Levitt to the rescue...
Lies, Damned Lies, and Managed Earnings: The Crackdown Is Here.
The nation's top earnings cop has put corporate America on notice: Quit cooking the books. Cross the line, you may do time.
Carol J. Loomis
Someplace right now, in the layers of a FORTUNE 500 company, An employee--probably high up and probably helped by people who work for him--is perpetrating an accounting fraud. Down the road that crime will come to light and cost the company's shareholders hundreds of millions of dollars.
Typically, the employee will not have set out to be dishonest, only to dodge a few rules. His fraud, small at first, will build, because the exit he thought just around the corner never appears. In time, some subordinate may say, "Whoa!" But he won't muster the courage to blow the whistle, and the fraud will go on.
Until it's uncovered. The company's stock will drop then, by a big percent. Class-action lawyers will leap. The Securities and Exchange Commission will file unpleasant enforcement actions, levy fines, and leave the bad guys looking for another line of work.
Eventually someone may go to jail.
And the fundamental reason, very often, will be that the company or one of its divisions was "managing earnings"--trying to meet Wall Street expectations or those of the boss, trying also to pretend that the course of business is smooth and predictable when in reality it is not.
Jail? This is not a spot that CEOs and other high-placed executives see themselves checking into, for any reason. Jail for managing earnings? Many corporate chiefs would find that preposterous, having come to believe that "making their numbers" is just what executives do. Okay, so the pressure might lead some of them to do dumb (but legal) things--like making off-price deals at the end of a quarter that simply steal from full-priced business down the road. Who cares? Others might even be driven to make hash of the rules that publicly owned companies are required to abide by, Generally Accepted Accounting Principles, known as GAAP. Sure, that might mean crossing a legal line, but so what?
Well, the "so what" is Arthur Levitt, chairman of the SEC and the grand enforcer when it comes to GAAP. Last year, with his attorneys and accountants digging into Bankers Trust and Cendant and W.R. Grace and Livent and Oxford Health Plans and Sunbeam and Waste Management--and who knows what other big companies the SEC isn't talking about--Levitt finally reached the gag point. He simply declared war on bad financial reporting.
The opening shots came in a New York speech, "The Numbers Game," that Levitt gave last September to CPAs, lawyers, and academics. Lynn Turner, chief accountant of the SEC (and formerly a partner of Coopers & Lybrand), recalls that as Levitt started to speak, waiters whipped around serving salads, and people began to eat. "Then," says Turner, "two amazing things happened. First, people put down their forks and started listening very hard. Then--and this just never happens--they pulled out notepads."
What they heard was the SEC chairman committing his agency in no uncertain terms to a serious, high-priority attack on earnings management. Since then several SEC officials have gone out of their way to state that there are many managements doing their accounting honestly, but that night the chairman spared no one. He roundly criticized a business community that greeted "accounting hocus-pocus" with nothing more than "nods and winks." Among the accounting tactics he blasted were improper revenue recognition, unjustified restructuring charges, and the artifices called "cookie-jar reserves." Accountants know all of these (and more) as "accounting irregularities"--intentional misstatements in financial reports, which Levitt and his team regard as very often the equivalent of fraud.
In a recent conversation with FORTUNE, Levitt left no doubt that he intends to keep the heat on. What's at stake, he says, is nothing less than the credibility of the U.S. financial-reporting system, traditionally thought to be the best in the world. It will not now, he vowed, be undermined by managements obsessed with making their numbers. "It's a basic cultural change we're asking for," he said, "nothing short of that."
For those who can't get with the program, the punishment increasingly could be criminal prosecution. The SEC does not itself have the ability to bring criminal actions, so the chairman has been out jawboning people who do, like Attorney General Janet Reno and various U.S. Attorneys. Levitt would particularly like to see these folk nail brokers who cheat investors, but there are accounting-fraud cases in which he wants indictments as well.
One U.S. Attorney in tune with the SEC's tough new line is Mary Jo White, of New York's Southern District. White has brought a string of accounting-fraud actions and says she still has "a lot" in the pipeline. Her district has two bigtime criminal cases even now--Livent and Bankers Trust, both stemming from managed earnings. However, as White points out, "On the criminal side, we don't use that polite a term; we call it accounting fraud or 'cooking the books.' " White has also prosecuted smaller cases that she prizes for their deterrence value. Object lessons don't work in most areas of the law, she says, but "significant jail time" for a white-collar executive is apt to give others of his ilk severe shakes.
What qualifies as significant? In March, Donald Ferrarini, the 71-year-old former CEO of a New York insurance brokerage, Underwriters Financial Group (UFG), got 12 years. (He is appealing.) Ferrarini had cooked the most basic recipes in the book: He overstated revenues and understated expenses, a combo that magically converted UFG from a loser into a moneymaker. The scam, uncovered in 1995, cost shareholders, policyholders, and premium finance companies close to $30 million.
One reason Ferrarini faces such a long stretch in jail is that sentencing guidelines treat $30 million as a lot of money. And so they should, considering that there really isn't much difference between $30 million lost in an accounting fraud and the same amount lifted in a bank robbery. But that sum is peanuts compared with the vast sums lost over the past couple of years as one big accounting scandal after another reeled out. The toll doesn't suggest that the next execs to be sentenced for accounting crimes should expect much in the way of leniency.
Whether all this is enough to change the culture at the top of U.S. business remains to be seen. In taking on earnings management, Levitt is threatening a practice many CEOs regard as part of their bill of rights. The former communications director of a prominent FORTUNE 500 company remembers the blast his CEO once let loose at the financial managers and lawyers trying to tell him that the quarterly earnings he proposed to announce weren't accurate. Roared the CEO: "Stop fooling around with my numbers! The No. 1 job of management is to smooth out earnings."
Or take this anecdote out of General Electric's recent history. In 1994 the Wall Street Journal ran a long, front-page story detailing the many ways that Jack Welch and his team smoothed earnings at GE. Among them were the careful timing of capital gains (which is a permissible way of managing earnings, says the SEC) and the creative use of restructuring charges and reserves (which sometimes is not). Immediately, so a GE staff member told a FORTUNE writer, GE people got calls from other corporations--specifically, according to the account, AIG, Champion International, and Cigna--saying, "Well, this is what companies do. Why is this a front-page story?"
One would have hoped the answer was obvious. The fundamental problem with the earnings-management culture--especially when it leads companies to cross the line in accounting--is that it obscures facts investors ought to know, leaving them in the dark about the true value of a business. That's bad enough when times are good, like now. Let business go south, and abusive financial reporting can veil huge amounts of deterioration. |
