How Cooking the Books Works

Vishnu Nair (Chartered Accountant) (935 Points)

25 March 2010

How Cooking the Books Works

Introduction to How Cooking the Books Works

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The year 2002 saw the end of an era of skyrocketing stock prices and booming businesses. Things that had seemed to be too good to be true were just that. Companies that we previously thought of as unstoppable didn't have the earnings they told us they did.

Instead, they had been "cooking the books" to create the appearance of earnings that really didn't exist. A company is guilty of cooking the books when it knowingly includes incorrect information on its financial statements -- manipulating expenses and earnings to improve their earnings per share of stock (EPS).

Up to No Good...

In this article, we'll look at the tricks that some companies used to beef up their financial documents as well as why they do it. We'll also examine some of the fallen giants like Enron and WorldCom to see what happened and where they are now.

Why Cook the Books?

Managing earnings (or "cooking the books"), is simply a way of making things look better than they actually are to keep stockholders happy, entice new investors, meet budgets, and most importantly, earn executive bonuses. Executive bonuses are tied to specific levels of earnings, making it extremely tempting to do just about anything to meet -- or appear to meet -- the goal. But not all book cooking is motivated by greed. By making revenues appear larger than they actually are, a struggling company could stay afloat with investors' money until it can turn a true profit.

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Here's an example. Imagine you're a kid with a lemonade stand and you want to build a roof over it so that you and your customers aren't in the hot sun. You don't have the money because business hasn't been that good. Your brother has the money, but he won't lend it to you unless he knows that he'll make something in the deal. You're sure that having a covered lemonade stand will make all the difference for your business because your customers will enjoy sipping their drinks in the cool shade. So you decide to creatively boost your current sales figures and offer your brother a chance to invest in your business. He gives you the money to build your roof in exchange for 25 percent of your profits. For reasons unknown to you, the covered stand doesn't really sell any more lemonade than the uncovered stand did. Now your brother is mad, because the profit he thought he was going to make was based on phony sales figures. At this rate, it'll take four summers to break even and much more to actually make a profit.

Thank you

Thank you to Michael W. Williams for his assistance with this article.

I nvestors are attracted by rising stock prices of public companies, which make the company's financial statements extremely important documents. Wall Street analysts depend on the documents and input from the companies themselves for their recommendations. The public company depends on the infusion of cash from investors to fund company growth. Stockholders expect the price per share to go up once they buy stock. When the price goes down, they lose money. (See How the Stock Market Works for more on stock prices and earnings per share.)

Accounting Background

The most important documents that a company puts together are its financial statements. These include a balance sheet, a cash flow statement, and a profit and loss statement. These documents quantitatively describe the financial health of a company and are used by almost every entity that deals with the company, including the company executives and managers themselves.

The following financial statements are usually compiled on a quarterly and annual basis:

The New York Stock Exchange

The balance sheet gives a snapshot or bird's eye view of the company's financial situation at a given date in time. It includes assets and liabilities and tells the business's net worth.
The cash flow statement shows cash that is coming in as well as the cash needed to go out over a period of time. It is very helpful for planning for large purchases, or to help be prepared for slow periods in the business. In simple terms, the cash flow equals cash receipts minus cash disbursements.
The profit and loss statement (also referred to as an income statement) lists revenues and expenses. It also lists the profit or loss of the business for a given period of time. It is helpful for planning and helps to control operating expenses.

Banks review the financial statements to decide if they will lend the company money (and at what interest rate if they choose to lend it). Investors review the documents to decide if they feel confident in the company enough to invest their hard-earned money. Company managers use them to analyze the business and determine how well they are doing. Many others also use the documents, so it is critical that they are accurate.

For public companies, these documents are audited by outside accounting firms that certify that the documents are compiled according to generally accepted accounting principles, or GAAP. These firms are still at the mercy of the information provided by the company, however. They are also interested in keeping their largest customers happy.

We'll look at the Sarbanes-Oxley Act of 2002 in the next section.

