How Cooked Books Are Threatening Directors
from Winter 1998
by Ann Reilly Dowd
You’ve seen the screaming headlines. Accounting “irregularities” send stock prices and corporate heads tumbling at Cendant, Livent, Sunbeam, Waste Management, and more. But don’t think the cooking of America’s corporate books ends there. Far more pernicious and pervasive is the everyday, mostly legal manipulation of corporate financial statements to meet or beat analysts’ earnings expectations.
The result: financial statements that are increasingly meaningless, indeed misleading, and often-befuddled board members—particularly those on audit committees—in the cross hairs of angry shareholders and government regulators. “We’re turning up the heat on audit committees,” says Nell Minow, a principal of the Lens Group, an activist money-management company that militates for better boards.
At stake for board members who sit idly by as managers fudge the numbers are two precious commodities: reputation and money. No director can make good decisions based on bad numbers. Had Waste Management’s financials, for example, given the board a true picture of the company’s health, some directors might have questioned the underlying business strategy. Instead, after years of inflated earnings, Waste Management was forced to take the mammoth $3.54 billion pretax charge against earnings last year that sent its stock careening and led to a takeover by a much smaller rival. Along with other shareholders, board members are counting their losses. Worse yet, they must contend with a raft of ugly and potentially costly class action suits.
Indeed, irate investors are quicker than ever to sue corporate managers and directors after news of cooked books implodes share prices. PricewaterhouseCoopers reports that the share of class action suits alleging accounting irregularities has more than doubled—from 19% in 1995 to 40% in 1997. Says Securities and Exchange Commission Chairman Arthur Levitt, who recently appointed a private-sector panel to improve the quality and vigilance of corporate boards: “Audit committees and how CEOs use or abuse them is an area which cries out for adjustment.”
Just how pervasive is the problem? No doubt, financial reporting in the United States is cleaner than virtually anywhere else in the world. Nonetheless, as the eight-year bull market has shown signs of petering out, corporate executives seem increasingly willing to go beyond the standard techniques of managing earnings—say, year-end sales promotions or deferring advertising or research and development expenditures in a bad sales year. No one knows for sure if outright fraud is actually increasing, though it certainly feels that way to many veteran investors. Says Vanguard Group founder John Bogle, a mutual fund industry wise man and a leading critic of accounting excesses: “Certainly the number of cases that have found the light of day are larger this year than any I can recall.”
What’s clearly exploding is the hocus pocus, the kneading and pulling of the so-called Generally Accepted Accounting Principles, or GAAP, in ways that are mostly legal but fundamentally misleading to investors—and, in the long run, often bad for business, too. Major institutional investors like Vanguard’s Bogle plus activists like Minow have long been sounding alarms. Now the SEC’s Levitt and other regulators are joining their crusade to clean up America’s books. “Too many corporate managers, auditors, and analysts are participants in a game of nods and winks,” said Levitt recently, in a major address outlining a multifront attack on accounting practices that go beyond the simply aggressive to the downright deceptive. “I fear that we are witnessing an erosion in the quality of earnings and, therefore, the quality of financial reporting. Managing may be giving way to manipulation. Integrity may be losing out to illusion.”
What drives management to fudge its numbers? And where are the accountants, regulators, and board members who are supposed to function as watchdogs for investors? Here are some of the main ingredients of the mess and ways to get back to numbers you can trust.
Earnings addiction
It’s no secret that the furious focus on quarterly earnings puts corporate managers under massive pressure to meet or beat analysts’ expectations. Miss by as little as a penny, and the market can send your stock into a nosedive and management into early retirement. And virtually all executives now get cash bonuses only if the year’s corporate earnings reach preset targets. What’s more, stock options are increasingly designed to be exercised and sold each quarter for cash, most often in a trading window that opens a day or two after the company reports its quarterly numbers. Do these performance incentives encourage fudging? A 1996 study in the Journal of Business Ethics, which put executives in play-acting roles, found 80% willing to understate charges to boost earnings and meet targets affecting their bonuses or stock options. At an April 1998 conference of nearly 100 chief financial officers hosted by Business Week, 67% said other executives had asked them to falsify financial results, while 12% admitted they actually had.
