August/September 2005

Issue 26

Editorial Board: Fran Denmark, Financial Writer; Jim Helik, Contributing Editor, Benefits & Pensions Monitor;
Steve Kirkland, Reporter, Bloomberg News

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Part 2: Who broke the story?

A look at 10 of the worst U.S. accounting scandals, and what brought them to light

By Lori Pizzani

Click here to read Part 1 of "Who broke the story?"

This is Part Two of a two-part series that examines some of the baddest "bad boys" in 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.

Sunbeam Corp. of Boca Raton, Fla.

What did it do?

In 1996, a struggling Sunbeam hired “Chainsaw Al” Dunlap, a turnaround specialist to restructure the company. But to improve the company’s results, Dunlap and other executives cooked the books, including:

creating of inappropriate accounting reserves that increased Sunbeam’s losses in 1996. This “cookie jar accounting” technique allowed execs to use reserves to pump up 1997 income, thereby claiming a fast turnaround;
recognizing $60 million in revenue for sales in 1997 that didn’t meet accounting standards;
not disclosing that the firm had engaged in “channel stuffing” by offering steep discounts and other inducements to clients if they bought excess products now;
deleting records showing pending returns of merchandise; and
misrepresenting performance and future prospects.

Who raised suspicion regarding its accounting practices?

A reporter. A June 1, 1998 article by Susan Scherreik, who wrote for Money Magazine at the time, called into question certain Sunbeam expenses characterized and accounted for as restructuring charges, including a $9 million environmental cleanup charge and a $17.7 million litigation reserve. That caught the attention of Sunbeam’s board of directors, who ordered an investigation.

What was the tip-off?

Scherreik’s article included a comment from Howard Schilit, CPA, president of the Center for Financial Research & Analysis in Rockville, Md., and author of the 2002 book “Financial Shenanigans — How to Detect Accounting Gimmicks & Fraud in Financial Reports” that noted that such possibly recurring cleanup and litigation expenses should be treated as an “ordinary part of doing business” and not as part of a one-time restructuring charge.

Red Flag Alert:

According to Schilit’s book, a key warning sign of channel stuffing is when “unbilled receivables" grow substantially faster than “billed receivables.” That was what happened when Sunbeam enticed retailers in late 1996 into loading up on $35 million worth of seasonal gas grills that would not be shipped or billed for another six months. The technique boosted Sunbeam’s reported sales, noted Schilit.

Tyco International of Exeter, N.H., then New York City

What did it do?

Regulators accused the top executives of raiding the company’s coffers from 1996 to 2002 by not disclosing that they:

took millions of dollars in loans from a corporate loan program designed to encourage employees to buy company stock and used most of the money to buy yachts, estate jewelry, vacation estates and real estate holdings and to make personal investments;
took millions of dollars in interest-free relocation loans designed to assist relocated employees and used the money to purchase luxury apartments, ski resorts and other properties;
received compensation taken in the form of forgiven loans not previously reported and asked employees to falsify records by recording phantom offsetting amounts;
used luxury New York City apartments rent-free and received other corporate perks; and
sold millions of dollars in Tyco stock.

Who raised suspicion regarding its accounting practices?

An analyst. A 1999 report published by David Tice, CFA, a money manager and the founder and president of David W. Tice & Associates in Dallas suggested that Tyco was using “accounting intrigue” to bloat its earnings. Tyco’s stock swooned.

In December 1999, Tyco announced the SEC was conducting an informal investigation related to charges and reserves taken in connection with the company’s multitude of acquisitions.

What was the tip-off?

Apparently, nondisclosure speaks louder than words.

Red Flag Alert:

According to Robert Olstein, chairman and chief investment officer of Olstein Associates in Purchase, N.Y., nondisclosure of material information needed to assess the value of a company is one of his top financial red flags. “The good news is that (in general) right now the quality of earnings are the highest we’ve seen in 10 years. The bad news is that there are still red flags indicating potential problems, although they can be temporary anomalies,” he says.

If a footnote explanation is difficult to comprehend, that is a definite red flag, said professor Allen Blay, assistant professor of accounting at the A. Gary Anderson Graduate School of Management, University of California, Riverside, in an interview with The Financial Journalist newsletter. “I teach my students, if you are auditing a company and somebody gives you a vague answer, ask for more detail, don’t just accept the answer.”

Waste Management Inc. of Oak Brook, Ill.

What did it do?

Senior executives executed a massive accounting fraud that inflated profits by $1.7 billion. The SEC charged that management:

assigned unsupported and inflated salvage values of garbage trucks, as well as inflated the estimates of the trucks’ useful lives. They also assigned arbitrary salvage values to assets not previously having salvage value;
failed to record expenses for decreases in the value of landfills as they were filled, and refused to record expenses necessary to write-off costs of unsuccessful and abandoned landfill development projects;
improperly capitalized many expenses;
failed to establish sufficient reserves to pay for income taxes, and established inflated liabilities related to acquisitions;
hid schemes by using “netting,” an accounting manipulation that eliminated $490 million in current period operating expenses and accumulated prior accounting misstatements by offsetting them against unrelated one-time gains on assets; and
engaged in “geography,” an accounting trick that moved tens of millions of dollars between various line items on the income statement.