The Sarbanes-Oxley Act

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In 2002, President Bush signed the Sarbanes-Oxley Act into law to "re-establish investor confidence in the integrity of corporate disclosures and financial reporting" [ref].The act was brought on by the large number of corporate financial fraud cases (such as those of Enron, WorldCom, Tyco, Adelphia, AOL, and others) and by the end of the "boom" years for thestock market. The Act requires all public companies to submit both quarterly and annual assessments of the effectiveness of their internal financial auditing controls to the Securities and Exchange Commission.

Each company's external auditors must also audit and report on the internal control reports of management and any other areas that may affect internal controls. The company's principal executive officer and principal financial officer must personally certify that the financial reports are true and that everything has been disclosed. Many of the Act's provisions apply to all companies, United States and foreign. However, some provisions apply only to companies that have equity securities listed on an exchange or NASDAQ.

Important organizations related to the Sarbanes-Oxley Act include:

The Securities and Exchange Commission (SEC):
The U.S. Securities and Exchange Commission (SEC) protects investors by maintaining the integrity of the securities markets, based on the idea that all investors should have access to certain basic facts about an investment. The SEC requires public companies to disclose meaningful financial information (and other types of information) to the public so all investors can determine whether or not a company's securities are a good investment.

The SEC also oversees stock exchanges, broker-dealers, investment advisors, mutual funds, and public utility holding companies. Each year the SEC files between 400-500 civil enforcement actions against individuals and companies that break securities laws.

Financial Accounting Standards Board (FASB):
The Financial Accounting Standards Board establishes standards for financial accounting and reporting. Those standards dictate how financial reports must be prepared.

Generally Accepted Accounting Principles (GAAP):
GAAP is the accepted method for accountancy (the practice of accounting). It works with the authority of the FASB and establishes a common set of procedures for compiling financial statements.

The details of the Sarbanes-Oxley Act address many of the tactics companies have used to "cook the books" over the years. In the next few sections, we'll go over some of the more popular methods of improving a company's bottom line -- if only on paper.

Off-balance Sheet Accounting and Manipulation Methods

Photo courtesy MorgueFile

With off-balance sheet accounting, a company didn't have to include certain assets and liabilities in its balance sheet -- it was "off-sheet" and therefore not part of their financial statements. We'll talk more later about how the Sarbanes-Oxley Act changed this practice. While there are legitimate reasons for off-balance-sheet accounting, it is often used to make a company look like it has far less debt than it actually does. Some types of off-balance-sheet accounting move debt to a newly created company specifically for that purpose, which was the case with Enron. These are called special purpose entities (SPEs) and are also known as variable interest entities (VIEs).

Off-balance-sheet entities can be created for several reasons, such as when a company needs to finance a business venture but doesn't want to take on the risk, or when there is too much debt to get a loan. By starting a new SPE, they can secure a loan through the new entity. There are situations where it makes sense to start an SPE. If your company wants to branch out into another area outside of its core business, an SPE will keep that risk from affecting the main balance sheet and profitability of the company. Prior to 2003, a company could own up to 97 percent of an SPE without having to report the liabilities of the SPE on its balance sheet.

Synthetic Leases
Synthetic leases often use SPEs to hold title to a company's property and lease that property back to the company. Because of off-balance-sheet accounting, synthetic leases allowed companies to reap the tax benefits of ownership without having to list it as a liability on their balance sheets.

Synthetic leases could also be signed with some entity other than an SPE. Banks, for example, would often purchase property for businesses and lease it back to them via a synthetic lease. The company leasing the property avoids the liability on the balance sheet but still gets to deduct interest and depreciation from its tax bill.

The End of the Hiding Game
New requirements from the Financial Accounting Standards Board now require SPEs to be listed on a company's balance sheet. Section 401(a) of the Sarbanes-Oxley Act requires that annual and quarterly financial reports disclose all material off-balance sheet transactions, arrangements, and obligations. The rules also require most companies to provide an overview of known contractual obligations in an "easy-to-read tabular format"[ref].

