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 Who broke the story?
A look at 10 of the worst U.S. accounting scandals, and who brought them to light
By Lori Pizzani
This is Part One of a two-part series that examines some of the baddest "bad boys" of the world of corporate accounting scandals — who actually broke the story, what the company executives did and what transgressions caused their house of cards to tumble.
Adelphia Communications Corp. of Coudersport, Pa. and later Denver, Colo.
What did it do? (Click here to read official SEC complaint)
Between 1998 and 2001, the company’s founder and three sons, all part of the Rigas family, plus other executives:
fraudulently excluded $2.3 billion dollars in company bank debt from its consolidated balance sheet by shifting those liabilities to the off-balance sheets of affiliates;
created bogus documents showing fictitious repayments of debts;
falsified financial statements, claiming that all liabilities were clearly noted;
inflated cable subscriber numbers, the extent of cable plant upgrades and earnings, all aimed at meeting Wall Street’s earnings expectations;
concealed blatant self-dealing that included raiding Adelphia’s coffers to pay for open market purchases of Adelphia stock, timber rights in Pennsylvania, construction of a $12.8 million golf course, pay off personal loans and purchase luxury condos in Colorado, Mexico and New York City by Rigas family members.
Who raised suspicion regarding its accounting practices?
An analyst. During a March 27, 2002 earnings conference call with Adelphia executives, Oren Cohen, then a senior media analyst with the high-yield credit research department at Merrill Lynch, pressed executives and raised questions about their use of the up-until-then undisclosed $2.3 billion off-balance sheet liability smuggled into a footnote.
What was the tip off?
Adelphia executives evaded answers noting that additional disclosures would not immediately be made, and casually reassured analysts that there were other company assets that were being used as collateral against liabilities. Cohen was unable to justify the half-answers, and couldn’t understand how the Rigas family members had funded their stock purchases.
Six days later, the SEC notified Adelphia that it would conduct an informal inquiry, whereby the SEC staff generally asks for the voluntary release of certain company documents. (If a company declines to cooperate, or the SEC believes additional information is needed to carry out the investigation, it may subpoena documents under the guise of a “formal order of investigation.”)
Red Flag Alert:
Look out for “financial engineering” transactions such as off-balance sheet entries, says Dr. Bala G. Dharan, professor of accounting at the Jesse H. Jones Graduate School of Management, Rice University in an interview with The Financial Journalist newsletter. Since the implementation of the Sarbanes Oxley Act of 2002, companies have been required to clearly disclose all off-balance sheet transactions, lease obligations, special arrangements and other relationships that could affect a company's financial condition, operations or liquidity. While these can be legitimate transactions, they are often a way for companies to hide slow growth, or are attempts to solve, hide or reclassify business problems, he added. Many companies with problems will he happy to describe the problem in detail, will often apologize for it and then detail plans to fix it.
Enron Corp. of Houston, Texas
What did it do? (Click here to read official SEC complaint)
Enron’s troubles started in the early 1990s. Among other things, the company’s top executives:
made false statements and caused omissions of material facts in the corporation’s financial statements, including concealing losses in new business units;
set up several special purpose entities (SPEs) that allowed Enron to illegally shift liabilities and poorly performing assets off its balance sheet. That allowed for artificially inflated earnings, driving up the price of Enron stock, which was linked to executives’ salaries, bonuses and other perks. These SPEs, labeled “related party transactions” were shown to be secretly tied back to partnerships of Enron executives, and very little information about them or their activities was publicly disclosed;
engaged in multiple complex financial transactions between SPEs, all designed to pump up income and earnings and line executives’ pockets with fees derived from the transactions;
repeatedly reassured analysts and investors about the company’s financial well-being while secretly selling millions of dollars in Enron stock.
In October 2001, Enron took a non-recurring earnings charge of $1 billion and in an attempt to correct an unrelated accounting error, reduced shareholders’ equity by $1.2 billion. Those events precipitated a downward spiral, eventually leading to Enron’s record bankruptcy.
Who raised suspicion regarding its accounting practices?