“The recipe of choice,” says Walter Schuetze, the chief accountant in the SEC’s enforcement division, “is premature recognition of revenue, followed by improper deferral of costs, including salaries and advertising.” In the case of Cendant, for example, executives inflated pretax profits by about $500 million for the last three years, largely by booking false revenues for the firm’s discount club memberships. [Editor’s note: Two owners of this magazine have past and present associations with Cendant.] At Waste Management, the numbers-crunchers stretched out depreciation writeoffs on an armada of trucks and dumpsters far beyond their useful lives, while inflating the value of landfills, recycling facilities, and hazardous waste plants. At the Broadway production company Livent, corporate impresarios reportedly kept two sets of books, one with the real numbers, the other with profits propped up by inflating revenues from the sale of show sponsorships and other rights and improperly reporting lavish production expenses.
In each case, the idea was to make reported earnings glitter, though the methods were clearly contrary to the aims of GAAP. It worked for a time, until it didn’t, and the companies typically were forced to announce accounting irregularities and restate earnings, which sent their stocks crashing. Meanwhile, the SEC is investigating most of the cases.
More typically, executives try to observe the letter of the accounting principles but stretch them to just before the point where, as Schuetze puts it, “the rubber band breaks.” One of the hottest gimmicks these days is the “big bath.” Theoretically, financial statements are supposed to provide a snapshot of how a company is performing in a single year. Revenues, expenses, and earnings are supposed to be contemporaneous. But in reality, many corporations are aggressively mixing apples and oranges, pitching current and future expenses—some real, some not so real—into single, giant writeoffs, most often during corporate restructurings. In fact, the whole purpose of some restructurings seems to be to wash the books clean of pesky expenses. Whatever the motivation, restructurings are clearly the rage: Over the last two years, the number of companies taking restructuring charges more than doubled from 96 in 1995 to 230 in 1997, according to earnings tracker First Call.
In the short term, such baths are usually splashing successes as Wall Street analysts and investors interpret them, sometimes correctly, as signs that the company is taking tough steps to become more competitive. Better yet for management, big restructuring charges boost future reported earnings by eliminating the need to write off those costs over time. The real problem arises when companies pitch into the bath more than legitimate restructuring costs related to layoffs or closing down divisions, creating a distorted picture of the company’s finances. Among the liabilities improperly included, say SEC insiders, are wages, litigation costs, and operating losses related to divisions that are to be shut down. Quips Schuetze: “There’s so much water flooding over the top of the tub, you need a mop to clean it up.”
Warning that restructurings should not be considered an opportunity for “flushing all the associated costs—and maybe a little extra—through the financial statements” at once, Levitt says the SEC will soon require more detailed corporate disclosures. The agency wants companies to show beginning and ending balances, as well as activity in between, “to better understand the nature and effects of restructuring liabilities and other loss accruals.” Also expect the SEC to provide more detailed guidance on what constitutes legitimate restructuring writeoffs and to force those who bend the rules to restate earnings. Schuetze suggests that directors “ask deep and searching questions of management and the outside auditors about (a) whether the amount of assets recorded on the balance sheet is recoverable; (b) what the ingredients in any restructuring charges are; and (c) whether they are in compliance with official accounting literature.” He adds, “Too often, boards don’t get out their shovels and picks and dig deep enough to see what’s really going on.”
Merger madness
Much like peanut butter and jelly, accounting chicanery and merger mania just seem to go together. In some cases, the urge to acquire appears to blind otherwise-savvy corporate execs to financial warning signals. Consider the case of Michael Ovitz, the former Hollywood power broker and president of the Walt Disney Co., who put up $20 million last April to buy Livent, the producer of such Broadway hits as Ragtime and Showboat. Only two months later, the company announced “accounting irregularities” that would force it to restate earnings dating back to the beginning of 1996, while suspending its flamboyant founder Garth Drabinsky. (Drabinsky had been kicked out as CEO of Cineplex Odeon in 1989 amid charges of overly aggressive accounting.) Shouldn’t Ovitz, who hired KPMG Peat Marwick to help do his due diligence, have smoked out such dirty doings? Livent spokesman James Badenhausen says that the new management did know going in that Livent was known for aggressive accounting but thought it was within the acceptable limits of GAAP.