This new ruling has essentially ended the days of the SPE and the synthetic lease -- even though they are still legitimate practices.

Expense Manipulation

Photo courtesy MorgueFile

Accelerating a company's expenses may not seem to be the way to boost the appearance of earnings, but it depends on when those earnings need to be boosted. There are legitimate and illegitimate reasons to accelerate expenses. A legitimate example would be making equipment purchases when earnings are high rather than when they were planned.

Here's an example of a less legitimate earnings acceleration. A manager's bonus is based on his meeting a certain earnings goal. Once the target earning level has been exceeded, that manager might decide to spend money now that was budgeted to be spent in the next year because having higher earnings this year won't mean a bigger bonus for him. Spending money this year that was budgeted for next year, however, could help ensure he meets next year's level as well.

While this may seem like the same thing as making purchases when earnings are high, it depends on the circumstances. If making those purchases earlier than planned has no adverse affect on the business, then perhaps there is no problem. In many instances there is an adverse affect, however. For instance, buying computer equipment six months earlier than expected can mean a big difference in the actual equipment purchased -- power, features, and price can all change dramatically.

Delaying Expenses
Companies that are cooking the books have been known to capitalize expenses that are really everyday expenses. AOL was charged with engaging in various acts of securities fraud -- among other things -- between 1992 and 1996. In one part of a larger case, AOL was accused of listing advertising expenses (the cost of creating those CDs and diskettes they send out) as capital expenses rather than regular expenses. This presented a false picture of the company's profitability and boosted the stock price. The disks should have been expensed as they were mailed.

In an upcoming case study, you'll see that WorldCom capitalized expenses that should have been operating expenses to the tune of billions of dollars.

When companies land a big contract to provide a product or service over a long period of time, they're supposed to spread the revenue over the cost of the service contract. Some companies have been known to show the sale and revenue in the quarter in which the contract was signed.

Here are some other examples of premature revenue booking:

Photo courtesy MorgueFile

Recording sales after the products were ordered but before they were shipped to the customer
Recording revenues when the sales involved contingencies that allowed the customer to return the merchandise
Overstating revenues by speeding up the estimated percentage of completion for a project in process
Recording revenues by shipping products that weren't ordered by the customer or by shipping defective products and recording revenues at full rather than discounted prices.
Recording revenues when unassembled products are shipped from the manufacturing plant -- they must set up a separate assembly location and assemble the products before the products can actually go to the customers

Trying to improve future earnings by "front loading" future expenses and booking them in the current quarter is another example. This has been done during the acquisition of a company. The company will pay off (or even pre-pay) expenses in order to increase the earnings per share (EPS) over that of previous quarters for the combined company.

Non-recurring Expenses and Pension Manipulation

While this category of expenses was meant for things that would only occur once in order to keep it from affecting regular operating expenses, it has been abused in the world of "managed earnings." By over-budgeting for a "non-recurring" expense, companies have been known to then move the excess money over as earnings.

In-Process R&D Charge-Offs
Another way companies have increased their earnings per share is through in-process R&D (Research & Development) charge-offs. Here's how it works. A large company buys a small company that has new technology in development. The technology is not yet ready for commercialization, so the large company writes off the related costs. Later on, the technology is further developed and ready for market, but with a much lower R&D expense.

Now the GAAP requires companies to charge off that expense. This charge will reduce earnings and must be disclosed in the financial statements.

Operating expenses are the everyday costs of running a business. Capital expenses are business expenses for long-term assets, such as equipment. They are not tax deductible as business expenses, but may be used for depreciation or amortization -- in other words, the expense is somewhat delayed by being stretched over several years.

Pension Plan Manipulation
Many companies have defined benefit pension plans for their employees. These are plans that pay out a specific, defined amount at retirement. Companies are required to maintain enough money in their retirement account to pay benefits to everyone in the event that the company goes out of business.

