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The Honolulu Advertiser
Posted on: Sunday, February 17, 2002

Bookkeeping suddenly in corporate firestorm

By Matt Krantz
USA Today

Accounting has come a long way.

The mere mention of the word used to glaze over the eyes of students and investors alike. But suddenly, the cryptic ways of bean counters have ignited a firestorm stretching from Wall Street to Capitol Hill and beyond and possessing the power to destroy billions of dollars in value.

Just a whisper of the A-word sends stocks swooning, forcing even blue-chip companies such as General Electric to reassure investors about their bookkeeping. Worries are so high, they're threatening to foil the business plans of companies such as Tyco.

Every day seems to bring another bombshell disclosure about an accounting investigation. Companies including Global Crossing and Enterasys have been named the targets of these probes. Enron has headlined the accounting scandal.

But it isn't as if accountants just woke up and started cooking the books last year. Most companies use accounting tricks to prop up earnings, especially during quarters in which things aren't going so well, says Robert Olstein, manager of the Olstein Financial Alert fund.

During the '90s, executives increasingly had their pay tied to stock options, which provided intense incentive to keep the share prices rising.

When the market was booming, this connection was considered a motivation for good management. Critics say it also motivated companies to push the accounting envelope to keep revenue and earnings growing.

But conditions created by the first recession in a decade and two years of a nasty stock market have made those accounting shenanigans blow up in their faces.

Accounting sleight of hand comes in many forms. Cookie-jar reserves. Off-balance-sheet debt. Cozy deals with partners. Channel stuffing. Done well, these tactics can do more for a company's books and stock price than a killer product or stellar sales force. And accountants, eager to please their customers, know how to help companies navigate the gray areas and keep these things legal.

Auditors, who work for the companies, aren't exactly great watchdogs. They are trained to ignore discrepancies that aren't "material." In fact, a number can be off by as much as 9 percent and still be cleared by an auditor. Most audits check only a random sample of a company's transactions.

Enron isn't an isolated case, and fallout from the energy company's accounting scandal has drawn attention to the techniques companies use to make their businesses look better than they really are:

Accounting loopholes allow some companies to ignore major costs of doing business when tallying up their profit. In the case of Sears, that cost is store leases.

Sears has left off its balance sheet — the usual place a company shows what it owes others — $2.4 billion in leases that it is on the hook to pay. The omission is thanks to an accounting loophole that lets companies look better financially by leasing property rather than buying it.

While legal, the maneuver in Sears' case is a big omission, because it's not added to the $22.2 billion the company reported as debt, says Brett Trueman, accounting professor at the University of California at Berkeley. Sears declined to comment.

Such gimmicks are legal. But slick accounting is making financial statements of little value for anyone who doesn't know the code. Accounting rules have become so convoluted, investors must wade through pages of notes just to get basic facts about a company, such as how much debt it has or how much money it makes.

Critics say accounting has become more of a way for companies to justify their games, rather than preventing them from playing them. "No matter what rules we set, (companies) will learn to present themselves in the best light," says Charles Lee, accounting professor at Cornell University. "Folks out there are very creative."

Even a minor change in the way a company does its accounting can make a huge difference in the bottom line. A company can use tactics to lower the tax it pays, change the method it uses to count inventory or even use profit expected from its employees' pension plans to goose the bottom line.

Such changes aren't minor. About 10 percent of the 2001 earnings reported by IBM under the helm of CEO Lou Gerstner came from gains from its giant pension plan, versus just 3 percent in 1999, says Merrill Lynch's Steven Milunovich. That jump was attributed in part to IBM raising the expected rate of return from the plan to 10 percent from 9.5 percent in 2000.

Another example of how a seemingly small assumption can boost the numbers is RSA Security, which makes computer security systems. Back in the first quarter of 2001, RSA started booking revenue as soon as it sold goods to its distributors rather than waiting until the distributors sold the goods. That change boosted RSA's revenue $1.7 million in the three months ended March 31, 2001.

While the bump was just 2 percent of revenue, the change disturbed some analysts. Jordan Klein at UBS Warburg says it signals that the company is being less conservative, because distributors could return the goods to RSA after it has already counted the revenue.

Regulators are irked because RSA didn't mention the change in its press release when it reported earnings April 10, 2001. Investors didn't hear of the change until the 10-Q was filed on May 14. That is the subject of an investigation by the Securities and Exchange Commission.

RSA's chief financial officer, John Kennedy, says RSA made the change only after working with the distributors for three years and finding they didn't return much.

Cozy deals in which companies swap goods are perfectly legal. They help each other make their numbers by buying goods from each other in a "swap." Both can book the revenue right away but can spread the cost of buying the goods over about three years.

While swaps are used in many industries, it's the "dirty little secret" of the software industry, says Nathan Schneiderman, analyst at Wedbush Morgan.

Such an arrangement helped Siebel beat analysts' estimates the first quarter of 2001, while most techs were suffering, he says. During the period, Siebel's revenue got a boost from $38 million in license fees it collected from vendors it bought goods from at about the same time. While that is a small percentage of revenue, it almost all goes straight to the bottom line.

Siebel still uses swaps, although its reliance on them is down, Schneiderman says. The company booked only $12 million in revenue from such arrangements during the three months ended Sept. 30, the most recent data available.

Global Crossing's former finance vice president, Roy Olofson, has alleged that a similar deal occurred at the telecom firm, which just filed for bankruptcy court protection.

The complaint centers around how Global booked leases with telecom firms. Those deals, according to Olofson, immediately boosted revenue even though related costs could be spread over a long period. Global has disputed those charges and insists it followed accounting rules, but the SEC is investigating.

Such maneuvers have made financial statements so complicated even CPAs have trouble reading them, says Joseph Wells, chairman of the Association of Certified Fraud Examiners. It took a bear market, and Enron, to make investors care.

"It's been getting this way for 25 years," he says. "Enron is the latest and greatest of a system that's broke. How many Enrons are there out there getting ready to blow up?"