How Corporate Crooks Cook the Books

"The single most important piece of fundamental information you need about a company is its correct earnings," Dr. Martin D. Weiss advises in The Ultimate Safe Money Guide.

"It's no coincidence, therefore, that earnings information is often the prime target for manipulation and distortion - by none other than the company officials who are responsible for compiling and issuing the data for each quarter."

Weiss says that the problem arises when company officials are pressured by Wall Street to meet the Street's "overblown expectations" fearing that if they don't the price of their stock will be "severely punished."

"So when they realize their actual earnings are falling short, many resort to gimmicks (both legal and illegal) to twist the truth. The consequences for investors are disastrous."

Nine West: When investigated by the Securities and Exchange Commission for allegedly misrepresenting revenues after its 1995 acquisition of U.S. Shoe Corp., its stock plunged.

Shareholders in Summit Medical saw their stock slide nearly 90 percent for similar reasons.

Stock in McKesson HBOC plunged 82 percent after it was forced to restate three years' worth of revenues because of accounting improprieties.

Sunbeam Corp. falsely reported $96 million in income it never earned. The stock was virtually wiped away - down 93.4 percent.

Tyco fell 58 percent, Informix fell 89 percent, and Safety-Kleen lost a whopping 96 percent - all because of allegations that their earnings has been distorted. And then there were Enron and Global Crossing ....

Weiss notes that in each case, when the truth finally came out, and by the time most investors learned what had happened and sold their stock, it was too late.

These are not isolated cases. Weiss says that in a close look at more than 6,000 companies listed on U.S. stock exchanges, 1,697 - nearly one out of three - had significant discrepancies between earnings and cash flow. Such results are, he wrote, a red flag, leading to suspicions of earnings manipulations, legal or illegal.

Why do companies do this, he asks. "Simple. The officials of America's corporations get up to 90 percent of their compensation in stock and stock options. So they have everything to gain by putting out information that will boost the value of their own investments in the company.

What happens, therefore, when a company's stock drops by 30 percent, for example?

"The Big Cheese loses one third, one half, or even two thirds of his or her personal wealth, in the case of a big outfit that can run into the hundreds of millions of dollars."

Knowing that there is nothing better to pump up stock prices than a positive earnings report, "unscrupulous CEOs massage the numbers, hide losses any way they can, artificially inflate revenues, and when all this fails, look you straight in the eye and lie their rich, well-tailored fannies off."

Weiss lists some of the tricks corporate bigwigs use to cook the books. One is falsely inflating the goodwill value of the company. Another is padded sales reports, and another is playing games with details of stock options.

Once the information has passed through corporate headquarters and reached Wall Street, you can "add on a whole new layer of hype and distortion."

It's interesting that major league baseball teams cook their books in the exact OPPOSITE way...they hide profits and turn profits into losses...and the sports media simply blindly repeats what they are told without checking or understanding.

Baseball teams aren't publicly held companies, and they're constantly trying to get taxpayers to pay for new stadiums for them, and also trying to win over public opinion in labor disputes, so they constantly lie about their losses.

One neat trick is for a team to pay MASSIVE rent for the stadium, which the team owner owns...Huizenga did this in Miami...so it makes it looks like the Marlins lost money, when, in fact, they only lost money because they were paying the owner of the team massive rent to use Pro Player Stadium.

Another is for a team owned by a major media company that also broadcasts the games to get paid almost nothing for broadcast rights.

This is a little cock-eyed. First, what alternative does this guy suggest to stock options to have a high level exec. work for a firm. The stockholders want this guy in bed with them. Obviously, there is the possibility of fraud, but that will always be a problem no matter what you do. Other possibilities are to pay your head managers the same thing no matter what the firm does. If you like that idea, consider how the world would work if everyone was paid like government employees. Another alternative is to have all (or more) employees work on a commission basis. That is, each employee is paid according to his sales. You can bet that there will be a lot of sales in a give year, but it is unlikely that the firm will be able to collect the accounts payable from a lot of these guys. You get a similar problem if you pay according to curreny year's earnings. You will have good short term tactics, but sorry long term strategy.

Second, over the long term a steadily improving balance sheet is probably more important than a good income statement. A rational, long term (excuse the redundancy) investor will be more interested in being rich than in having a high income. As a result, Dr. Weiss' comment that "The single most important piece of fundamental information you need about a company is its correct earnings" is probably incorrect; particularly in a world where there is a differential between capital gains and true income. The balance sheet, and postive changes to it, are the key. Certainly a good income is a postive factor towards a good long term balance sheet, but there are other factors to consider also. Finally, this guy talks about cooking the books with goodwill when discussing an income statement. For the most part, goodwill is not an income item, it is a balance sheet item. Certainly inflated goodwill can distort a balance sheet, which is a big deal, but it does not usually affect the income statement as implied in the article.

The long and the short of the deal is that you do not stop fraud by making more rules; you stop fraud by quickly punishing crooks. More rules, poorly understood and rarely enforced, will increase the opportunity for fraud and decrease the vigilence for fraud.

Can an Engineer ask, just what do outside auditors do to earn their paychecks? This isn't rocket science. You can ship a lot bricks on December 31, but that catchs up with you pretty quickly. I remember going through acceptance testing of a newly designed system almost 24/7 on the last week of December once (don't ask about the wife) so we could book $10,000,000 before December 31. But we actually shipped the goods, including user's manuals, toolkits and spares. Even if we didn't ship, we get credit for inventory, somehow accounts receivable look better on the bottom line.

Fraud is fraud, we pay CPAs to get our money's worth within the game's limits. Most of us are only aware of the basic rules, that's what professionals are for. Those who break the rules are subject to the people who we pay to enforce the law. As you said, more rules don't guarantee the laws will not be broken.

People must be paid according to performance. I don't understand salaries, but I have never worked for anyone. I totally agree with the commission concept, it makes the effort more like one's own business.

I haven't the foggiest idea of what you're referring to.

Baseball teams aren't publicly held, hence, they have no motivation to inflate their earnings for stock price purposes. It was a simple statement of fact. Most businesses aren't publicly held either, as you state, but I fail to see the relavance of that at all.

And what on earth do you mean by asking what "side" I'm on? I was simply noting something interesting about major league baseball teams and how they cook their books in a similar but opposite way to publicly-held companies.

When you build a system "to-order" you move contract line items (CLIN's) from inventory to accounts billable when the customer signs off on last constituent part of the CLIN. It is not considered good form to have $10,000,000.00 (there abouts) CLIN's made up of 100's of clearly identifiable and separate parts. If you were supplying, say, kits to upgrade the radar in a B-52, you would want to get paid for your non-recurring engineering (NRE) when the customer accepted the design, and, say, get paid for each kit accepted by the customer. In the actual case we were not allowed to bill for anything until last piece was accepted by the customer. Stuff designed and delivered in 1989 wasn't billed until December 31, 1992 (in the actual case) because of the Stoopid way our contracts folks negotiated.

My point was, if you ship bricks (non-compliant merchandise) you may show it as accounts billable in one quarter, but you'll get hammered on returns (and lawsuits) in the next. Short term you might be able to boost the books, but doesn't anybody balance the corporate checkbook. What do accountants do to earn a paycheck?

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