Photo courtesy MorgueFile

It makes sense for companies to invest that money so it will grow. Rather than investing in something safe like bonds, some companies invest in the stock market. Accounting rules allow any "extra" money that the fund earns to be claimed as company profit. Companies can "estimate" how much it believes the money will grow each year rather than going by actual numbers. They use their estimate to figure how much money they should plan to put into the fund and how much they can consider profit.

The potential for companies to inflate their earnings by underestimating the contributions required to fully fund their retirement funds is high. Even assuming a percentage point or less can mean a difference of hundreds of millions of dollars on a company's balance sheet. Many company pension plans have been underfunded because the companies assumed that the stock market will perform as it did in the late nineties, which is nowhere near the rate of returns right now.

These methods for earnings management are just the tip of the iceberg when it comes to ways to manipulate a company's earnings. There's a fine line between legitimate earnings management and "cooking the books." Let's take a look at some real-life cases and learn how they did it.

Case Study: Enron

Background
Once the seventh largest company in America, Enron was formed in 1985 when InterNorth acquired Houston Natural Gas. The company branched into many non-energy-related fields over the next several years, including such areas as Internet bandwidtth, risk management, and weather derivatives (a type of weather insurance for seasonal businesses). Although their core business remained in the transmission and distribution of power, their phenomenal growth was occurring through their other interests. Fortune Magazine selected Enron as "America's most innovative company" for six straight years from 1996 to 2001. Then came the investigations into their complex network of off-shore partnerships and accounting practices.

How the Fraud Happened
The Enron fraud case is extremely complex. Some say Enron's demise is rooted in the fact that in 1992, Jeff Skilling, then president of Enron's trading operations, convinced federal regulators to permit Enron to use an accounting method known as "mark to market." This was a technique that was previously only used by brokerage and trading companies. With mark to market accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income. This was money that might not be collected for many years. It is thought that this technique was used to inflate revenue numbers by manipulating projections for future revenue.

Use of this technique (as well as some of Enron's other questionable practices) made it difficult to see how Enron was really making money. The numbers were on the books so the stock prices remained high, but Enron wasn't paying high taxes. Robert Hermann, the company's general tax counsel at the time, was told by Skilling that their accounting method allowed Enron to make money and grow without bringing in a lot of taxable cash.

Enron had been buying any new venture that looked promising as a new profit center. Their acquisitions were growing exponentially. Enron had also been forming off balance sheet entities (LJM, LJM2, and others) to move debt off of the balance sheet and transfer risk for their other business ventures. These SPEs were also established to keep Enron's credit rating high, which was very important in their fields of business. Because the executives believed Enron's long-term stock values would remain high, they looked for ways to use the company's stock to hedge its investments in these other entities. They did this through a complex arrangement of special purpose entities they called the Raptors. The Raptors were established to cover their losses if the stocks in theirstart-up businesses fell.

When the telecom industry suffered its first downturn, Enron suffered as well. Business analysts began trying to unravel the source of Enron's money. The Raptors would collapse if Enron stock fell below a certain point, because they were ultimately backed only by Enron stock. Accounting rules required an independent investor in order for a hedge to work, but Enron used one of their SPEs.

The deals were so complex that no one could really determine what was legal and what wasn't. Eventually, the house of cards began falling. When Enron's stock began to decline, the Raptors began to decline as well. On August 14, 2001, Enron's CEO, Jeff Skilling, resigned due to "family issues." This shocked both the industry and Enron employees. Enron chairman Ken Lay stepped in as CEO.

In the next section we'll look at how the fraud was discovered.

Enron: Discovering Fraud

On August 15, Sherron Watkins, an Enron VP, wrote an anonymous letter to Ken Lay that suggested Skilling had left because of accounting improprieties and other illegal actions. She questioned Enron's accounting methods and specifically cited the Raptor transactions.

Later that same month, Chung Wu, a UBS PaineWebber broker in Houston, sent an e-mail to 73 investment clients saying Enron was in trouble and advising them to consider selling their shares.