Reporters and analysts. A September 20, 2000 article in the Texas regional edition of The Wall Street Journal by reporter Jonathan Weil was one of the first to question the use of gain-on-sale accounting (where a company estimates the future profitability of a present trade, but books a current profit based upon that estimated future profitability) by several energy trader companies, including Enron. The practice is legal, but raises concerns over the accuracy of projections into the future.
He also questioned Enron's use of mark-to-market accounting that is mandated of companies with outstanding energy-related contracts, some of which can span decades. Accounting rules dictate that companies estimate the fair value prices of these contracts on their balance sheets, but valuations can be based on fuzzy assumptions made by management.
The focus on Enron continued when in February 2001, analysts Lou Gagliardi and John Parry wrote a report that also raised concerns about Enron's profitability. By March 2001, Fortune ran a cover story titled "Is Enron Overpriced?" by reporter Bethany McLean that again raised doubts about Enron's valuation.
In his February 6, 2002 testimony before the House Committee on Energy and Commerce, James Chanos, founder and president of Kynikos Associates, an investment management firm in New York, echoed Weil’s concerns noting that based upon his experience with other companies, gain-on-sale accounting can tempt management to make overly aggressive assumptions. If future assumptions fell short, company executives would be required to adjust previously booked earnings downward. That might drive management to execute even bigger deals with more aggressive assumptions to offset those necessary revisions, Chanos claimed. He likened management’s use of gain-on-sale accounting to a crack cocaine habit.
What was the tip off?
For Weil, who had just done a story on the gain-on-sale accounting methods used by sub-prime home equity lending firms, Enron’s use of this method aroused suspicion. Moreover, the real story behind Enron was that the company kept reporting higher and higher earnings, but not increasing cash flows. The firm was disguising borrowings as cash flow from operations, Weil said during an interview with The Financial Journalist newsletter.
Red Flag Alert:
According to Chanos’ congressional testimony, a company’s adherence to generally accepted accounting principles (GAAP), which are inherently imbedded with estimates, projections and forecasts, doesn’t guarantee that a company’s earnings and financial health aren’t being overstated.
Weil noted that warning bells sounded when he sat down to interview visibly nervous Enron executives for this article, and received evasive and almost nonsensical answers to his questions. “Those kind of responses made me realize they weren’t on solid ground,” he said. “Enron had ‘trust me’ numbers.”
Lucent Technologies of Murray Hill, N.J.
What did it do? (Click here to read official SEC complaint)
For fiscal year 2000, the firm improperly recognized $1.148 billion of revenue — $511 million was prematurely recognized while $637 million should not have been recognized at all that year;
It also improperly recognized $470 million of pre-tax income by overstating a portion of its income and prematurely recognizing another portion;
To induce customers to purchase products, thereby meeting sales goals and driving up executive bonuses and company revenues, employees engaged in improperly granted or disclosed side and credit agreements;
The SEC charged that company executives circumvented internal controls, falsified documents and hid secret side deals from appropriate company personnel.
Who raised suspicion regarding its accounting practices?
The company itself. In November 2000, just months after the firm’s September 30 fiscal year-end, Lucent announced that in preparing its financial statements, it had identified a “revenue recognition issue” of about $125 million and had voluntarily notified the SEC. One month later, Lucent announced it had discovered another $554 million in misapplied revenues for 2000. A regulatory investigation followed.
Red Flag Alert:
Large increases in revenues from previous years can be a signal something is amiss, especially in an industry not typically associated with large year-over-year growth of revenues, noted Dr. Dharan in a research paper he co-authored regarding the red flags in Enron’s revenue reporting. Large increases in revenues can point to ties to executive compensation levels, creating opportunities for creative accounting, he said in an interview with The Financial Journalist newsletter.
Qwest Communications International of Denver, Colo.
What did it do? (Click here to read official SEC complaint)
In 2000 and again in 2001, company executives accelerated the revenue recognition generated from two major sales of equipment transactions, to meet double-digit revenue growth predictions, thus artificially bolstering revenues;
The SEC charged that Qwest executives demanded that subordinates meet or exceed earnings objectives at all costs so they could continue promoting the firm to analysts and the public as a fast growing, progressive and forward-thinking company;
Qwest management falsified documents related to the transactions and made false public statements.