In other cases, the accounting rules seem to be fueling the merger boom. Take the popular accounting convention called “pooling,” which can effectively wipe much of the cost of a stock acquisition off a company’s books for those combinations that meet the SEC’s rigid criteria. That’s in contrast to traditional “purchase” accounting, which requires a firm to write off over as many as 40 years goodwill, or the premium paid over book value for the acquired firm. With goodwill gone, the company using the pooling method can boost its future earnings dramatically. Merger experts say as many as one-third of today’s mergers would disappear without pooling. Indeed, the number of companies using pooling for acquisitions over $100 million exploded from 11 in 1990 to 364 in the first eight months of 1998, according to Securities Data Co. At the least, conscientious directors need to be able to sort out how much a proposed merger is motivated by accounting rules and how much by more fundamental business judgment.
Companies that cannot qualify for pooling have hit on another trick to boost future reported earnings: the immediate expensing of in-process R&D. “These writeoffs are supposed to reflect the value of what companies are actually working on,” says the SEC’s Turner. But putting a dollar figure on the future value of research not yet completed is a highly subjective exercise, and it is tempting to err on the side of optimism. Since IBM used this technique to write off virtually the entire cost of its acquisition of software maker Lotus Development in 1995, the ploy has been used by hundreds of companies, particularly high-tech and pharmaceutical concerns with lots of ongoing research. In a recent survey of 1,000 companies, New York University accounting and finance professor Baruch Lev found 389 that wrote off in-process R&D in the 1990s, versus only three in the 1980s. Even more stunning, those writeoffs averaged a massive 75% of the companies’ acquisition costs.
Regulators recognize that as long as such techniques are legal, corporate executives and their boards will feel pressured to use them. Consequently, the Financial Accounting Standards Board is considering new rules for mergers that would eliminate pooling and force all companies to follow a purchase accounting method. Meanwhile, Levitt has asked the American Institute of Certified Public Accountants to clarify the ground rules for writing off purchased R&D, as well as other tricks of the trade involving restructurings and the timing of revenue recognition. And the SEC itself plans to crack down on those who stretch the rules too far. Says Turner: “We want to nip this thing in the bud.”
Rusty rules
Another fundamental problem underlying the recent spate of accounting shockers is the fact that GAAP is increasingly out of sync with today’s business realities. The accounting rules were developed in an industrial economy, but this is the information age. How do you precisely measure the value of R&D, customer lists, brand names, patents, and other intellectual property? Of course, this situation creates opportunities for creativity, like the ballooning practice of in-process R&D writeoffs. Former SEC Commissioner Steve Wallman says “GAAP is not broke but is getting increasingly rusty.” Others are less charitable. Superlawyer Bill Lerach, the king of securities class action suits, suggests renaming GAAP “Cleverly Rigged Accounting Ploys,” or CRAP.
Nowhere do the rules fit worse than in Hollywood. For the last 20 years, film producers have been allowed to write off their production costs over the life of the movie. That system worked just fine when the only market for films was the local movie house and their lifespan was typically less than a year. But in today’s world, when Armageddon can be syndicated on TV, sold as a video, and marketed abroad, a film’s potential life can be extended for many years, giving film companies enormous leeway to boost reported earnings by stretching out expenses and lumping flops and blockbusters together. This accounting flexibility has shrouded Hollywood financial statements in more mystery than a Spielberg thriller. As a result, says David J. Londoner, a managing director in research at U.K.-based investment bank Schroders, it’s virtually impossible for analysts or investors to compare the performance of movie companies. Fortunately, that may soon change as a result of new rules under consideration by FASB. Londoner estimates these changes would force the industry to write off as much as $2 billion in advertising and other expenses that otherwise would have been used over many years to prop up or smooth out reported earnings.
