The exit of the old and the onset of the new millennium appeared to have put a number of American corporation s on the fraud spot initiated by Enron and Worldcom. Sunbeam management led by its key officers Albert Dunlap and Russell Lersh followed suit and soon found the company at the bankruptcy protection doorsteps of the Securities and Exchange Commission begging for understanding to avoid the ire of stockholders.
The senior management of Sunbeam engaged in a fraudulent scheme to create the illusion of a successful restructuring of the company thus facilitates a sale of the Company at an inflated price. According to the complaint, the defendants employed a laundry list of fraudulent techniques, including creating "cookie jar" revenues, channel stuffing, recording revenue on contingent sales, and accelerating sales from later periods into the present quarter, and using improper bill and hold transactions. This is a classic case of fraudulent earnings management practices that have caused investors billions of dollars in losses and threaten to undermine the integrity of the stock markets.
Dunlap, a turn-around specialist, was hired by Sunbeam's Board in July 1996 to restructure the financially ailing Company. Dunlap placed Kersh in charge of Sunbeam's finance organization. Soon after their arrival, Dunlap and Kersh promised a rapid turnaround to enable Sunbeam to substantially improve its financial performance. Together with Sunbeam senior executives Gluck, Uzzi, and Griffith, they then employed improper accounting techniques and undisclosed non-recurring transactions to meet promised sales and earnings figures.
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These actions inflated the price of Sunbeam shares to a high of $52 per share in March 1998. The illegal conduct began in 1996 with the creation by Kersh and Gluck of inappropriate accounting reserves, which increased Sunbeam's reported loss for 1996. These "cookie-jar" reserves were then used to inflate income in 1997, thus contributing to the false picture of a rapid turnaround.
In addition, to further boost income in 1997, and to create the impression that Sunbeam was experiencing significant revenue growth, Dunlap, Kersh, Gluck, Uzzi, and Griffith ("the Sunbeam officers") caused the Company to recognize revenue for sales that did not meet applicable accounting rules. As a result, for fiscal 1997, at least $60 million of Sunbeam's reported (record-setting) $189 million in earnings from continuing operations came from accounting fraud.
Also in 1997, the Sunbeam officers failed to disclose that Sunbeam's 1997 revenue growth was, in part, achieved at the expense of future results. The Company had offered discounts and other inducements to customers to sell merchandise immediately that otherwise would have been sold in later periods, a practice also known as "channel stuffing." The resulting revenue shift threatened to suppress Sunbeam's future results of operations. Also read Sunbeam corporation case study
Phillip E. Harlow, a partner at Arthur Andersen, Sunbeam's outside auditing firm, authorized unqualified audit opinions on Sunbeam's 1996 and 1997 financial statements although he was aware of many of the Company's accounting improprieties and disclosure failures. In early 1998, the Sun-beam officers took increasingly desperate measures to conceal the Company's mounting financial problems, meanwhile attempting to finance the acquisition of three other companies, in part through a bond offering.
The Sunbeam officers again engaged in, and recognized revenue for, sales that did not meet the applicable accounting rules; again caused Sunbeam to engage in acceleration of sales revenue from later periods; deleted certain corporate records to conceal pending returns of merchandise; and misrepresented the Company's performance and future prospects in its filing on Form 10-Q for the first quarter of 1998, its offering materials in connection with the bond offering, its press releases, and its communications with analysts.
In June 1998, negative statements in the press about the quality of the Company's earnings prompted Sunbeam's Board of Directors to begin an internal investigation. This resulted in the termination of Dunlap, Kersh and other members of Company management and, eventually, to an extensive restatement of Sunbeam's financial statements from the fourth quarter of 1996 through the first quarter of 1998. Albert J. Dunlap of Sunbeam was accused of accounting fraud at a company he headed in the 1970s but hid that history from later employers, according to a published report Monday.
The New York Times reported that Dunlap was fired in 1976 as president of Nitec Paper Corp. and subsequently accused by the company's owner of overstating inventory, fabricating sales, and covering up a loss of $5.5 million. Twenty years later, Dunlap became a well-known executive on Wall Street and gained the infamous nickname as "Chain Saw Al" for his brutal cost-cutting at Scott Paper Co. and Nitec.
