SEC Turns Up the Heat

By THOMAS S. MULLIGAN

May 23, 1999 12 AM PT

TIMES STAFF WRITER

NEW YORK —

Cadillac inflates sales numbers to edge out Lincoln for the luxury car crown. W.R. Grace & Co. allegedly creates a fiscal “cookie jar” to dip into when it needs a boost in profits.

Sensormatic Electronics Corp. backdates shipping documents to tweak revenue. Donnkenny Apparel Co. is accused of hiding piled-up inventory in an idle warehouse.

What’s going on here? Many American investors have long believed that U.S. companiesoperate under the most rigorous and informative accounting standards in the world.

But in recent months, a rash of allegations of phony accounting has stung business boardrooms--and raised troubling questions about the corporate profit boom of the 1990s upon which Wall Street’s spectacular bull market is largely based.

Accounting-related blowups at companies such as Cendant Corp., McKesson HBOC Inc., Sunbeam Corp. and Oxford Health Plans Inc. have spawned investor lawsuits and devastated stock values.

Can investors trust the financial information they’re getting from U.S. firms?

The Securities and Exchange Commission is worried enough that it has, over the last eight months, devoted major resources to blowing the whistle on the accounting tricks that companies use to fluff up their earnings--and, by direct connection, their stock prices.

SEC Chairman Arthur Levitt and his deputies have given no fewer than a dozen speeches since last fall denouncing “managed earnings,” misleading accounting of merger deals, dubious restructuring charges, and conflicts of interest between auditors and their clients.

Besides jawboning and soliciting advice from a blue-ribbon panel, the SEC also has filed fraud lawsuits against chemical giant W.R. Grace and other firms, and has delivered blunt warnings to many others.

No one is suggesting that the U.S. accounting system overall has suddenly become corrupt. Indeed, much of what Levitt has complained about falls well short of outright fraud.

And in many cases, such as that of W.R. Grace, the issue is interpretation rather than concealment, said Edmund L. Jenkins, new chairman of the Financial Accounting Standards Board, a private rule-making body of the accounting profession.

“The fact is, the information is there to be discovered,” he said of U.S. corporate accounting. “With financial reporting in much of the rest of the world, you don’t even get a shot at it.”

Still, Levitt worries that the cumulative effect of accounting controversies is an erosion of trust.

“Today, American markets enjoy the confidence of the world,” Levitt said in September in a speech kicking off the SEC’s campaign. “How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?”

The stock market’s lofty heights are both cause and effect in the number-twisting game that the SEC is targeting.

Strong earnings growth at many companies from 1994 to 1997 helped push stocks dramatically higher--which in turn leaves managers, typically loaded with stock options, now fearful of a share price plunge if they fail to meet Wall Street’s profit expectations.

“The pressure to meet analysts’ expectations to the penny belies the very nature of the estimation process,” Jenkins said.

The climate in which a firm’s stock is eviscerated because of a barely missed profit target is itself responsible for some accounting abuses, Jenkins said in an interview at FASB’s Norwalk, Conn., headquarters.

The desire to keep earnings flowing smoothly was at the heart of W.R. Grace’s alleged infractions, according to the SEC. In its lawsuit, filed in December, the agency charged Grace with improper use of financial reserves and abuse of the doctrine of “materiality”--both sore spots with Levitt.

The SEC charged that the firm understated earnings in 1991 and ‘92, diverting up to $20 million into a reserve account to be used to boost profits in leaner years.

When the process was reversed and reserves were added into earnings in 1995, Grace failed to spell out what it was doing, the SEC alleges. Investors might easily have assumed that all of 1995 earnings growth stemmed from Grace’s basic businesses.

Grace, which is contesting the SEC’s charges, previously explained to the agency that the effect on earnings was too small to be “material.”

Abraham Briloff, retired accounting professor at Baruch College of the City University of New York, faults analysts for spending so much energy trying to predict quarterly earnings to the penny, inciting company managements to jump through hoops to make the numbers.

Corporate accounting is not an exact science, Briloff said, adding, “It involves judgment calls with respect to an enterprise that doesn’t exist for quarterly earnings.”

Analysts “ought to stop riding herd on the quarterly numbers” and focus on their real job, which is evaluating the total business enterprise in order to help investors make informed decisions, he argues.

Grace was the first headline enforcement action in the SEC’s campaign, but it was followed by fraud suits against Livent Inc., Donnkenny and Sensormatic, among others.

The SEC has charged Livent, a Toronto-based theatrical firm, in connection with what the agency says was an eight-year scheme to inflate earnings.