Who raised suspicion regarding its accounting practices?

The auditors. Arthur Andersen, as the company’s auditor, discovered recurring improper accounting practices and annually provided Waste Management executives with a list of recommended adjustments, which management ignored.

What was the tip-off?

In July 1997, a new CEO ordered a review of all North American operations, including accounting practices, which revealed accounting misdeeds requiring restatements from 1992 through 1997. Three months later, the new CEO resigned in apparent disgust.

Red Flag Alert:

Inflated profits can result from improperly shifting expenses as Waste Management had done by first moving operating expenses (such as maintenance and repair and interest expenses) to the balance sheet and characterizing them as Plant and Equipment, explained Schilit in his book. Then the company would depreciate these costs over a 40-year time span.

Worldcom Inc. of Clinton, Miss.

What did it do?

Management manipulated financial results by improperly:

reducing operating expenses—thereby artificially boosting income—through the improper releasing of certain reserves held against operating expenses, and recharacterizing certain expenses as capital assets;
reducing reserves held against “line costs” (the various fees WorldCom paid to outside third-party telecom firms for the right to access their network facilities to service its own customers) and transferring certain line costs to its capital asset accounts, thereby inflating income; and
representing itself as a profitable company when it was not, and was, in fact, concealing large losses.

The company eventually restated multiple financial reports to the tune of $9 billion.

Who raised suspicion regarding its accounting practices?

An employee. According to WorldCom, in March of 2002, the SEC asked for the voluntary release of company records, but cited no cause for the inquiry. Later it was revealed that Cynthia Cooper, an internal auditor at WorldCom, had begun a previously scheduled internal audit in May of 2002 and found a number of questionable transfers dating back to 2001. In June 2002, she sought the ear of the board’s audit committee and raised concerns over certain accounting practices. The board immediately fired the firm’s chief financial officer.

What was the tip-off?

Cynthia Cooper, the internal auditor/whistleblower with inside knowledge of the firm’s practices, identified questionable transfers for items previously expensed.

Red Flag Alert:

Earnings management, the manipulation of earnings toward a predetermined target, is one of the more prevalent tactics used by companies who play the financial numbers game, notes professors Mulford and Comiskey in their book. It all boils down to perception, they add. “Earnings management is the active manipulation of accounting results for the purpose of creating an altered impression of business performance.”

Xerox Corp. of Stamford, Conn.

What did it do?

From 1997 to 2000 the company used seven aggressive accounting techniques including:

accelerating recognition of leased equipment revenue by over $3 billion and increasing pre-tax revenue by $1.5 billion;
booking revenue generated for providing services over the life of equipment leases at the very beginning of the lease;
shifting of revenue so that other equipment-leasing income would be recognized earlier than allowed; and
using over $1 billion in assorted one-time accounting actions to boost operating results through the improper use of cookie jar reserves.

Who raised suspicion regarding its accounting practices?

The company itself, followed quickly by the SEC. In June 2000, Xerox revealed it would look into potentially wrongful business and accounting practices in its Mexico subsidiary. It was later made public that the SEC began conducting its own investigation one week after Xerox’s announcement.

The Xerox-commissioned independent investigation of its Mexico unit concluded that a bevy of irregularities existed including: ineffective collection actions, inappropriate re-aging of past due accounts, billing inaccuracies, insufficient bad debt reserves, improper trade classification pertaining to the sale, lease or rental of equipment, and failure to adhere to corporate policies and procedures. Thirteen employees were fired.

Xerox announced that it had subsequently launched a worldwide review of its internal audit controls and found that the issues uncovered in Mexico were not found elsewhere.

What was the tip-off?

Press reports in February 2001 revealed that in May of 2000, a veteran assistant treasurer at Xerox had alerted the company’s chief financial officer and two other executives about Xerox’s questionable accounting techniques in light of the Mexico investigation. The whistleblower told the executives that many of the accounting irregularities found in the Mexican unit were taking place in other Xerox units across the globe.

Although the whistleblower was fired a few days later, the SEC continued its investigation, which ended with Xerox restating its financial statements from 1997 to 2001, and an agreement to pay a $10 million penalty—the largest ever levied against a public company at that time.

Red Flag Alert:

Xerox is a classic example of a company fond of recognizing revenues too early, said professor Blay in his interview with The Financial Journalist newsletter. Since the rules regarding when to recognize revenue are based only on principles, companies can take advantage. Start with reading the footnotes, he said. The footnotes to a company’s financial statements will reveal the company’s policies on revenue recognition.

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