Helping others cook their books: It's a recipe for disaster

August 13, 2008

Your company's best corporate customer needs help. Earnings are down. You could help that company's revenues look rosier with a sham transaction. And, why wouldn't you? After all, it's not your company's financial statements you're sweetening. You're just bringing a little aid to the table for someone else.

With your help, that other company could stay hot in the market. Its shareholders won't suffer because of missed earnings expectations. You won't either, you think.

Should you play along? No way, says Marianne Jennings, a professor of legal and ethical studies at the W. P. Carey School of Business. Even if your own earnings are for real, you could face criminal charges for aiding another company with "creative" accounting.

Jennings maintains that business people don't seem to realize that earnings management is wrong. In her experience, many rationalize: "I'm not embezzling. I don't cheat on my travel expenses. Ergo, I'm ethical."

According to Jennings, business people should look more closely at wink-and-nod deals. As recent court cases prove, helping someone else cook their books may get you burned.

Numbers game

Earnings manipulation is not new, but it seems more prevalent these days, Jennings continues. "People used to say, 'Well, we didn't sell enough.' Now they ask, 'How can we make it look like we did sell enough?'" People seem to view iffy transactions as devices to get around earnings disappointments.

"We are reaping the rewards of 30 years of moral relativism," she notes. That is, people may admit they're manipulating transactions, but they'll justify it by saying they've saved shareholders money or preserved jobs for employees. "There are some pretty 'noble' reasons people give for crossing ethical lines," she adds. Noble? Probably not. Smart? Absolutely not.

"Any time you're manipulating numbers, you're not really paying attention to business," Jennings says. She maintains that earnings manipulation is just a temporary fix, and one more likely to hurt a company than help it in the long run. "I'd rather worry about a change in strategy when I'm down 10 percent in sales than when I've manipulated earnings and I'm down 30 percent because I haven't resolved any underlying issues."

According to Jennings, earnings manipulation not only fools investors. It fools employees, who could be addressing company weaknesses. "If numbers are down, people look for ways to solve the problems. If numbers are on target, people think everything is OK," she says.

Whiff test

On the other hand, earnings manipulation doesn't fool shareholders -- or anyone else -- forever, she continues. "It's going to come out." And, when it does, courtroom drama may follow.

As a case in point, Jennings recently wrote an article for Corporate Financial Review in which she covered what regulators called "serious hoodwinking" at General Re, one of the world's largest reinsurers -- the people who insure insurance companies. In 2000, after American International Group (AIG) appeared to have insufficient reserves for potential claims, AIG made a reinsurance deal with General Re that apparently added another $500 million to AIG loss reserves. Money changed hands. Risk didn't.

"The transaction was a sham," Jennings wrote in her article. Although the deal was designed to show nervous shareholders that AIG was prudently shoring up its loss reserves, no real risk passed to General Re. "As the Securities and Exchange Commission (SEC) described it, there was a round trip of $500 million in cash from AIG to General Re and then back again to AIG." General Re earned $5.2 million for its trouble. Company executives earned criminal indictments, and four General Re and one AIG executive were convicted or entered pleas.

Jennings' article quotes comments made by Deputy Attorney General Paul McNulty about the case: "This indictment sends a clear message to corporate America that executives will be brought to justice not only for cooking their own books, but also for knowingly helping their counterparts do the same."

Email and taped phone calls among the General Re team indicate that executives did worry about the legality of their deal. Still, they chose to believe their actions were acceptable. "They'll find ways to cook their books," John Houldsworth, then-CEO of the General Re subsidiary that inked the deal, told his chief financial officer. "We won't help them to do that too much. We'll do nothing illegal."

Prosecutors disagreed, and, in 2005, Houldsworth pled guilty to conspiracy to misstate financial statements. The CFO was found guilty on all 16 counts charged in the indictment. AIG paid a $1.64 billion fee for misleading investors, although no executive was indicted.

Earnings manipulation can happen in many ways, Jennings points out. "Stuffing the channel" is one. When a company ships product and books the sale, but it's not a real sale -- that's stuffing the channel, she explains. And, that's one of the accounting "irregularities" that eventually bankrupted Sunbeam Corp. in 2001.

As the online encyclopedia Wikipedia explains it, the company gave "large discounts to retailers who bought far more merchandise than they could handle; the excess merchandise was shipped to warehouses to be delivered later, but the sales revenue was booked immediately. With the stores hopelessly overstocked, unsold inventory piled up in Sunbeam's warehouses."

Sunbeam also was charged with using "cookie-jar" accounting, or the practice of using reserves from profitable years to offset losses in lean years.

In the end, former Sunbeam CEO Al Dunlap agreed to pay a $500,000 fine to the SEC, plus another $15 million to defrauded investors who filed a class-action suit. According to news accounts, Dunlap never admitted wrongdoing.

But, few of us do. And, as Jennings points out, "We all kind of massage things a little. How many times have parents given kids the down payment on a house, with the understanding that the kids will pay that money back, but the bank doesn't know that?"

Still, according to Jennings, people generally can and do sniff out stinky deals -- or at least have an inkling of impropriety -- even when they can't bring themselves to walk away from them. That, she says, is something companies should address.

Ethical upgrade

To bring employee ethics up to snuff, Jennings offers several pointers. For instance, she recommends storytelling. "Law is anecdotal. So are ethics," she explains. "People don't realize they're involved in wrongdoing until they see examples of what happened in other transactions."

She maintains that ethics and compliance training should go beyond legal reviews, compliance guidelines and penalty reviews. "What people need is training that explains problem transactions," she says. The lesson trainees must take away is, "We're not in the business to manipulate earnings. We're in business to do business."

Jennings also suggests that some general ethics and compliance training should take place with employees from all corporate levels in the same room, since it makes the point that everyone must be concerned with toeing the line.

Plus, she's a fan of dialogue. She recalls one CEO who, in a corporate blog, shared that he no longer charged the company for any travel expenses beyond lodging and transportation, and he invited employees to respond to this news. "Employees went nuts for three days debating about this," Jennings recalls.

After a few days of commentary, the CEO wrote another posting explaining that he didn't expect employees to pick up their on-the-road meals. He simply wanted them to know he's careful with company money, and he wants them to be careful, too. But, the email exchange got people talking and thinking, Jennings says, which probably helped some see where they'd crossed a few lines themselves.

Along with inviting talk, she says companies should invite disclosure. "We reward people for results, but we don't reward people who throw down the flag and say, 'Time out.' That's a signal in itself," she notes, particularly if people are punished or flat-lined in their careers for blowing the whistle.

Before someone can cry "foul," however, that person has to recognize a foul play has gone down. Many argue that those involved don’t see the issue. Many don't want to, Jennings maintains.

She'll tell you: "A lot of people respond to me, saying, 'That's a gray area.' But, gray disappears into black very quickly. And, that's where people get in trouble."

The same murky discomfort that tells people they're stepping into a gray area is probably good guidance to quit moving toward the darkness. Intuition and conscience deserve a listen, according to Jennings. "If you think there's a problem, there is a problem," she concludes.

Bottom Line:

  • Many people see iffy accounting -- especially if it has an underlying transaction associated with it -- as an acceptable way to make financial numbers more attractive.
  • Creative accounting with sham transactions is not a legal or ethical way to boost the bottom line.
  • If you're manipulating earnings, you're not managing business properly, according to legal and ethical expert Marianne Jennings.
  • Ethics training should tap examples, prompt dialogue and include all levels of corporate workers.