Qwest has since erased nearly $2.5 billion of revenue from its 2000 and 2001 financial records.
Who raised suspicion regarding its accounting practices?
A trio, including the company itself, the SEC and a savvy reporter. In late 2001, Qwest’s finance department launched an investigation that led to the discovery of improperly recognized revenue.
But the SEC had already been on Qwest’s trail. In December 2000, in reviewing the firm’s 2000 annual report, the SEC asked Qwest to justify certain accounting items. Then again, in 2001, it met with the company’s then chief financial officer to challenge Qwest’s accounting. But the regulator did not launch a more formal investigation until March 2002.
An article by Kris Hudson in the October 27, 2003 issue of the Denver Post, broadly revealed that the regulator had previously been sniffing around for some time. Hudson learned of the on-again, off-again regulatory inquiries by obtaining a series of non-public records under the Freedom of Information Act.
What was the tip off?
When the payments expected to be made to the firm on one agreement with a client never materialized as expected, Qwest itself began an investigation, thereby identifying the problem.
Red Flag Alert:
Revenue recognition is an area ripe for abuse if companies are stretching to meet sales goals, revenue projections or avoid the sting of disappointing analysts’ earnings expectations, says several experts.
Rite Aid Corp. of Camp Hill, Pa.
What did it do? (Click here to read official SEC complaint)
The company’s senior management engaged in several accounting misdeeds that included:
grossly overstating income from May 1997 through May 1999. In 1999 alone, the SEC charged that income was inflated by 5,500%. Consequently, cumulative pre-tax earnings were revised downward by $2.3 billion, and net income was revised by $1.6 billion;
the systematic inflation of deductions that the company took for damaged and expired goods that weren’t returned to vendors in 1998 and 1999, it also overcharged vendors for undisclosed markdowns;
management’s failure to record $55 million in accrued expenses for stock appreciation rights granted to employees in 1998 and 1999;
multiple reversals of already recorded expenses, resulting in overstated income;
manipulation of reported earnings through reductions in the cost of goods sold and accounts payable;
immediately capitalizing certain costs related to new store sites considered, but decided against, instead of writing off these so-called “dead deal” expenses when it decided not to build;
Rite Aid’s former chairman and CEO not disclosing personal interests he had with store properties, not disclosing real estate partnerships that generated fees to him and falsifying the minutes of a finance committee meeting that never occurred.
Earlier this year, Rite Aid’s former chairman and CEO was sentenced to eight years in prison for fraud.
Who raised suspicion regarding its accounting practices?
Reporters. A January 29, 1999 article in The Wall Street Journal by reporters Mark Maremont and Robert Berner, ties Rite Aid’s chairman to undisclosed real estate deals where Rite Aid stores were located, prompting an SEC investigation. Other executives were also noted as having similar ties. The reporters had checked land and tax records. The article also noted that an import firm with business ties to the chairman and his father were the paid suppliers to Rite Aid of candy, cough drops and tooth brushes.
What was the tip off?
On March 19, 1999, less than two months after that article, Rite Aid filed a registration statement with the SEC relating to debt securities it issued. The regulator apparently took a very close look at that filing and all other company disclosures and accounting practices, and compelled the company to make adjustments to its financial statements for 1997 and 1998, thus beginning the discovery of other abuses.
Red Flag Alert:
Financial fraud, or aggressive accounting? “Fraudulent financial reporting carries a more negative stigma and connotes much greater deceit than what is implied by accounting actions considered only to be aggressive,” noted professors Charles Mulford and Eugene Comiskey of The College of Management, Georgia Tech Institute of Technology in the 2002 book they co-authored “The Financial Numbers Game.” But what starts as an aggressive application of accounting principles may later become known as fraudulent financial reporting if it continued over an extended period and is found to entail material amounts, the professors say.
To read Part Two of "Who broke the story?" look in the next issue of The Financial Journalist newsletter
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