Sherron Watkins then met with Ken Lay in person, adding more details to her charges. She noted that the SPEs had been controlled by Enron's CFO, Fastow, and that he and other Enron employees had made their money and left only Enron at risk for the support of the Raptors. (The Raptor deals were written such that Enron was required to support them with its own stock.) When Enron's stock fell below a certain point, the Raptors' losses would begin to appear on Enron's financial statements. On October 16, Enron announced a third quarter loss of $618 million. During 2001, Enron's stock fell from $86 to 30 cents. On October 22, the SEC began an investigation into Enron's accounting procedures and partnerships. In November, Enron officials admitted to overstating company earnings by $57 million since 1997. Enron, or "the crooked E," filed for bankruptcy in December of 2001.

Where Are They Now?
Enron's CFO, Andrew Fastow, was behind the complex network of partnerships and many other questionable practices. He was charged with 78 counts of fraud, conspiracy, and money laundering. Fastow accepted a plea agreement in January 2004. After pleading guilty to two counts of conspiracy, he was given a 10-year prison sentence and ordered to pay $23.8 million in exchange for testifying against other Enron executives.

Jeff Skilling and Ken Lay were both indicted in 2004 for their roles in the fraud. According to the Enron Web site, "Enron is in the midst of liquidating its remaining operations and distributing its assets to its creditors. "

On May 25, 2006, a jury in a Houston, Texas federal court found both Skilling and Lay guilty. Jeff Skilling was convicted of 19 counts of conspiracy, fraud, insider trading and making false statements. Ken Lay was convicted of six counts of conspiracy and fraud. In a separate trial, Lay was also found guilty on four counts of bank fraud.

Kenneth Lay died of a heart attack on July 5, 2006, and a federal judge ruled that his conviction was void because he died before he had a chance to appeal. On October 23, 2006, Skilling was sentenced to 24 years in prison.

Next, we'll learn how WorldCom and Tyco cooked the books.

Case Study: WorldCom

WorldCo m took the telecom industry by storm when it began a frenzy of acquisitions in the 1990s. The low margins that the industry was accustomed to weren't enough for Bernie Ebbers, CEO of WorldCom. From 1995 until 2000, WorldCom purchased over sixty other telecom firms. In 1997 it bought MCI for $37 billion. WorldCom moved into Internet and data communications, handling 50 percent of all United States Internet traffic and 50 percent of all e-mailsworldwide. By 2001, WorldCom owned one-third of all data cables in the United States. In addition, they were the second-largest long distance carrier in 1998 and 2002.

How the Fraud Happened
So what happened? In 1999, revenue growth slowed and the stock price began falling. WorldCom's expenses as a percentage of its total revenue increased because the growth rate of its earnings dropped. This also meant WorldCom's earnings might not meet Wall Street analysts' expectations. In an effort to increase revenue, WorldCom reduced the amount of money it held in reserve (to cover liabilities for the companies it had acquired) by $2.8 billion and moved this money into the revenue line of its financial statements.

That wasn't enough to boost the earnings that Ebbers wanted. In 2000, WorldCom began classifying operating expenses as long-term capital investments. Hiding these expenses in this way gave them another $3.85 billion. These newly classified assets were expenses that WorldCom paid to lease phone network lines from other companies to access their networks. They also added a journal entry for $500 million in computer expenses, but supporting documents for the expenses were never found.

These changes turned WorldCom's losses into profits to the tune of $1.38 billion in 2001. It also made WorldCom's assets appear more valuable.

How it Was Discovered
After tips were sent to the internal audit team and accounting irregularities were spotted in MCI's books, the SEC requested that WorldCom provide more information. The SEC was suspicious because while WorldCom was making so much profit, AT&T (another telecom giant) was losing money. An internal audit turned up the billions WorldCom had announced as capital expenditures as well as the $500 million in undocumented computer expenses. There was also another $2 billion in questionable entries. WorldCom's audit committee was asked for documents supporting capital expenditures, but it could not produce them. The controller admitted to the internal auditors that they weren't following accounting standards. WorldCom then admitted to inflating its profits by $3.8 billion over the previous five quarters. A little over a month after the internal audit began, WorldCom filed for bankruptcy.

