by Stephen Frey
“The pattern is established. You scratch my back, I’ll scratch yours. The CFO and the lead partner get even chummier. The wives become friends and the couples take vacations together at the Boca beach house.”
Conner stopped scrawling notes for a moment. The e-mail was starting to make perfect sense. Rusty was the junior person and Victor was the lead partner. “You haven’t painted a pretty picture of the accounting profession,” he commented.
“Understand,” Jackie replied, “I’ve described the exception, not the rule. But it happens. Enron and WorldCom are excellent examples. And I guarantee you there are more big companies out there with problems. Some will be exposed and some won’t. But you better believe those problems usually involve complicity between the company and its outside auditors. I don’t like throwing stones at my profession, but you asked me how it could happen. That’s how.”
“Why wouldn’t accounting firms do something to address these problems?” Conner asked. “Like rotate lead partners? If that lead partner you described automatically had to transfer to another client every two years, the scenario would be less likely. Don’t you think? He wouldn’t want the next partner to discover what he’d been doing.”
“Some firms do implement that kind of rotation. But what you have to appreciate is that it takes a great deal of time to fully understand aFortune 500 Company. They’re so huge. So many divisions, products, and locations. At the point a lead partner on an audit is just getting his hands around the company, and is best prepared to identify problems like fraud—if he’s honest—he’d be moved on. If you believe your people are ethical, it’s better to keep them in place. You can’t assume your people are dishonest. That creates a terrible culture.”
“What’s the answer?”
“Accounting firms have to do their best to hire ethical employees. Then have checks and balances that aren’t overly invasive. Two lead partners on every client. An audit department within the accounting firm constantly doing internal spot checks on their people just like the IRS performs random audits on taxpayers. So that it’s expected, not unusual.”
“Which would add costs,” Conner observed. “A great deal of overhead burden.”
“Exactly. And that’s the last thing a professional services firm wants. So if one firm doesn’t do it, then the others can’t either because they won’t be able to compete on price. It’s a very difficult problem,” she acknowledged.
Conner held up one hand. “Okay, I understand your point on the big picture. But now I want specifics. How does that CFO who’s building the vacation home in Boca actually manipulate the company’s EPS number so he can keep paying the construction crew to build the wine cellar? Where’s the sleight of hand?”
“The easiest thing to do in the short run is book fraudulent revenues,” Jackie answered without hesitation. “Just claim you sold more products than you actually did. It sounds simple, but, executed the right way, it can be very effective.”
“Explain,” Conner said, beginning to take notes again.
“Let’s use a one-product company for this discussion. It’ll make things easier to explain. And to understand. Let’s say we’re talking about a T-shirt company. They have to buy machines to knit the T-shirts, and yarn to feed into the knitting machines. They have to pay people to service the machines, a sales department to sell the T-shirts, and they have overhead. Executives, a finance staff, human resources people, et cetera. Let’s say they sell each shirt to the retail stores for a dollar, and, after all their costs, the company makes ten cents a shirt. If they sell thirty million shirts a year, their annual revenue is thirty million dollars, and their net income is three million. That three million is what’s left over for shareholders after everything else is paid. As I’m sure you can appreciate, there’s a lot of hard work and risk involved in making that three million dollars, too.”
Conner shrugged. “Yeah, so?”
“If the T-shirt company’s CFO wants to turn three million dollars of net income into six million real quick, to double it, the easiest way is just report that the company sold another three million shirts. That would add another three million dollars to the bottom line at a dollar a shirt because there haven’t been any costs associated with those fraudulent revenues. It’s pure profit at a dollar a shirt. The CFO would be more than happy to open the books and dare anybody to find those additional expenses, because he knows nobody could. They really aren’t there, because they weren’t incurred. The only thing the CFO would have to worry about is that someone finds out that the revenues aren’t real. That those extra three million shirts weren’t really shipped to stores.”
“Exactly,” Conner agreed. “Which is a big risk.”
“Not as big as you might think,” Jackie cautioned. “Not in the short term anyway.”
“Why not?”
“How can anybody figure out how many T-shirts the company actually sold?” Jackie asked.
Conner considered the question. “You could contact the retail stores and get a person in the purchasing department there to confirm how many shirts they bought from you that year. Retailers have to keep track of that information.”
“They do, but they aren’t going to go out of their way to volunteer it to anyone. And the retailer doesn’t have any idea how many shirts the company sells to other accounts. So they aren’t going to think anything’s unusual if someone there picks up the company’s annual report and sees thirty-three million dollars of revenue as opposed to thirty. The point is, you’d have to really be looking for the problem. And you’d have to be inside the company because the retailers aren’t going to hand that sales data out to just anybody. That kind of information is closely guarded. The executives at the T-shirt company who are in on the scam certainly aren’t going to tell anyone. And, if the accounting firm is in on the scam, they aren’t going to tell anyone, either.”
