 by SOP 98-4
"Deferral of the Effective Date of a Provision of SOP 97-2." In December 1998, the
AICPA issued SOP 98-9 "Modification of 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 believes that their adoption will not have a material
effect on the timing of our revenue recognition or cause changes to our revenue
recognition policies. Product license revenues are generally recognized upon the
execution of a contract and shipment of the related software product, provided that no
significant Company obligations remain outstanding and the resulting receivable is
deemed collectible by management. Maintenance revenues are derived from customer
support agreements generally entered into in connection with initial product license sales
and subsequent renewals. Fees for our maintenance and support plans are recorded as
deferred revenue when billed to the customer and recognized ratably over the term of the
maintenance and support agreement, which is typically one year. Fees for our education
and consulting services are recognized at the time the services are performed.

The majority of MicroStrategys sales closed in the final days of the fiscal period which

is common in the software industry and as stated by the company in there 10K. The following in

an excerpt from the companys 10K for the fiscal year December 31, 1998.

The sales cycle for our products may span nine months or more. Historically, we have
recognized a substantial portion of our revenues in the last month of a quarter, with these
revenues frequently concentrated in the last two weeks of a quarter. Even minor delays in
booking orders may have a significant adverse impact on revenues for a particular
quarter. To the extent that delays are incurred in connection with orders of significant
size, the impact will be correspondingly greater. Moreover, we currently operate with
virtually no order backlog because our software products typically are shipped shortly
after orders are received. Product license revenues in any quarter are substantially
dependent on orders booked and shipped in that quarter. As a result of these and other
factors, our quarterly results have varied significantly in the past and are likely to
fluctuate significantly in the future. Accordingly, we believe that quarter-to-quarter
comparisons of our results of operations are not necessarily indicative of the results to be
 expected for any future period. See "Risk Factors--Potential Fluctuations in Quarterly
Operating Results."

SEC Investigations and Proceedings

According to the SEC investigation, it seems things went wrong for MicroStrategy from

the time of its public offering in June 1998 through March 2000. The software company

materially overstated its revenues and earnings contrary to Generally Accepted Accounting

Principals (GAAP). The companys internal revenue recognition policy in effect during the

relevant time period stated that the company recognized revenue in accordance with SOP 97-2.

The company, however, had not complied with SOP 97-2, instead recognizing revenue earlier

than allowed under GAAP.

As stated in the SEC administrative proceedings, a majority of the companys sales

closed in the final days of the fiscal period resulting in the contracts department receiving

numerous contracts signed by customers that needed (according to company policy) to be signed

by MicroStrategy. In order to realize the desired quarterly financial results, the company held,

until after the close of the quarter, contracts that had been signed by customers but had not yet

been signed by the company. Only after the company determined the desired financial results

were the unsigned contracts distributed, between the just-ended quarter and the then-current

quarter, signed and given an effective date. In some instances, the contracts were signed

without affixing a date, allowing the company to assign a date at a later time. GAAP and

MicroStrategys own accounting policies required the signature of both the company and the

customer prior to recognizing revenue. Table 2 identifies improper revenue recognition realized

by MicroStrategy that were material to the reported financial results for that fiscal period.
 Table 2 Revenue Recognition Problems

Revenue
Fiscal Improperly
Company Period Recognized
Involved Effected Issue with Transaction Problem with Transaction (in thousands)
Shopko Stores, Inc. 12/31/98 Accounting for multiple- MicroStrategy accounted for the software $4,500,000
element transactions consisting product element as though it were separate
of providing software licenses, from the service and warrant obligation
as well as, extensive consulting recognizing the entire $4.5 million
and development services and a received in the transaction as software
warrant permitting Shopko to product license revenue, allocating no
purchase 50,000 shares of revenue to the extensive service
MicroStrategy common stock obligations or the warrant
Choicepoint, Inc. 3/31/99 Contract not signed by Choicepoint did not sign contract until $956,000
customer April 2, 1999, but contract was dated
March 31, 1999
K-Mart Corporation 3/31/99 Arrangement to provide MicroStrategy improperly recognized $2,300,000
software licenses, maintenance approx. $2.3 million and the revenue was
and services, in connection with later deferred since the value of the future
the transaction, the sales staff product could not be determined and the
issued a side letter to K-Mart product had yet to be delivered
promising the delivery of future
products at no cost
NCR Corporation 9/30/99 Contract not signed by MicroStrategy signed contract in the early $27,500,000
company hours of October 1, 1999
NCR Corporation 9/30/99 MicroStrategy's agreement with Because a company cannot provide $17,500,000
NCR included a license to "all "Vendor Specific Objective Evidence" of
current and future generally the fair market value for unspecified future
available software products in products, SOP 97-2 requires the
the company's product line" application of contract accounting to
arrangements containing unspecified
future product obligations, the company
improperly recognized $17.5 million
Sybase, Inc. 9/30/99 The two companies essentially Consistent with GAAP, this transaction $5,000,000
swapped $5 million of software should have been accounted for as a barter
transaction and would have resulted in no
revenue being recognized until such time
as the software was used by MicroStrategy
internally or was sold to another party
Primark Corporation 12/31/99 Transaction not complete/or Prior to midnight negotiations broke down $5,000,000
signed by either party over an issue that was not resolved until
the following week and contract not signed
by either party until January 3, 2000
Exchange 12/31/99 Accounting for multiple- Exchange Applications agreed to pay the $14,000,000
Applications, Inca element transactions which company $65 million dollars for the (1)
included, among other things, right to resell MicroStrategy's product line
software and extensive as a VAR; (2) consulting and development
consulting and development services of a dedicated business unit of the
service elements company's employees; and (3) intellectual
property rights to product developed by
the dedicated business unit. MicroStrategy
improperly separated the software product
element of the transaction from the service
component and as a result recognized
$14.1 million

