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A look at cooked books
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July 28, 1999: 10:47 p.m. ET
CNN and Fortune report on SEC crack down on managed earnings
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NEW YORK (CNNfn) - Staging Broadway spectacles like "Ragtime" made Livent one of the worlds most successful theater companies. But telling tall tales in its accounting books may send its founders up the river.
Garth Drabinsky and Myron Gottlieb face 16 criminal charges of conspiracy, securities fraud and making false statements.
"It is extremely brazen and it's a top-down fraud," U.S. Attorney Mary Jo White said. "It involved literally erasing expenses from the general ledger."
"All of these accounting manipulations were designed to understate expenses in order to fraudulently inflate earnings, to portray unsuccessful theatrical productions as profitable, and to meet quarterly and annual projections provided to wall street analysts," SEC Enforcement Director Richard Walker said. "Simply put, Livent cooked the books."
Drabinsky maintains his innocence.
"I would have never knowingly permitted the release of false financial statements about Livent," Drabinsky said.
But Securities and Exchange Commission Chairman Arthur Levitt says far too many executives, trying to keep up with the booming stock market, resort to what he calls hocus-pocus accounting.
"The motivation to satisfy Wall Street earnings expectations may be overriding common sense business practices," Levitt said. "In the process, I fear, we are witnessing a gradual but inexorable erosion in the quality of financial reporting."
An unprecedented number of major companies have been forced to restate earnings reports, often pummeling their stocks.
McKesson HBOC (MCK) lost nearly half its value after the drug wholesaler in April said it prematurely recorded 40 million dollars in sales. Sunbeam (SOC) dropped more than 90 percent over the past year after the appliance maker restated earnings because it had recorded millions in phony sales.
Cendant (CD) fell 83 percent over several months last year, after the consumer services company revealed its CUC unit had posted half a billion dollars in false profits.
Cendant CEO Henry Silverman expressed outrage at former CUC executives.
"When some of our former partners are put in jail, I think that'll give us an emotional lift, if not a financial one," Silverman said.
With accounting scandals costing investors billions, SEC Chairman Levitt last fall announced a crackdown on earnings management, but this crackdown is different.
"The SEC is launching more investigations into more big companies than ever before," Levitt said. "The list of targets includes plenty of Fortune 500 players, including Bankers Trust, Cendant, Waste Management and W. R. Grace."
"Enforcement provides sort of the shotgun behind the door for people who really don't get the message any other way," he added.
Richard Walker and his team of lawyers and accountants are leading that crackdown, issuing record-breaking fines.
"Probably the poster child for us is the case that we brought against W.R. Grace and some of its senior folks, in which we charged that they had managed earnings by setting up, if you will, a cookie jar reserve," Walker said.
In a precedent-setting, the SEC charged not that the company fabricated profits, but that it set aside profits from good times to record later, in bad times. Grace denies wrongdoing, arguing it did the right thing in boosting reserves.
But Walker said that in the Grace case they charged that the reserves were established not conservatively, but without any reasonable basis, the healthcare units profits were declining.
"By establishing a reserve and bleeding it into income in later years, the company made it seem as though the profits were increasing," Walker said. "That misleads investors, and that's wrong."
He noted that their attorneys have also said that if they're guilty, so is everybody else in corporate America but cautioned that there's no defense or excuse that everybody else is doing it.
"If you're going beyond what accounting permits, then, then you're in violation of the law," he added.
The SEC and W.R. Grace (GRA) settled their case, with the company agreeing to spend one million dollars to promote accurate financial reporting.
The SEC's crackdown gets added muscle from law enforcement officials like New York's U.S. Attorney Mary Jo White.
"We don't use managed earnings as our terminology. Its out and out fraud, cooking the books," White said.
White said her office has tripled the number of securities fraud cases in the past four years, often including CEOs and their companies.
"We look at what kind of corporate culture has been set from the top, in terms of compliance, and what are the safeguards to make sure that employees don't cross the line, and don't mislead investors, don't cook the books. And if that's been a lax climate, its much more likely to lead to a criminal charge against their entire company," she added.
The most recent example, Bankers Trust, pleaded guilty to three felony counts after taking unclaimed customer funds as income, and was fined 63 million dollars.
"The deterioration in the honesty of financial reporting I think is at an epidemic level," White warned.
Howard Schilit analyzes corporate reports, looking for signs of trouble. He says law enforcement is no match for the relentless, daily pressure on executives to maximize their profits and stock prices.
Schilit added the pressure companies feel to make and exceed Wall Streets earnings is unbelievably high.
"There are many situations where companies are in jeopardy of missing Wall Streets targeted earnings for the period, and they begin to make some cute accounting changes, changes that an average investor has no chance of catching," he said. "And even sophisticated Wall Street analysts are having difficulty catching that kind of manipulation."
"In my judgment, most companies are doing it. Well over half of public companies," he added.
Peter Lewis, a CEO of Cleveland-based insurance company Progressive, did managed earnings for a time, announcing the formula in which they were achieving steady earnings flow.
"That's when I discovered that we were misleading ourselves, and that we were making wrong decisions based on the numbers that we had contrived," Lewis said.
Lewis doesn't buy arguments that investors benefit when managed earnings keeps stocks high.
"The only shareholders who benefit are the ones who sell out, and who gives a damn for the shareholders who sell," Lewis said. "I care about the shareholders who are, not the shareholders who were."
Progressive's stock is volatile, just like its earnings, jumping 20 points last fall when profits beat expectations, then dropping 30 in Jan. when earnings fell short. But Progressive (PGR) has out-performed the S&P 500 for years.
"The fact that we don't do it gives us a competitive advantage," Lewis said.
Now Lewis passionately fights earnings management.
"I think honesty is a very important attribute, and I think that any dishonesty is bad for all people who are touched by it," he said.
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