ACCOUNTING FRAUD.

Learning from the Wrongs

Sunbeam 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 experiments 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 fraud 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 unaffectionately 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, CUC 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 directors likely have no clue about any shenanigans. But there are plenty of instances where someone aware of the fraud stepped forward. "Most frauds are not found by fraud investigations," says Dan Jackson, president of Jackson and Rhodes, a Dallas-based 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. He cites the case of Tyco International, a well-managed company that makes home-security 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 Exchange Commission later gave it a clean bill of health.

"It doesn't seem to matter whether it's the SEC or some newsletter, everyone seems willing to sell a stock now even if there's just a hint of questionable practices," Willens says. "Nobody wants to own the next Cendant or Sunbeam."

Accounting irregularities are getting the attention of Corporate America for another important reason: allegations that companies are not conforming to Generally Accepted Accounting Principles have become a growth industry for lawyers. A study issued in August by PricewaterhouseCoopers calls the role that accounting allegations now play in federal securities litigation "striking."

It wasn't supposed to happen 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 safe-harbor legislation took effect -- when just 25 percent of the 185 cases were accounting-related.

The new law clearly did not provide a safe harbor for material misstatements arising in companies' audited financial statements, notes Harvey Kelly, a partner at PWC's financial advisory services group in New York who provided commentary for the just-released study. "The act provided some protection to the companies if things turned out differently, as long as they warned people about forward-looking statements," Kelly says. "But if the reported results don't meet the 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 10b-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 GAAP-related 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.

Sunbeam is a good example of a company that engaged in creative revenue recognition. A review of the company's books by auditors from Deloitte & Touche and Arthur Anderson in the autumn of 1998 -- it took nearly four months for them to unravel what "Chainsaw Al" biographer John A. Byrne called the "dirty bag" of accounting complications -- found that the company's recorded profits of $109.4 million in 1997 were illusory. Restated, the earnings amounted to a mere $38.7 million.

How did Dunlap and his buccaneering allies at Sunbeam do it? One strategy was Sunbeam's practice of "bill-and-hold," in which retailers like Wal-Mart and Costco, in exchange for a discount, agreed to purchase shipments of grills six months before they were needed and pay for them six months later -- not within 30 days, as the SEC's guidelines for bill-and-hold accounting state. The grills were 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-hold is "a device that auditors need to be 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 inventory 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."

At CUC International -- a shopping club company that merged with hotel and car rental company HFS to form Cendant -- phony accounting entries created the illusion of millions in profits, making CUC a darling of Wall Street analysts for more than a decade. When the mess was uncovered in the wake of the merger, it cost investors -- including corporate pensions, mutual funds and 401(k) plans -- $19 billion. The fraud is also landing three top financial executives in prison, including CUC's former chief financial officer, 40-year-old Cosmo Corigliano, who faces up to 10 years in jail. The SEC is bringing additional charges against the trio, as well as several other former executives.

What is so astonishing, observers have noted, is that such a massive fraud continued for so long. Corigliano was a 23-year-old, newly minted accountant fresh from Ernst & Whinney when he went to work for CUC in 1983, the year the company went public. The fraud was not discovered until after the merger in 1997. "The activities had started about then [1983]," Corigliano told a judge in June, when he pleaded guilty to fraud charges. Accountants Ernst & 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 CUC businesses were overstated by approximately $500 million before taxes during the 1995-1997 period alone. Investigators noted the use of such questionable devices as irregular revenue recognition, understatement of reserves, delays in recording credits and recording of fictitious receivables.

The use of a restructuring reserve fund amounting to several hundred million dollars was an especially notable feature. Rather than covering one-time costs associated with takeovers, the reserve fund became a vehicle for con-cealing ordinary business expenses and losses and a pot that could be dipped into to meet expected earnings results. "For companies into 'cookbooks' and 'sins books,'" Regan says -- citing the jargon frequently used at companies employing accounting scams -- "this is a relatively common vehicle."

Rite Aid presents another case where efforts to unravel accounting irregularities have proven to be a Herculean task. In July, Rite Aid restated its books and admitted that it had overstated profits during the prior two years by more than $1 billion. After spending more than $50 million in accounting fees to 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 accounting 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 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 of goods 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 been 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 fearful 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 companies charged with fraudulent financial 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 boards of directors were dominated 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 both patterns were particularly apparent at Cendant, where "you did not have independent directors, and both companies [CUC 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 struck 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 get-rich-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 that accounting manipulation 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 York.

Tips for Avoiding Fraud

* Develop strong audit committees and outside directors.

* Beware of a preoccupation with reporting strong earnings, which can be a slippery slope.

* Institute a series of checks and balances: Different people should make a sale, book a sale and collect the money.

* Steer clear of gimmicks like reserve funds, capitalizing ordinary expenses 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 whistle-blowers.