ETHICS

ACCOUNTING

FRAU
By Paul Sweeney

Learning from the Wrongs

S

unbeam Corp. will long be remembered as more than a household name for electric appliances and camping equipment. It will also be notable for more than a decade of mismanagement and dubious experiment.s in ruthless cost-cutting and wholesale firings. For years to come, the name "Sunbeam" will bring to mind a company that relied on questionable accounting gimmicks and outright fraLid in sacrificing the company's reputation on the altar of enhanced earnings and a jacked-up stock price. It happened under the direction of disgraced CEO Albert Dunlap — the notorious, take-no-prisoners West Point graduate and veteran corporate downsizer unaffectionateiy known as "Chainsaw Al" — who put company managers under orders to get the stock price up at any cost. One way to do that, as it turned out, was to report robust .sales of electric blankets in the summer and barbecue grills in late autumn. Eventually, earnings woes and Dunlap's bluster prompted his ouster by an aroused board of

directors in June 1998. That was followed shortly by the replacement of accounting firm Arthur Andersen and a series of investigations and shareholders lawsuits, most of which are still pending. Sunbeam joins an ignominious cluster of companies — Rite Aid, c u e International (now part of Cendant Corp.), Livent, Oxford Health Plans, Phar-Mor, Miniscribe and, most recently. MicroStrategies — in business's hall of shame. All of these companies have one depressing feature in common: top managers who, whether out of desperation or greed, apparently turned to accounting trickery to manufacture imaginary sales and other revenues and pump up earnings, sometimes over a period of years. Writing in The Wall Street Journal, one pundit recently reckoned that just three recent fraud cases — Sunbeam, CUC and Oxford — burned shareholders for an aggregate $34 billion when the troubles surfaced and the stocks plummeted. Chief financial officers and comptrollers at such companies may be under duress and persistent pressure to look the other way — though published studies suggest that, regrettably, they are often

involved, Outside direaors likely have no clue about any shenanigans. But there are plenty of instances where someone aware of the fraud stepped forward. "Mcist frauds are not found by fraud investigations," says Dan Jackson, president of Jackson and Rhodes, a Dallasbased accounting firm. "It's usually because of a disgruntled employee, a dissatisfied vendor or someone with a conscience.'' These days, just the suggestion that a company may have accounting irregularities is enough to drive down its stock price, notes Robert Willens, an accounting analyst at Lehman Brothers. I Ie cites the case of Tyco International, a well-managed company thai makes homesecurity and alarms systems but which was rumored to have accounting problems by the Tice Report, a markets newsletter published by short-seller David Tice. After Tice raised suspicions, the company lost one-third of its value, although the Securities and Hxchange Commission later gave it a clean bill oï health. "It doesn't seem to matter

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this way. Congress passed the Private Securities Litigation Reform Act of 1995 to give companies relief from what were seen as a rash of frivolous lawsuits. The law provided corporations with breathing room in the form of "safe-harbor" provisions that allowed businesses to make "forward-looking" statements without fear of being sued if earnings predictions or growth projections failed to materialize. Yet the number of class-action lawsuits on behalf of shareholders has returned to pre-reform act levels — and the No. 1 reason, the PWC study concludes, is assertions of accounting improprieties. Figures compiled by the Big Five accounting firm show that in 1999, 108 of the 205 private class-action lawsuits - more than 50 percent — involved allegations of accounting irregularities. That figure represents the highest percentage of accounting-related charges made during any single year of the decade. It is also nearly double the share that accounting-related charges played during 1995 — the year before the safeJohn Coffee, a securities expert at Columbia University Law School, says harbor legislation took effect — that close control by company founders and a dearth of outside direcwhen just 25 percent of the 185 tors can lead to problems. cases were accounting-related. The new law clearly did not provide a safe harbor for material son: allegations that companies whether it's the SEC or some misstatements arising in compaare not conforming to Generally newsletter, everyone seems willing nies' audited financial statements, Accepted Accounting Principles to sell a stock now even if there's notes Harvey Kelly, a partner at have become a growth industry just a hint of questionable pracPWC's financial advisory services for lawyers. A study issued in tices," Willens says. "Nobody group in New York who provided August by PricewaterhouseCoopwants to own the next Cendant or commentary for the just-released ers calls the role that accounting Sunbeam." study. "The act provided some allegations now play in federal Accounting irregularities are protection to the companies if securities litigation "striking." getting the attention of Corporate things turned out differently, as It wasn't supposed to happen America for another important realong as they warned people PRICEWATERHOUSECOOPERS FIGURES SHOW THAT about forwardlooking stateIN 1 9 9 9 , MORE THAN 5O PERCENT OF PRIVATE ments," Kelly says. "But if the CLASS-ACTION LAWSUITS INVOLVED ALLEGATIONS reported results OF ACCOUNTING IRREGULARITIES. don't meet the