The big (only) five
So where are the auditors? Critics suggest that the consolidation of the accounting industry from the Big Eight companies through most of the 1970s and 1980s to only five today has reduced competition and sapped some of the profession’s old rigor. Others worry about conflicts of interest created by the shift from auditing to consulting, which is more profitable and generates about half of Big Five revenues, up from only 15% in 1978. Still other potential conflicts result from the steady stream of Big Five auditors going to work for their corporate clients. Two of the CFOs who presided over Waste Management’s excessive depreciation stretch-outs, for example, came from the firm’s auditor, Arthur Andersen.
Accounting execs dismiss most of the criticism, noting that too much of their business depends on auditing revenues to play fast and loose with the numbers. Just in case, the AICPA issued new performance standards last February that outline steps outside auditors should take to ferret out fraud. And it’s noteworthy that four of the Big Five were involved in at least one of the recent scandals and all five in the subsequent reviews of the auditors who didn’t spot the problems in the first place.
At the urging of the SEC and the AICPA, a private-sector group, the Independence Standards Board, was created in May 1997 to measure auditors’ independence and, if need be, to suggest reforms. Among the fixes activists hope the ISB will consider: a ban on accounting firms auditing their consulting clients.
Weak cops
Until Levitt’s recent initiative, the SEC has largely been asleep at the switch on accounting fraud at large firms, bringing only a handful of such cases against major corporations. “Those who stretch the rules know the most the SEC will do is make them sign a consent decree and impose a fine,” says Lerach. “When it comes to big firms with sophisticated accountants, the SEC has been an empty suit on enforcement. And as business has recognized that, it’s become bolder and bolder.” That calculus could change, however, if the SEC follows up Levitt’s tough talk with more high-profile enforcement actions. “Enforcement will be on the upswing,” promises the SEC’s Schuetze. “In the last five years, we brought about 100 accounting cases a year. Now the number may rise to 125, 150, or 200.”
Awful audit committees
Not all audit committees are toothless tigers, but too many still are. “Often the chairman is the oldest guy on the board,” says corporate governance expert and board member Robert Lehrer, who is also a professor emeritus at the Columbia University Graduate School of Business. “The members are often the youngest of the directors, who don’t know anything and are put there to learn something, but it can take a long time.” Likewise many members lack strong accounting or financial backgrounds. And all too often, they have personal ties to top management. Only 53% of audit committees are composed totally of outside directors, according to a 1997 survey by Russell Reynolds Associates, a leading executive recruiting firm. Among companies with more than $10 million in market capitalization, that figure drops to just 46%.
Sometimes even outside directors are not so independent. Consider the case of Cendant, whose audit committee was composed of four outside directors. So far, so good. But two of them were friends and investment partners of Chairman Walter Forbes, and two ran companies that had business relationships with Cendant. While several had finance backgrounds, none had accounting experience. To help strengthen corporate audit committees, the New York Stock Exchange and the National Association of Securities Dealers is forming a blue-ribbon panel to be co-chaired by John Whitehead, retired senior partner of Goldman Sachs, and Ira Millstein, a lawyer and corporate governance expert, to develop by year’s end a series of recommendations “to get the right people to do the right things and ask the right questions.” Among the reforms that corporate governance experts say the group should consider:
- Audit committees should be composed only of outside directors with substantial accounting or financial experience, significant personal investment in the company, and no personal ties to top management. “Audit committee members must be truly independent in mind and relationships,” says former FASB Chairman Donald Kirk, now a professor at Columbia. “Coziness is a threat to clear thinking.”
- Members should have a rock-solid relationship with the company’s outside accounting firm. First, the board’s audit committee, not management, should choose the firm. Second, members of the audit committee should meet regularly with the outside auditors—without management present.
- Most important, audit committee members should see themselves as watchdogs for investors. That means focusing on the quality and clarity of financial reports—not just whether they meet the letter of the law. And it means asking tough questions of management and auditors—even if that means throwing a little food around the corporate kitchen.