“But the cash won’t be collected because the retailers have never been billed for those extra three million shirts,” Conner protested. “That’s the problem.”
“True, but big companies don’t report their financial statements on a cash basis. They book revenues when they ship the T-shirts, not when they get the cash. In a lot of industries, corporate customers may not pay invoices for sixty or ninety days. Sometimes even longer. So the CFO would record the extra three million dollars of revenue when he claimed his company shipped the T-shirts to the retailers, making the company’s net income go up by three million, and doubling the earnings per share. When the CFO recorded the revenue on the income statement, he would also record a receivable on the balance sheet. An IOU from the retail store that he records on the T-shirt company’s balance sheet to reflect the fact that the retailers supposedly owe the company another three million dollars. Just as he would do when real shipments occurred. And nobody suspects a thing.”
“But those bad receivables will be on the balance sheet forever,” Conner pointed out. “The T-shirt company will never collect the cash, because the CFO never actually sent a bill to the retailers. The retailers don’t really owe the company anything.”
“So what?” Jackie asked. “When the company prepares their financial statements for the public at year end, the receivable amount on the balance sheet is an aggregate number. There are plenty of real receivables in that line item. Only a few people have access to the details of the receivable ledger. Only they would know that some of the receivables are no good.But they’re all in on the scam. ”
Conner nodded, understanding now why Jackie had spent time explaining why complicity with the independent accountants was so important.
“Maybe next year the T-shirt company’s sales really take off,” Jackie continued. “The company sellsixty million shirts, so revenues would be sixty million dollars. But the CFO wants to make certain his fraud isn’t uncovered, so he claims the company only sold fifty-seven million shirts. And he applies the extra three million dollars of cash that comes in from the three million T-shirts he says they didn�
�t sell to that fake three-million-dollar receivable he booked last year. Again, nothing comes to light because only a few people know what happened. Everything’s fine and they’ve all gotten stock options anyway, so why are they going to blow the whistle?”
Conner nodded. “The company records fake revenue on the income statement and fake receivables on the balance sheet and everything looks great. The books are inflated, but how would Joe Investor ever figure out that anything was wrong?”
“He never would,” Jackie agreed. “Especially if it’s aFortune 500 company with multiple divisions and thousands of products.”
“Right,” Conner agreed.
“Maybe that’s the dirty little secret our junior guy detected at Company Y,” Jackie said. “Maybe he did a spot confirmation at one of Company Y’s divisions and the receivables ledger didn’t jibe with what the customers told him. In fact, it wasn’t even close. But he and his wife needed that nursery and, besides, the lead partner promised him that the CFO would reverse those fraudulent entries over the next year as business improves. So our junior guy complies and Mr. Merlot becomes his best buddy.
“Now let’s determine what effect the accounting magic has on the stock price,” Jackie suggested. “Let’s say Company Y’s price-earnings multiple is pretty constant at around twenty times. So, if the earnings per share is one dollar, the share price should be about twenty dollars. But suddenly, net income doubles because they do the same thing the T-shirt company did. They book false revenues and rope the board and the accountants into the scam with financial incentives. So earnings per share doubles. Now it’s two bucks a share and the share price quoted on the New York Stock Exchange quickly climbs to forty bucks because the world is accustomed to this company having a price earnings ratio of twenty times. Noweverybody’s building houses in Boca and West Palm. ‘Live large’ becomes the company motto. There’s champagne and caviar at the board meetings, and private planes for the senior executives. The banks and the bond markets lend the company a ton more money to expand, becausethey believe every number and every word in the glossy annual report, too. How could they not? The so-called independent accountants have signed off on everything.
“The senior executives use the bank and bond money not only to expand but also to pay themselves exorbitant salaries and bonuses. To build an even bigger headquarters with all the latest high-tech gadgets, and maybe even give the worker bees a little extra cash. Everybody loves these guys, and Wall Street is throwing more money at them.
“Back to the CFO,” Jackie said, switching gears. “He really had intended to reverse the fraudulent revenue entry over the next year because, down deep, it makes him nervous. But he can’t. In fact, instead of reversing the entry, he’s got to make another fraudulent revenue entry the following year because the recession has gotten worse. An even bigger fraudulent entry this time because earnings per share needs to go up again so the party can rock on. The CEO has given him the directive. He doesn’t care what the CFO has to do, but the party has to keep going.” Jackie shook her head. “But now it’s too much. Almost all the receivables are bad and one day somebody starts sniffing something in the company’s accounting department. Somebody who isn’t in on the scam. Somebody who hasn’t been given a ton of options and a big bonus. He notices that it’s taking the company longer and longer to collect cash from customers. So, late one night he digs into the details of the receivable ledger when everybody else is out gulping down champagne. The next day, he makes a few calls to customers, finds out that the company never really shipped the goods. And suddenly, the party’s over.