In addition to the SEC’s civil action, the Justice Department is prosecuting Livent co-founders Garthy H. Drabinsky and Myron Gottlieb on criminal fraud charges. Both men deny wrongdoing.

In the Sensormatic case, the SEC accused the security systems manufacturer of illegally booking sales prematurely by backdating shipping documents. The company’s chairman and two former executives settled the case in March, agreeing to pay $140,000 in fines for their roles in the fraud.

Another action involving premature revenue recognition involved Donnkenny, a women’s apparel maker. The SEC accused the firm of “holding open” fiscal quarters to illegally push sales into the periods, bolstering financial results.

It also said Donnkenny hid surplus inventory in a third-party warehouse. The firm disputes the amounts involved, and its executives are fighting charges that they took advantage of insider knowledge that the company’s shares were fraudulently inflated.

As for the Cadillac snafu, the SEC didn’t get involved because it involved unaudited monthly sales numbers, which are mainly useful for bragging rights.

Cadillac apologized to archrival Lincoln for inflating December sales figures to hang onto the title of best-selling luxury brand for 1998. Cadillac, a division of General Motors Corp., blamed the action on “overzealous” lower-level employees.

While some companies have been exposed for illicitly puffing up results, others are under investigation for just the opposite: so-called big-bath restructurings that result in mammoth one-time charges against earnings.

Restructuring announcements have become routine in the corporate world in the ‘90s, and that’s the problem: The SEC is concerned that companies are taking excessive charges against earnings in restructurings, knowing that Wall Street won’t punish their stocks as much for a big one-time charge as it would for consistently reducing earnings by recording certain costs each quarter.

Some nonrecurring charges, such as those associated with divesting a line of business, have always been considered appropriate one-time write-offs. But in some cases, companies have thrown in items, such as computer-servicing costs, that should be treated as ongoing expenses.

Imagine yourself declaring that, instead of paying for groceries weekly this year, you have established a “reserve” that paid for them all at once. You’d have a lot more disposable income every week from now on.

Some firms have turned restructuring into a way of life. Serial restructurer Eastman Kodak Co., for example, has taken six major restructuring charges this decade.

In an example of what an SEC spokesman called “head-it-off-at-the-pass government,” agency officials have sent letters to 150 firms that announced restructurings last year. The SEC is reviewing charges taken to make sure they conform with proper accounting practices.

To money manager Robert A. Olstein, the current concerns over accounting carry a strong sense of deja vu.

In the early 1970s, as a 30-year-old financial analyst, Olstein began publishing a newsletter called Quality of Earnings Report, calling attention to questionable corporate accounting practices.

Shortly after the newsletter was launched, Olstein got a visit from then-SEC Chairman (and later CIA chief) William J. Casey, who told the young analyst that the agency was about to embark on its own campaign against accounting abuses.

Spearheading the sometimes controversial effort was Stanley Sporkin, then a Casey lieutenant and now a prominent federal judge. The SEC sparred for years with famed conglomerate Gulf & Western Corp., for example, alleging that the now-defunct firm improperly booked profits from sugar trading in the Dominican Republic.

“It’s different music but the same dance steps,” Olstein said of the SEC’s latest campaign.

In the ‘70s, conglomerates like Gulf & Western--nicknamed Engulf & Devour--created earnings magic through merger accounting. Although the conglomerate model is out of favor with investors, mergers remain a major source of creative accounting.

An increasingly common practice, especially in technology deals, is the writing off of “in-process” research and development. Under this technique, acquirers take large, immediate charges against earnings to reflect R&D; underway at the target company at the time of takeover.

The write-off is justified under the theory that the research might never find a commercial application and is thus of doubtful value as an asset.

But the beauty part, from a future-earnings standpoint, is that the bigger the immediate R&D; write-off, the smaller the amount of “goodwill” that must be carried on the acquirer’s books and written off over time.

Goodwill is the term for the premium that an acquiring firm pays above the net worth of the target company’s hard assets. Accounting rules require goodwill to be amortized--that is, deducted on a quarterly basis, reducing the bottom-line profits on which Wall Street focuses.

Jack Ciesielski, publisher of the Analyst’s Accounting Observer newsletter, maintains on his Internet site (https://www.aaopub.com) a feature called “The Charge Clock,” a compilation of corporate write-offs culled from news articles.

By Ciesielski’s tally, U.S. companies took 247 write-offs for in-process R&D; last year, totaling $19.6 billion. After Levitt cited the practice in his speech last September, the SEC began cracking down.