- The Securities and Exchange Commission likewise announced that it had filed civil and administrative actions in connection with the $40 million financial fraud at Centennial Technologies, Inc., a high-technology manufacturer based in Wilmington, Massachusetts. In that action, and in a related action the Commission filed against James Murphy, Centennial's former CFO, and two associates of Pinez's, Gilboa Peretz and Robert Lockwood, the Commission alleged that the defendants participated in a fraud designed to artificially inflate the value of Centennial and its stock.
- The Commission also alleged that Pinez and Murphy illegally sold Centennial stock while in possession of material nonpublic information that Centennial's earnings, assets and revenue had been significantly overstated. In addition to the injunctive actions, the Commission filed and simultaneously settled an administrative cease-and-desist proceeding against Centennial, charging it with violations of the antifraud, record keeping and internal controls provisions of the federal securities laws.
The civil injunctive actions allege that between April 1994 and January 1997, Pinez and Murphy orchestrated a massive fraud which made Centennial appear significantly more successful than it was. Among other things, they caused Centennial to recognize revenue from invalid or nonexistent sales, to include fake items in inventory and overvalue it in other ways, to make false additions to fixed assets, and to overvalue loans and investments resulting from less-than arms' length transactions.
As a result of these improper activities, Centennial overstated its earnings for this period by approximately $40 million: it reported approximately $12 million in profits when, in fact, it actually incurred losses of approximately $28 million. Based upon the false statements about the company's profitability, the stock price increased significantly. It rose 451% in 1996 alone, to $55.50 a share at the end of December, making it the best-performing issue on the NYSE for that year.
On February 11, 1997, upon discovery of the financial irregularities at Centennial, the company announced that Pinez had been fired and Murphy relieved of his duties. Trading was halted in the company's stock; when it resumed on February 18, 1997, the price of Centennial stock had plunged to slightly over $3 a share.
As part of their fraudulent activities, Pinez and Murphy orchestrated sales of nonexistent products to friends of Pinez's, including sales of a fake product called "Flash 98." Between February and May of 1996, Centennial sold $1.6 million worth of "Flash 98" to a company owned by Robert Lockwood. Despite the fact that the product did not exist, Lockwood paid $1.5 million for the "Flash 98" product that his company had purportedly received. Moreover, he made these payments with funds funneled to him from Pinez, via other intermediate companies.
Centennial improperly recognized an additional $2 million in revenue for December 1996 when Pinez and Murphy directed Centennial employees to ship fruit baskets to various Centennial customers, and to create fake sales documentation to make it appear as if Centennial had actually sold and shipped $2 million of Centennial product. One of the customers who assisted in this scheme was Gilboa Peretz, who accepted a fruit basket delivery as if it were really Centennial product, and falsely acknowledged that his company had purchased and received Centennial products.
Another customer was Bond Fletcher, who caused his company, Media Jet, to also accept deliveries of fruit baskets and treated them as if they were real deliveries of Centennial products.
U.S. Attorney Donald K. Stern states that "Pinez orchestrated a conspiracy that had Centennial include some $13 million of revenue from phoney sales over a period of 11 fiscal quarters. The alleged fraud included phony sales transactions of a fictional PC card called "Flash 98," along with the production of thousands of dummy PC cards designed to fool Centennial's outside auditors as to the value of the company's inventory, according to the indictment. The indictment also alleges that Pinez shipped the dummy cards to accomplices to create shipping records in connection with phony sales.
Shares in Centennial, based in Wilmington, Mass., soared over 500% in 1996 based on the company's glowing financial statements and rosy outlook for the future. But the stock was hammered in February, 1997, after it publicly announced that its auditors were reviewing its books. In July, 1997, Centennial wrote off millions of dollars in revenues falsely recorded from 1993 to 1997.
On ZZZZ Best, a short article in The Wall Street Journal reported that ZZZZ Best Company, Inc., of Reseda, California, had signed a contract for a $13.8 million insurance restoration project. This project was just the most recent of a series of large restoration jobs obtained by ZZZZ Best (pronounced “zee best”) Company. Located in the San Fernando Valley of southern California, ZZZZ Best had begun operations in the fall of 1982 as a small, door-to-door carpet cleaning operation.