Note:
The Strategy.com transactions combined similar service and software elements and thus presented similar revenue recognition issues as
those discussed above. They involved transactions with such company's as Ameritrade Holding Corporation; Metrocal, Inc; and Primark
Corporation.
SEC List of Violations

According to the SEC Accounting and Auditing Enforcement, Microstrategy violated

Sections 13(a), 13(b) (2) (A), and 13(b) (2) (B) of the Exchange Act and Rules 13a-1 and 13a-13.

These involved violations of reporting provisions, violation of record-keeping provisions, and

violation of internal control provisions. The company was asked to cease and desist from

committing any further violations of the relevant rules as well as take steps to comply with the

rules already violated. A copy of the SEC ruling is enclosed as Annexure A.

Todays Environment and MicroStrategy

MicroStrategy will announce its current quarter results on January 31, 2002. The

companys current 10Q (quarter ended September 30, 2001) states that towards the end of 2000

and throughout 2001, it has been affected by the global economic slowdown that has resulted in

a decrease in corporate spending on information technology. The terrorist attacks on September

11, 2001 magnified this economic trend during the third quarter. These macro-economic factors

have had an adverse impact on the Companys results of operations. The company has

developed a restructuring plan to better align operating expenses with revenue expectations to

help achieve company goals of making MicroStrategys core business profitable on an operating

basis by the end of 2001, excluding certain charges.

According to the press release announcement, financial results for the three- month period

ending September 30, 2001, MicroStrategy reported a pro forma net operating loss, which

excludes certain items, for the third quarter of $5.7 million that is $0.06 per share, an 81%

improvement from the third quarter of 2000.

Consolidated earnings for the third quarter of 2001 (GAAP) was $36.1 million compared

to a loss of $170.4 million in the third quarter of 2000. "With the third quarter financial results

exceeding consensus expectations, MicroStrategy remains on track to achieve core-business pro

forma profitability in Q4 2001," said Eric Brown, MicroStrategy President and CFO. Our

balance sheet remains strong with $43 million in cash and our core business produced positive

operating cash flow this quarter. We increased gross margins to 71% and have now reduced

annualized operational expenses by more than $185 million since the middle of last year."

"We have successfully implemented a comprehensive plan to substantially increase cost-

efficiency and productivity -- to do more with less," said Michael J. Saylor, Chairman and CEO.

He continued: "Our customer base continues to expand at a healthy rate and we maintained a

50:50 balance in new versus existing customer revenue for the quarter. Our technology continues

to set industry standards and our latest 7.1 release won the PC Magazine, Editors' Choice award

as the best business intelligence software. In the face of severe macro-economic turbulence, we

have configured our business to not only help us reach profitability on schedule, but also put us

in the right position to build on our market and technolo gical leadership in the years ahead."

Though the business-intelligence software vendor promises its getting closer to

generating a profit, but its third-quarter results show a vexing drop in license revenue, a key

growth indicator. The Company reported a net loss of $6.0 million on sales of $44.2 million for

the quarter ended September 30, 2001, but executives say the companys core operations will be

profitable this quarter. License revenue fell to $16.6 million from $28.1 million one year ago.

Beyond the revenue they bring in directly, new license sales also help drive revenue from

support and other services, which fell to $27.6 million in the quarter from $36.7 million a year

ago.

A Company that peaked at a share price of $ 333 per share is quoted at $ 3.15 per share

as of January 16, 2002. What a collapse!