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from Ernst & Whinney when he went to work for CUC in 1983, the year the company went public. The fraud was not discovered iiniil after the merger in 1997. "The activities had started about then 11983]," Corigiiano told a judge in June, when he pleaded guilty lo fraud charges. Accountants Ernst ¿4 Young have settled a $300 million lawsuit with Cendant, which alleged that the firm should have spotted the fraud at CUC. The New York law firm Willkie Farr & Gallagher and Arthur Andersen combined to investigate the accounting irregularities at Cendant and reported their findings to the audit committee of the company's board of directors. The report says earnings of former Sunbeam is a good example of CUC businesses were overstated a company that engaged in creby approximately $500 million before A COMMISSION INVESTIGATING INSTANCES OF taxes during ihe 1995-1997 period FRAUDULENT FINANCIAL REPORTING FOUND alone. Investigators noted the use of THAT AUDIT COMMITTEES AND BOARDS OF THE such questionable COMPANIES IT ANALYZED APPEARED TO BE WEAK devices as irregular revenue recognition, understatement of reserves, ative revenue recognition. A At CUC International — a shopdelays in recording credits and review of the company's books by ping club company that merged recording of fictitious receivables. auditors from Deloitte & Touche with hotel and car rental company and Arthur Anderson in the HFS to form Cendant — phony The use of a restructuring autumn of 1998 — it took nearly accounting entries created the illureserve fund amounting to several four months for them to unravel sion of millions in profits, making hundred million dollars was an what "Chainsaw Al" biographer CUC a darling of Wall Street anaespecially notable feature. Rather John A. Byrne called the "dirty lysts for more than a decade. than covering one-time costs assobag" of accounting complications When the mess was uncovered in ciated with takeovers, the reserve the wake of the merger, it cost — found that the company's fund became a vehicle for coninvestors — including corporate recorded profits of $109-4 million cealing ordinary business expenspensions, mutual funds and 401(k) in 1997 were illusory. Restated, es and losses and a pot that could plans — $19 billion. The fraud is the earnings amounted to a mere be dipped into to meet expected also landing three top financial $38.7 million. earnings results. "For companies executives in prison, including How did Dunlap and his buccainto cookbooks' and sins neering allies at Sunbeam do it? CUC's former chief financial offibooks,'" Regan says — citing the cer, 40-year-oid Cosmo Corigiiano, One strategy was Sunbeam's pracjargon frequently used at compawho faces up to 10 years in jail. tice of "bill-and-hoid," in which nies employing accounting scams The SEC is bringing additional retailers like Wal-Mart and Costco, — "this is a relatively common charges against the trio, as well as vehicle." in exchange for a discount, agreed several other former executives. to purchase shipments of grills six Rite Aid presents another case months before they were needed What is so astonishing, obwhere efforts to unravel accountand pay for them six months later servers have noted, is that such a ing irregularities have proven to — not within 30 days, as the SEC's massive fraud continued for so be a Herculean task. In July, Rite guidelines for bill-and-hoId long. Corigiiano was a 23-year-old, Aid restated its books and admitaccounting state. The grills were newly minted accountant fresh ted that it had overstated profits

accounting rules, you can make more of a case." Under the law, he adds, 'you're allowed to sue." The study reports that many of the GAAP violation cases have been brought under the anti-fraud provisions — Rule lOb-5 — of the Securities Act of 1934. The study also found that in 1999, more than 50 percent of accounting-related claims involved charges that companies mishandled revenue recognition. In 40 percent of the GAAPreluted claims, the study adds, companies overstated their assets, In addition, it found that irregularities in purchase accounting, liabilities and accounting estimates were also prevalent among the allegations.

also parked over the winter months in warehouses leased by Sunbeam because suppliers had no room for them. A similar program had been put in place during the summer of 1997 for electric blankets. Bill-and-hokl is "a device that auditors need to he very careful of," says Paul Regan, a forensic accountant at Hemming Morse in San Francisco, whose resume includes work on such fraud cases as MiniScribe and Phar-Mor. "Overstating revenues and concealing obsolete inventor>' happen in a majority of misstated financial statements," he adds. "You see it particularly in instances where there is major financial statement manipulation involving products or services, including software."