Where Are They Now?
When it emerged from bankruptcy in 2004, WorldCom was renamed MCI. Former CEO Bernie Ebbers and former CFO Scott Sullivan were charged with fraud and violating securities laws. Ebbers was found guilty on all counts in March 2005 and sentenced to 25 years in prison, but is free on appeal. Sullivan pleaded guilty and took the stand against Ebbers in exchange for a more lenient sentence of five years.

Case Study: Tyco

Tyco Background
Tyco International has operations in over 100 countries and claims to be the world's largest maker and servicer of electrical and electronic components; the largest designer and maker of undersea telecommunications systems; the larger maker of fire protection systems and electronic security services; the largest maker of specialty valves; and a major player in the disposable medical products, plastics, and adhesives markets. Since 1986, Tyco has claimed over 40 major acquisitions as well as many minor acquisitions.

How the Fraud Happened
According to the Tyco Fraud Information Center, an internal investigation concluded that there were accounting errors, but that there was no systematic fraud problem at Tyco. So, what did happen? Tyco's former CEO Dennis Koslowski, former CFO Mark Swartz, and former General Counsel Mark Belnick were accused of giving themselves interest-free or very low interest loans (sometimes disguised as bonuses) that were never approved by the Tyco board or repaid. Some of these "loans" were part of a "Key Employee Loan" program the company offered. They were also accused of selling their company stock without telling investors, which is a requirement under SEC rules. Koslowski, Swartz, and Belnick stole $600 million dollars from Tyco International through their unapproved bonuses, loans, and extravagant "company" spending. Rumors of a $6,000 shower curtain, $2,000 trash can, and a $2 million dollar birthday party for Koslowski's wife in Italy are just a few examples of the misuse of company funds. As many as 40 Tyco executives took loans that were later "forgiven" as part of Tyco's loan-forgiveness program, although it was said that many did not know they were doing anything wrong. Hush money was also paid to those the company feared would "rat out" Kozlowski.

Essentially, they concealed their illegal actions by keeping them out of the accounting books and away from the eyes of shareholders and board members.

How it Was Discovered
In 1999 the SEC began an investigation after an analyst reported questionable accounting practices. This investigation took place from 1999 to 2000 and centered on accounting practices for the company's many acquisitions, including a practice known as "spring-loading." In "spring-loading," the pre-acquisition earnings of an acquired company are underreported, giving the merged company the appearance of an earnings boost afterwards. The investigation ended with the SEC deciding to take no action.

In January 2002, the accuracy of Tyco's bookkeeping and accounting again came under question after a tip drew attention to a $20 million payment made to Tyco director Frank Walsh, Jr. That payment was later explained as a finder's fee for the Tyco acquisition of CIT. In June 2002, Kozlowski was being investigated for tax evasion because he failed to pay sales tax on $13 million in artwork that he had purchased in New York with company funds. At the same time, Kozlowski resigned from Tyco "for personal reasons" and was replaced by John Fort. By September of 2002, all three (Kozlowski, Swartz, and Belnick) were gone and charges were filed against them for failure to disclose information on their multimillion dollar loans to shareholders.

The SEC asked Kozlowski, Swartz, and Belnick to restore the funds that they took from Tyco in the form of undisclosed loans and compensations.

Where Are They Now?
Kozlowski and Swartz were found guilty in 2005 of taking bonuses worth more than $120 million without the approval of Tyco's directors, abusing an employee loan program, and misrepresenting the company's financial condition to investors to boost the stock price, while selling $575 million in stock. Both are serving 8 1/3-to-25-year prison sentences. Belnick paid a $100,000 civil penalty for his role. Since replacing its Board Members and several executives, Tyco International has remained strong.

The difference in the Tyco case and some of the others is that it is more related to greed than accounting fraud. For more information on cooking the books and related topics, check out the links on the next page.

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