Under the direction of Barry Minkow, the ambitious sixteen-year-old who founded the company and initially operated it out of his parents’ garage, ZZZZ Best experienced explosive growth in both revenues and profits during the first several years of its existence. In the three-year period from 1984 to 1987, the company’s net income surged from less than $200,000 to more than $5 million on revenues of $50 million.
Minkow cost investors and creditors $100 million. The company that Minkow founded was, in fact, an elaborate Ponzi scheme. The reported profits of the firm were nonexistent and the huge restoration contracts, imaginary. As one journalist reported, rather than building a corporation, Minkow constructed a hologram of a corporation. In July 1987, just three months after the company’s stock had reached a market value of $220 million, an auction of its assets netted only $62,000.
Unlike most financial frauds, the ZZZZ Best scam was perpetrated under the watchful eye of the Securities and Exchange Commission (SEC). The scrutiny of the SEC, one of the largest Wall Street brokerage houses, a large and reputable West Coast law firm that served as the company’s general counsel, and an international public accounting firm had failed to uncover Minkow’s daring scheme. Ultimately, the persistence of an indignant homemaker who had been bilked out of a few hundred dollars by ZZZZ Best resulted in Minkow being exposed as a fraud.
Barry Minkow was introduced to the carpet cleaning industry at the age of twelve by his mother, who helped make ends meet by working as a telephone solicitor for a small carpet cleaning firm. Although the great majority of companies in the carpet cleaning industry are legitimate, the nature of the business attracts a disproportionate number of seedy characters. There are essentially no barriers to entry: no licensing requirements, no apprenticeships to be served, and only a minimal amount of start-up capital needed. A sixteen-year-old youth with a driver’s license can easily become what industry insiders refer to as a “rug sucker,” which is exactly what Minkow did when he founded ZZZZ Best Company.
Minkow quickly recognized that carpet cleaning was a difficult way to earn a livelihood. The ease of entry into the field meant that cutthroat competition was hue of prevalent within the industry. Customer complaints, bad checks, and nagging vendors demanding payment complicated the young entrepreneur’s life.
From this beginning, the ZZZZ Best fraud blossomed. Initially, the insurance restoration work, which was totally fictitious, was a small sideline that Minkow used to generate paper profits and revenues to convince bankers to loan him money Minkow’s phony financial statements served their purpose, and he expanded his operations by opening several carpet cleaning outlets across the San Fernando Valley Minkow soon realized that there was no need to tie his future to the cutthroat carpet cleaning industry when he could literally dictate the size and profitability of his insurance restoration ‘‘business.’’ Within a short period of time, insurance restoration, rather than carpet cleaning, became the major source of revenue appearing on the ZZZZ Best income statements.
Minkow’s "the sky is the limit" philosophy drove him to be even more innovative. The charming young entrepreneur began using his phony financial statements to entice wealthy individuals in his ever-expanding social network to invest in ZZZZ Best. Eventually, Minkow recognized that the ultimate scam would be to take his company public, a move that would allow him to tap the bank accounts of investors nationwide.
On the other hand, Waste Management Company founder Dean L. Buntrock, five others were sued for massive fraud lasting more than 5 years. Defendants inflated profits by $1.7 billion to meet earnings targets while reaping millions in ill-gotten gains while defrauded investors lose more than $6 billion. The complaint, filed in U.S. District Court in Chicago, charges that defendants engaged in a systematic scheme to falsify and misrepresent Waste Management's financial results between 1992 and 1997. The complaint described one of the most egregious accounting frauds seen which for years defendants cooked the books, enriched themselves, preserved their jobs, and duped unsuspecting shareholders.
According to the complaint, the defendants abetted violations of, antifraud, reporting, and record-keeping provisions of the federal securities laws. Defendants' fraudulent conduct was driven by greed and a desire to retain their corporate positions and status in the business and social communities. Buntrock set earnings targets, fostered a culture of fraudulent accounting, personally directed certain of the accounting changes to make the targeted earnings, with charitable contributions made with fruits of his ill-gotten gains or money taken from the company.