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during the prior two years by more than $1 billion. After spending more than $50 million in accounting fees lo pore over its murky financial records, according to The Wall Street Journal, the company also reported a net loss of $1.14 billion for the fiscal year ending in February. Both the SEC and the U.S. Attorney's Office are looking into whether the irregularities at Rite Aid officially constitute fraud. Meanwhile, the company's former top management — including its ex-CEO, former president and former CFO — as well as its account-

of g o o d s sold. Among other things, Rite Aid boosted income by recording credits from vendors that hadn t been earned. Rite Aid differs from Cendant and Sunbeam in one important respect: Its accounting firm, KPMG, questioned the integrity of the company's books and resigned from the account. At Sunbeam, the improprieties were discovered only after Dunlap got fired by a restive board. At Cendant, they came to light when an employee who had b e e n participating in the subterfuge finally blew the whistle. While accounting fraud remains the exception — even at 108 cases in 1999, the number of shareholders lawsuits involving accounting is still "quite a small portion of companies that file financial statements," says PWC's Kelly — certain patterns frequently crop up. One is the presence of a tough and powerful CEO who frightens subordinates, notes San Francisco-based accountant Regan. "It's a fairly common theme to have a personality like 'Chainsaw Al' — a domineering bully whom people are feaiftil of. They are afraid of coming up short of the established goals." This observation is borne out by a report from the Committee of Sponsoring Organizations of the Treadway Commission, issued in March 1999- The panel studied 200 c o m p a n i e s charged with fraudulent fmancial reporting from 1987-1997. Among its findings was the observation that top executives were frequently involved, In 83 percent of the cases, the report found, either the CEO or the chief financial officer — or both — were associated with financial statement fraud. Common Characteristics The report, "Fraudulent Financial Reporting: 1987-1997," also noted that the audit committees and boards of the companies it analyzed appeared to be weak. Most audit committees seldom met, and lx)ards of directors were dominat-

Tips for Avoiding Fraud
• Develop strong audit committees and outside directors. • Beware of a p r e o c c u p a t i o n with reporting strong earnings, which can be a slippery slope. • Institute a series of checks and b a l a n c e s : Different p e o p l e should make a sale, book a sale and collect the money. * Steer clear of gimmicks like reserve funds, capitalizing ordinary e x p e n s e s and excessive "bill-and-hold" periods. • Be careful with revenue recognition and purchase accounting. ^' Have 800 numbers or other lines of communication available for potential whisde-blowers. ing firm, KPMG, are all being sued in a class-action brought on behalf of shareholders. The stock, which sold as high as $24 in mid-1999, was under $5 in early August. Accounting experts say that Rite Aid engaged in just about every form of accounting impropriety available. For example, it capitalized ordinary expenses to inflate current income and hid depreciation expenses by counting them as construction-in-progress, according to the Journal. The biggest adjustments — more than $500 million over two years — came in the category of inventory and cost

ed by insiders and others with close connections to the company. The report concluded, too, that "a significant portion of the companies were owned by the founders and board members." Several observers have noted that bodi patterns were particularly apparent at Cendant, where "you did not have independent directors, and both companies ICUC and HFS] were entrepreneurial and controlled by their founders," notes John Coffee, a securities expert at Columbia University Law School. Adds corporate gadfly and shareholder activist Nell Minow, a Washington, D.C.-based attorney: "What Htruck me about Cendant was that, over the same period of time, its compensation committee met eight times but its audit committee met only twice." As most investigations show, the motive for the fraud was to drive up a company's stock price and satisfy Wall Street's expectations. For that reason, many observers fret that corporate controls are more necessary than ever, now that the bull market can no longer be relied on to lift stocks in general. In the meantime, the getrich-quick mentality at many Internet and New Economy start-ups, coupled with prevailing compensation schemes that involve .stock and stock option grants, create an ideal breeding ground for aggressive financial reporting. This is especially true in an era when the auditing function is seen as a commodity, and accounting firms rely on the integrity of management. Says law professor Coffee: "Often you're dealing with companies founded by 20-year-olds who are impatient with the Old Economy's ways of doing things. They don't understand thai accounting manipulaiton affects your credibility for a long, long time, You don't recover once you ve been found to have fabricated your numbers." Paul Sweeney is a freelance business writer based in New Yorii.

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