Questions

1. What are the rules of revenue recognition under SOP97-2 that was violated by the
MicroStrategy? Apply the facts reported in the case.

2. Go to the website: http://www.microstrategy.com/. Access the Investors section under

Company. You can access the SEC filings from April 1998 onwards. What is the impact
on earnings per share of the restatements? Identify earnings per share for every quarter
since the first restatement in 1997. Do you notice any trends?

3. Access the 10K for the years 1998 and 1999. Access the cash flow and income
statements. Does the cash flow statement indicate any signs of problems related to
revenue recognition?

4. Refer to sections 13(a), 13(b) (2)(A) and 13(b)(2)(B) of the Exchange Act? What were
the exact violations of Microstrategy?

5. Refer to the Administrative Proceedings file no 3-10388 the Accounting and Auditing
Enforcement of the SEC dated December 14, 2000 as well as Annexure A. Identify the
actions to be taken by Microstrategy in order to comply with the relevant sections of the
Exchange Act.

6. Suggest actions that need to be taken by other software companies to avoid penalties
similar to that suffered by MicroStrategy.
 Citations

Andrews Publication Inc. Case: Securities Fraud/Pleading Standards: In re MicroStrategy Sec.

Litig. Magnitude of Restatements Precludes Dismissal in MicroStrategy Case

DM Review. MicroStrategy Earnings Results Exceed Expectations

Ernst & Young booklet on SOP 97-2; http://www.ey.com/global/gcr.nsf/US/SOP_97-

2_Software_Revenue_Recognition_as_Affected_by_SOP_98-4_-_Assurance_&_Advisory_Business_Services_-
_Ernst_&_Young_LLP

Microstrategy Chart; Http://finance.yahoo.com/q?s=mstr&d=c&k=cl&a=v&p=s&t=3m&l=on&z=m&q=l

Microstrategy report:
Http://yahoo.marketguide.com/mgi/mg.asp?target=/stocks/companyinformation/ratio&ticker

Microstrategy 10Q ; Management Discussion; Http://biz.yahoo.com/e/011114/mstr.html

Phillips, Thomas J. The Right Way to Recognize revenue. Journal of Accountancy, June 2001

Quarterly Financials of Microstrategy Http://biz.yahoo.com/fin/l/m/mstr_qc.html

Statement of Position 97-2 Software Revenue Recognition

SEC web site; Http://www.sec.gov

-United States of America before the SEC, administrative proceedings file no. 3-10388
In the Matter of MicroStrategy, Inc
-Fact Sheet Staff SAB 101 Revenue Recognition, 12/3/1999
-Office of the Chief Accountant: Letter from SEC Chief Accountant to FASB re:Revenue
Recognition and EITF Issue 00-21, July 19,2001
-Speech by SEC Staff: Revenue Recognition, May 31, 2001
-U.S. SEC Washington, D.C. Litigation Release No. 16829 / December 14, 2000
-SEC Brings Civil Charges Against MicroStrategy, Three Executive Officers for
Accounting Viola tions
-Letter from the Chief Accountant: Accounting Issues Related to Internet Operations

Wasserman, Elizabeth. A Search for Redemption. Industry Standard, 1/22/2001

 Annexure A

Securities and Exchange Commissions Ruling for MicroStrategy

The Commission finds that MicroStrategy violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B)
of the Exchange Act and Rules 13a-1 and 13a-13 thereunder.

ACCORDINGLY, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act,

that MicroStrategy:
A. Cease and desist from committing or causing any violations and any future violations of
Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and
13a-13 thereunder; and
B. Comply with, and take steps to effect future compliance with, Sections 13(a),
13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13
thereunder upon such terms and conditions as MicroStrategy has undertaken to
implement the following:

Corporate Governance Undertakings

1. Corporate Governance and Audit Committee Composition
MicroStrategy's Board of Directors currently includes Saylor, Bansal and four independent
directors. MicroStrategy shall add one additional independent director to the Board who is
independent of the company and is not objectionable to the Commission. The new director shall
have prior experience as a Chief Financial Officer of a public company (or other officer
primarily responsible for external financial reporting) or as a member of an Audit Committee of
a public company.
2. Non-Management Board Members Departures
MicroStrategy shall for a period of three years report to the Commission within ten days on the
full facts and circumstances surrounding the departure (for any reason whatsoever) of any non-
management member of the Board of Directors including, but not limited to, any disagreements
with the departing director on accounting principles, practices or procedures employed by
MicroStrategy or over the quality of MicroStrategy's internal control environment. The statement
shall be shown to the departing director before its submission to the Commission and the
departing director shall be given the opportunity to comment to the Commission on the
statement.
3. Audit Committee and Charter Enhancements
MicroStrategy shall adopt an updated charter for the Audit Committee consistent with the
recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate
Audit Committees and the Commission's recently adopted rules on Audit Committee disclosure.
The Charter shall include provisions relating to:
1. the independence of Audit Committee members;
2. the oversight responsibilities of the Audit Committee, including those with respect to the
positions and functions of the Chief Financial Officer and Director of Internal Audit; and
3. the reporting obligations of the Audit Committee under Item 306 of Regulation S-K and
Item7(e)(3) of Schedule 14(a).
Management Undertakings
MicroStrategy shall add to its management a Director of Internal Audit. In addition,
MicroStrategy shall create an Internal Audit Department appropriate for the size and business.
The Director of Internal Audit shall be an individual with appropriate qualifications and
experience for the position and shall be hired after consultation with and approval by the Audit
Committee.