Other fraudulent acts committed were the non-recording of write-offs in some instances, overruled accounting decisions that would have a negative impact on operations. Likewise the group destroyed damaging evidence, misled the company's audit committee and internal accountants, and withheld information from the outside auditors. He profited by more than $900,000 from his fraudulent acts. The complaint alleges that defendants fraudulently manipulated the company's financial results with deceptive disclosures to meet predetermined earnings targets.
The company's revenues were not growing fast enough to meet these targets, so defendants instead resorted to improperly eliminating and deferring current period expenses to inflate earnings. They employed a multitude of improper accounting practices to achieve this objective.
Among other things, the complaint charges that defendants: avoided depreciation expenses on their garbage trucks by both assigning unsupported and inflated salvage values and extending their useful lives, assigned arbitrary salvage values to other assets that previously had no salvage value, failed to record expenses for decreases in the value of landfills as they were filled with waste, refused to record expenses necessary to write off the costs of unsuccessful and abandoned landfill development projects, established inflated environmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated operating expenses, improperly capitalized a variety of expenses, and failed to establish sufficient reserves (liabilities) to pay for income taxes and other expenses.
To reduce expenses and inflate earnings artificially, defendants then primarily used "top-level adjustments" to conform the company's actual results to the predetermined earnings targets, according to the complaint. The inflated earnings of prior periods then became the floor for future manipulations. The consequences, however, created what Hau referred to as a "one-off" problem. To sustain the scheme, earnings fraudulently achieved in one period had to be replaced in the next.
Defendants allegedly concealed their scheme in a variety of ways. They also are charged with using accounting manipulations known as "netting" and "geography" to make reported results appear better than they actually were and avoid public scrutiny. Defendants allegedly used netting to eliminate approximately $490 million in current period operating expenses and accumulated prior period accounting misstatements by offsetting them against unrelated one-time gains on the sale or exchange of assets.
They are charged with using geography entries to move tens of millions of dollars between various line items on the company's income statement to, in Koenig's words, "make the financials look the way we want to show them. Defendants were allegedly aided in their fraud by the company's long-time auditor, Arthur Andersen LLP, which repeatedly issued unqualified audit reports on the company's materially false and misleading annual financial statements. At the outset of the fraud, management capped Andersen's audit fees and advised the Andersen engagement partner that the firm could earn additional fees through "special work."
Andersen nevertheless identified the company's improper accounting practices and quantified much of the impact of those practices on the company's financial statements. Andersen annually presented company management with what it called Proposed Adjusting Journal Entries ("PAJEs") to correct errors that understated expenses and overstated earnings in the company's financial statements.
Management consistently refused to make the adjustments called for by the PAJEs, according to the complaint. Instead, defendants secretly entered into an agreement with Andersen fraudulently to write off the accumulated errors over periods of up to ten years and to change the underlying accounting practices, but to do so only in future periods, the complaint charges.
The signed, four-page agreement, known as the Summary of Action Steps (attached to the Commission's complaint), identified improper accounting practices that went to the core of the company's operations and prescribed 32 "must do" steps for the company to follow to change those practices. The Action Steps thus constituted an agreement between the company and its outside auditor to cover up past frauds by committing additional frauds in the future, the complaint charges.
Defendants could not even comply with the Action Steps agreement, according to the complaint. Writing off the errors and changing the underlying accounting practices as prescribed in the agreement would have prevented the company from meeting earnings targets and defendants from enriching themselves, the complaint says. Defendants' scheme eventually unraveled. In mid-July 1997, a new CEO ordered a review of the company's accounting practices.
That review ultimately led to the restatement of the company's financial statements for 1992 through the third quarter of 1997. When the company filed its restated financial statements in February 1998, the company acknowledged that it had misstated its pre-tax earnings by approximately $1.7 billion. At the time, the restatement was the largest in corporate history.
The series of fraudulent acts committed by a number of companies illustrate the wanton disregard of the accounting principles governing financial recording, reporting and control. It appears from the cases that management fraud wastes billions of resources as well as affects investors and the value of their investments. The general tendency therefore is to bloat the revenues and hide the expenses.
The ethical component of management is therefore again demanded upon the managers. After all the analyses have been made, the root cause of the frauds committed is the inability of management to exercise good governance and the inability to control greed in the corporate world.
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Published by: American Institute of Public Accountants.
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