“Maria Bartiromo breaks the story on CNN a few mornings later and by that afternoon the banks and the bondholders are accelerating their loans because of multiple covenant defaults in the loan agreements and the indentures. They demand to be repaid immediately, but the company can’t possibly repay all the loans and the notes at the same time. So the business seeks bankruptcy protection, and the executives are escorted single file out of the glittering new headquarters building in cuffs. The next thing you know, those same executives are up in front of Congress trying to explain their actions. One or two try, but the rest of them plead the Fifth because they see it’s all happening just so the congressmen can look like hard-asses to their constituents. So the president can pound the lectern during his State of the Union Address and tell the nation how he’s going to propose massive changes in the accounting profession and the cozy way things are done on Wall Street. The executives wait for their trials while the lawyers and the regulators sift through the ashes.
“The Saxons shrug their shoulders and slink off into the night, while the poster children on the board whine about how they thought something was up, but the Saxons wouldn’t listen. Congress and the president end up proposing regulations my five-year-old niece could circumvent—which are never passed anyway—and our executives spend a year or two in a minimum security prison somewhere in Pennsylvania playing round-robin tennis tournaments.” Jackie sat back in her chair. “And that’s how it goes, Conner. The really sick thing is that when the executives get out of prison, they’ve still got millions of dollars in their bank accounts. Millions of dollars they’ve stolen from Joe and Jane Investor.”
The office was silent for a few moments.
“What happened at WorldCom?” Conner finally asked, glancing at the picture of Jackie’s parents.
“WorldCom happened because the accountants wereunderstating expenses, as opposed tooverstating revenues like I just described. They were recording expenses on the balance sheet that should have gone directly to the income statement. But it had the effect everybody wanted. It made the EPS number higher.Billions higher. You can understand why the stock price crashed when people found out that expenses were really billions and billions of dollars higher than what had been reported.”
“Sure,” Conner agreed, checking his shirt pocket to make certain the cargo was still there. “When we first sat down, you wanted to know why I was interested in all this,” he reminded her, now trying to push gently on the door instead of pulling harder. “Why?”
Jackie looked up from her desk. “Companies in trouble sometimes turn for help to small financial firms that are struggling, too. They know that small financial firms trying to make a name for themselves might be willing to overlook certain irregularities just to get a deal done.” She hesitated. “Be careful of the transactions Gavin Smith wants you to get involved in, Conner. I’m not accusing anyone of anything. Just be careful.”
Conner nodded. Jackie’s instincts were so good. Maybe he needed to take an audit of his own. “I will.”
“Did you know that Gavin Smith was supposed to have used investigators when he was at Harper Manning?”
Conner looked up. “What do you mean?”
“He’d dig up nasty nuggets on potential clients to influence them. At least, that was the rumor.”
Jackie wasn’t a gossip, and her network was very reliable. Besides, if Gavin was willing to spy on people inside his own firm, he probably wouldn’t hesitate to do the same thing to clients. “Tell me more.”
“Let’s say Gavin was competing with another investment bank for a big mergers and acquisitions assignment from aFortune 500 company. The eight-figure kind that could earn him a personal million-dollar bonus by itself. He’d hire his people to go sniff around for nasty information about the company’s senior executives, and use it to influence them to select him. The ‘If you choose me, no one will ever know what I found’ kind of thing. A lot of people are convinced that he was successful with his investment banking practice at Harper Manning because of that. A lot of peoplesay they’ll go to any length to do a deal. He actually did.”
“What kind of information would his people dig up?”
Jackie shrugged. “Affairs, drugs, sketchy financial dealings. The standard stuff.”
“How do you know?”
“I have friends, Conner. Lots of friends all over the Street. So I hear things. Y
ou know?”
“Why are you telling me this?”
“You need to watch out for yourself. If for nothing more than guilt by association.”
“Who did Gavin use to get that information?”
“I heard it was some ex-FBI guys he was close to, but I’m not sure.”
Conner took a deep breath. That sounded all too familiar. “One more question.”
“Yes?”
“Does the name Delphi mean anything to you? As in the name of a company or a division of a company based in Washington.”
Jackie’s eyes narrowed. “Maybe.”
After leaving Jackie’s office, Conner walked fifteen blocks north to Manhattan’s Diamond District, a concentration of jewelry stores located in the upper Forties between Fifth and Sixth Avenues.
He entered one of the stores and carefully removed a bundled-up tissue from his shirt pocket. Placing it on the glass counter in front of an elderly man dressed in a white shirt, black tie, and black pants. He peeled backed the thin paper. Inside was Liz’s engagement ring. “I want to know what this is worth.”
The elderly man leaned down and his long, curly earlocks fell about his face. He eyed the ring for a few moments, then removed his spectacles and picked up a jeweler’s loupe, scrutinizing the huge stone under a bright bulb. “A thousand dollars,” he finally announced, replacing the spectacles on his nose.
