The Art of Fudging Accounts

Creative accounting is actually a polite way of referring to fudging of accounts or manipulation of accounts. Often organizations resort to creative accounting to either make the financial results appear more or less attractive depending on whether they wish to impress others (bankers, shareholders) or to evade taxes.

Two cases of accounting manipulation or fraud which had international ramifications and in which thousands of employees and shareholders lost money are Enron of USA and Satyam from India. These two cases are amongst the biggest examples of accounting fraud. The cooapse of Enron also led to the demise of one of the biggest accounting firms in the world. Viz Arthur Andersen and the Satyam scandal, apart from bringing the Indian IT industry under a cloud has also put into question the credibility, at least in India, of Price Waterhouse Cooper, its auditors.

Let us look at how some other leading companies of the world used creative accounting to make their financial statements appear more impressive, closer to what they thought Wall Street expected of them

The giant telecommunication company WorldCom’s (Now MCI) strategy was to grow through acquisitions. Trouble was the company was not generating enough cash for the acquisitions it wanted to make. Therefore, it used stock as its currency, and paid for the companies it acquired partly with WorldCom shares. That meant it had to keep its share price high; otherwise, the acquisition would be too expensive. It also menat keeping profits high, so that Wall Street would give it a high valuation.

It paid for the acquisitions, partly through borrowing. A company doing a lot of borrowing has to keep its profits up; otherwise, the banks will stop lending it money. So on two fronts WorldCom was under severe pressure to report high profits. That, of course, was the source of the fraud that was ultimately uncovered. The company artificially boosted profits “with variety of accounting tricks, including understanding expenses and treating operating costs as capital expenditures”, as Business Week summarized the Justice Department’s indictment.

When it became known that WorldCom was not as profitable as it had claimed, the house of cards came tumbling down. Nevertheless, even if there had not been a fraud, worldCom’s ability to generate cash was out of step with its growth by acquisitions strategy. It could live on borrowing and stock for a white, but not forever.

Taking a big item off the income statement and putting it on the balance sheet, so that only the depreciation shows up as a charge against profits, can have the effect of increasing profits considerably.

A large portion of worldCom’s expenses consisted of so called line costs. These were fees it paid to local phone companies to use their phone lines. Line costs were normally treated as ordinary operating expenses, but you could argue (albeit incorrectly) that some of them were actually investments in new markets and would not start paying off for years. That was the logic pursued by CFO Scott Sullivan, anyway, who began “capitalizing” his company’s line costs in the late 1990s. Bingo: these expenses disappeared off the income statement and profits rose by billions of dollars. To Wall Street, it appeared that WorldCom was suddenly generating profits in a down industry – and no one caught on unitl later, when everything had colla sed.

Sunbeam of the US is another example of accounting manipulation, wherein net profits were shown, when they actually were not. It was run by the notorious CEO “Chainsaw Al” Dunlap. He arrived at Sunbeam in early 1997. By the time he got there, he already had a great reputation on Wall Street and a standard modus operandi. He would show up at a troubled company, fire the management team, bring in his own people, and immediately start slashing expenses by closing down or selling factories and laying off thousands of employees. Soon the company would be showing a profit because of all those cuts, even though it might not be well positioned for the longer them.
Dunlap would then arrange for it to be sold, usually at premium – which means that he was often hailed as a champion of shareholder value.
Sunbeam’s stock jumped more than 50 per cent on the news that he had been hired as CEO.

At sunbeam, everything went according to plan until Dunlap began readying the company for sale in the fourth quarter of 1997. By then he had cut the work force to half, from twelve thousand to six thousand, and was reporting strong profits. Wall Street was impressed that Sunbeam’s stock price had gone through the roof, which turned out to be a major problem. When the investment bankers went out the sell the company, the price was so high that they had trouble identifying prospective buyers. Dunlap’s only hope was to boost sales and earnings to the level that could justify the kind of premium a buyer would have to offer for Sunbeam’s stock.

Dunlap and it CFO,  Russ Kersh, used a whole bag of accounting tricks in the fourth quarter to make Sunbeam look for stronger and more profitable than it actually was. One of the tricks was a perversion of a technique called bill-and-hold-which is essentially a way of accommodating retailers who want to buy large quantities of products for sale in the future, but put off paying for them until the products are actually sold.

Say that you have a chain of toy stores, and you want to ensure that you have an adequate supply of Barbie dolls for the Christmas season. Somethimes in the spring, you might go to Mattel and propose a deal, whereby you will buy a certain number of Barbies, take delivery of them, and even allow Mattel to bill you for them – but you will not pay for the dolls until the Christmas season rolls aroung and  you start selling them. Meanwhile, you will keep them in a warehouse. It is a good deal for you, since you can count on having the Barbies when you need them, yet you can hold off paying for them until you have decent cash flow. It is also a good deal for Mattel, which can make the sale and record it immediately, even though it has to wait a few more months to collect the cash.

Dunlap figured that a variation on bill-and-hold was one answer to his problem. The fourth quarter was not a particularly strong period for Sunbeam, which makes many products geared towards summer – gas grills, for example. Therefore, Sunbeamwent to major retailers such as Wal-Mart and Kmart and offered to guarantee that they would have all the grills they wanted for the following summer provided they did their buying in the middle of winter. They would be billed immediately, but they would not have to pay until spring, when they actually put the goods in the stores. The retailers were cool to the idea. They did not have anywhere to keep all that stuff, nor did they want to bear the cost of storing of inventory through the winter. “No problem”, said Sunbeam. “We’ll take care of that for you. We’ll lease space near your facilities and cover all the storage costs ourselves”.

Supposedly, the retailers agreed to those terms and Sunbeam went ahead and reported an additional $ 36 million in sales for the fourth quarter based on the bill-and-hold deals it had initiated. The swindle worked well enough to fool most analysts, investors and even Sunbeam’s  board of directors, which in early 1998 rewarded Dunlap and other members of the executive team with lucrative new employment contracts. Although they had been on the job for less than a year, they received some $ 38 million in stock grants, based largely on the mistaken belief that the company had just had a stellar fourth quarter.

However, Andrew Shore, an analyst who specialized in consumer products companies, had been following Sunbeam since Dunlap arrived, and now was scrutinizing its financials. He noticed some oddities, like higher-than-normal sales in the fourth quarter. Then he calculated a ratio called days sales outstanding (DSO) and found that it was huge, far above what it ought to have been. In fact, it indicated that the company’s accounts receivable had gone through the roof. That was a bad sign, so he called a Sunbeam accountant to ask what was going on. The accountant told Shore about the bill-and-hold strategy. Shore realized that Sunbeam, in effect, had already recorded a hefty chunk of sales that would normally appear in the first and second quarter. After discovering this bill-and-hold game and other questionable practices, he promptly downgraded the stock.

The rest, as they say, is history. Dunlap tried to hang on, but the stock plummeted and investors grew wary of what Sunbeam’s financials were telling them. Eventually, he was forced out.

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