Compliance Undertakings
1. Corporate Code of Conduct
MicroStrategy shall adopt and implement through a comprehensive worldwide training effort a
Code of Conduct appropriate for the Company's size and business within 30 days of the date of
these undertakings. Prior to its adoption the Code of Conduct shall be reviewed and approved by
the Board of Directors.
The Code of Conduct shall at a minimum include policies relating to financial reporting,
documentation of transactions, confidentiality of Company information, compliance with the
Foreign Corrupt Practices Act, transactions in Company securities and communications with
investors, analysts and the media about Company matters. The Code of Conduct shall also
contain procedures by which employees may report suspected violations of the Code of Conduct
or other Company policies.
The Company shall require that each officer, director and employee sign a certification of
compliance with the Code of Conduct on an annual basis.
2. Global Revenue Recognition Policy
MicroStrategy shall adopt and implement a Global Revenue Recognition Policy within 30 days
of the date of these undertakings. The Policy shall include procedures to ensure compliance with
U.S. generally accepted accounting principles including, but not limited to, AICPA Statement of
Position 97-2 and any future amendments.
3. Contract Approval, Execution and Processing Policy and Procedures
MicroStrategy shall adopt and implement Contract Approval, Execution and Processing Policies
and Procedures within 60 days of the date of these undertakings. The policy shall require the
development of standard contract forms complying in all respects with the Company's Global
Revenue Recognition Policy and will establish procedures for the Chief Financial Officer's
approval prior to execution of any non-standard agreement. The policy shall reflect the
requirement in the Company's Global Revenue Recognition Policy that all material terms of all
contracts (except purchase orders issued against previously executed reseller or other similar
agreements) shall be signed by all parties to the transaction at least by the end of the period in
which revenue on the contract will be recognized. The Policy shall also, at a minimum:
a. formalize procedures governing the signing and dating of contracts, including the
creation and maintenance of a contract signature log to track contracts through the
approval and execution process,
b. establish procedures requiring the delivery of contracts signed by all parties (or valid
purchase orders) to the appropriate accounting personnel prior to revenue recognition,
invoicing or delivery of software, and
c. implement procedures for the retention of all necessary contract documents, including
drafts and correspondence.
4. Comprehensive Policies and Procedures Manual
MicroStrategy shall adopt and implement within 90 days of the date of these undertakings a
Comprehensive Policies and Procedures Manual for its accounting, finance, contracts and other
related operations personnel. In addition to the Global Revenue Recognition Policy and the
Contract Approval, Execution and Processing Policies and Procedures described above, the
Manual shall include polices and procedures relating to the following:
a. reporting and review of material transactions entered into by the Company's foreign
subsidiaries,
b. establishment and documentation of subjective reserves and allowances,
c. bank, payroll and other account reconciliation,
d. fixed asset inventories, accounting and security,
e. customer credit policies and due diligence,
f. collections and accounts receivable,
g. non- monetary, barter or reciprocal arrangements,
h. documentation or controls relating to reseller arrangements, and
i. documentation of estimates used in contract accounting and other accounting areas
dependent on estimates.
5. Training and Education on Policies and Procedures
MicroStrategy shall provide all officers, directors and employees subject to the policies and
procedures in these undertakings with the necessary training and education on the new policies
and procedures. In addition to the provision of the policies and procedures, together with relevant
background materials, such training and education will include, at a minimum, both initial
training sessions immediately following adoption of the policy (as part of the implementation
process) and annual training updates.

Compliance with the Undertakings

The new independent member of the Board of Directors, appointed pursuant to these
undertakings, shall review the Company's implementation of and compliance with these
undertakings. The new director's review shall begin no earlier than six months from the date of
these undertakings and the new director shall report the results of the review to the Company and
the Commission within three months after the start of the review