In closing the books on its $37-billion merger with MCI Communications, MCI WorldCom last year proposed what would have been the largest R&D; write-off in history: a one-time charge of up to $7 billion.

The plan was flagged by the SEC, however, and after consulting with the regulators, the long-distance firm lopped $3 billion off the charge.

A number of other firms, in response to SEC pressure, also have reduced restructuring charges or otherwise modified their accounting statements. SunTrust Banks of Georgia last year cut its loan-loss reserves by $100 million and restated three years’ worth of earnings in response to an SEC inquiry.

On a parallel plane with the SEC, the FASB is contemplating eliminating the immediate write-offs of in-process R&D.;

Far more controversial was the FASB’s unanimous vote last month to eliminate “pooling of interests” accounting in certain all-stock mergers. In a pooling arrangement, the two firms simply combine their assets and avoid putting goodwill on their books.

The FASB’s pooling decision, which would take effect Jan. 1, 2001, is to be adopted following a comment period that ends in August.

The net effect would be to depress the reported earnings of the surviving company in a merger, because goodwill would have to be deducted as a quarterly charge instead of ignored.

However, there is no certainty that the ruling will stand, according to Lawrence Revsine, accounting professor at Northwestern University. The technique is popular enough that Revsine expects a lobbying campaign to retain the practice in some form.

There is ample precedent for political challenge to FASB edicts. Five years ago, the board proposed a requirement that companies deduct from earnings the value of stock options awarded to their executives. Not only would this have slashed bottom-line earnings across the corporate landscape, but it would have cast an unwanted spotlight on one of corporate America’s most controversial and popular forms of compensation.

The response was a frontal assault, in the form of federal legislation that would have stripped the FASB of its independence, making its rulings subject to SEC approval.

Under pressure, FASB backed off, substituting a watered-down rule, since adopted, under which firms are required to report the value of executive options and the effect they would have on earnings. But the item is allowed to be reported in a note, rather than as a charge that shows up on the bottom line of the income statement.

“Is pooling sufficiently contentious to start another war? I don’t know,” Revsine said. “But I will be watching the debate with interest.”

Overhanging all of this debate is one major question: Are investors happy to allow companies to bend accounting rules if it means that the bottom line continues to sparkle, and share prices along with it?

The answer, according to pessimistic money manager David W. Tice, is yes.

“At the end of bull markets or manias like this one, people just aren’t focused on fundamentals,” said Tice, who manages the Prudent Bear Fund in Dallas.

Tice wished Levitt well in his effort to spotlight accounting problems but said it probably will take a market trauma before the message gets through.

Times staff writer Thomas S. Mulligan can be reached at thomas.mulligan@latimes.com.

* SPOTTING THE SIGNS: What investors should watch for in evaluating corporate earnings reports. C15

What’s the Bottom Line? Depends on Your Definition

U.S. companies have always taken “write-offs” against earnings when making major changes in their businesses--such as divesting poor-performing divisions. But regulators are questioning whether write-offs now have become too frequent, and are being misused by companies that know investors may be less concerned about “one-time” charges than about business expenses that consistently reduce earnings.

Restructurings surge . . .

Number of companies announcing restructuring charges each year:

1999: 936*

* annualized pace based on year-to-date total

. . . taking a bigger bite of profits

Annual write-offs taken by the blue-chip Standard & Poor’s 500 companies, as a percentage of profit before write-offs:

1998: 17.6%

“Operating” vs. “Reported” Profit

Investors have been conditioned to pay attention to “operating” earnings, which is profit before one-time write-offs. Companies encourage that, because “reported” earnings--what’s left after write-offs--have grown far more slowly for shareholders in recent years. Operating profit versus reported profit for S&P; 500 companies, per index “share,” growth from 1994 to 19998:

Operating profit

1994: $33.00

1998: $45.79

Change: +39%

Reported profit

1994: $30.60

1998: $37.71

Change:: +23%

Source: First Call; Goldman Sachs & Co.

*Anualized pace based on year-to-date total.

Taking Charge(s): The Mega Write-Offs of 1998

Jack Ciesielski, a certified public accountant and publisher of the Analyst’s Accounting Observer newsletter, tracks corporate write-offs taken for various purposes. Here are the largest charges announced in 1998 by U.S. companies:

Restructuring Charges

(Taken for job terminations, unit divestitures, etc.)

Company: Amount (millions)

Motorola: $1,333

Xerox: $1,110

Citigroup: $703

Ford Motor: $631

Moore: $630

In-Process Research Charges

(Taken by an acquiring company to write off research underway at the target firm)

Company: Amount (millions)

MCI WorldCom: $3,300