Material Whirl

Plus, a stock-transfer scam forces a big nonoperating charge; new evidence that banks put the squeeze on credit customers; the inside dope on earnings management attempts; and more.


Material Whirl

Despite the 1999 Securities and Exchange Commission guidance on materiality (SAB No. 99), companies continue to run afoul of the SEC disclosure rule by using an arbitrary threshold–usually 5 percent of revenues–as the basis for hiding transactions.

The latest materiality scheme involves troubled Qwest Communications International Inc., which is under SEC investigation for, among other things, questionable barter arrangements with now-bankrupt Global Crossing. In March, the SEC launched another–albeit informal–probe into revenue-recognition issues tied to Qwest Dex, the company’s directory business. Qwest maintains that the revenues amounted to 0.2 percent of total reported revenues, rendering the changes immaterial to its financial condition and unnecessary to report.

But since Dex is one of the businesses that Qwest might sell to raise cash to reduce debt, an accounting problem could have far greater ramifications than the small percentage of revenues indicates, notes credit analyst Carol Levenson, with Chicago-based research firm Gimme Credit. SAB 99 seems to corroborate Levenson’s point. – Marie Leone

Crime and Punishment

Coming Clean

Arthur Andersen LLP’s punishment will hardly matter if it is found guilty in its obstruction of justice trial, scheduled to begin this month. A guilty verdict would deny Andersen, already hemorrhaging clients, the right to audit public companies, easily the final nail in its coffin.

But experts say other companies ought to take time now to reread the decade-old federal sentencing guidelines, because actions that corporations take today can soften the future blow if they fight the law and the law wins.

Viewed as an assault on white-collar crime when they took effect in November 1991, the guidelines automatically increase sentences if, for example, high-level personnel participate in, condone, or are “willfully blind” to an offense.

Yet, explains attorney Neil V. Getnick of New York’s Getnick & Getnick, judges must also include mitigating factors in the formula by which they calculate the severity of a sentence. For example, a company’s “culpability score” is reduced if, prior to the offense, it had policies and programs in place to prevent and detect violations.

Getnick, who helps clients set up internal crime prevention and monitoring programs, is quick to note that such leniency is just one potential benefit of corporatewide integrity programs. “Companies that have the best success are those that focus on instilling integrity, not guarding against criminal sentencing,” he says. When something does go wrong, the worst mistake executives can make is to think they can change what has happened, adds attorney Phil Feigin of Denver-based Rothgerber, Johnson & Lyons and a former securities regulator. “You have to coldly, cruelly, and clinically assess what damage has occurred,” he says. Feigin’s first rule of finance: it will never be better tomorrow. Indeed, promptly reporting an offense, cooperating, and accepting responsibility for criminal conduct are also mitigating factors under the guidelines.

Of course, established policies and self-reporting are not get-out-of-jail-free cards. Andersen’s interpretation and implementation of its preexisting document retention and destruction policy may ultimately prove to be the core of the case. “Andersen is instructive,” says Getnick. “Beyond the legal technicalities, the single most important thing is to embrace the spirit of the sentencing guidelines and the integrity aspects they embody.” –Tim Reason

Overstuffed No More

The percentage of overfunded pension plans slipped from 57% to 48%, according to’s
2002 Defined Benefit Survey. Smaller plans (less than $10 million in assets) were hit hardest. Nearly one-third are 80% to 94% funded.

Bankruptcy filings for 2002 will hit 200, predicts PricewaterhouseCoopers, 57 less than in ’01 but the highest 2-year total since 1991-92.

Asbestos Litigation

Particulate Matters

A common joke among moviegoers in the 1920s was to insist that “asbestos”–the word printed in large letters on the theaters’ fireproof curtains–was Latin for “welcome.”

For many companies today, however, asbestos just means curtains.

That’s no joke. Asbestos litigation has driven more than 50 U.S. companies into bankruptcy–about 20 since the beginning of 2000 alone. Many experts had relied on estimates that the total number of asbestos plaintiff filings would top out at 500,000, explains Raji Bhagavatula, a principal at consulting and actuarial firm Milliman USA. But lawsuits soared past that mark last summer and show no sign of abating.

Milliman now puts the ultimate total at 1.1 million lawsuits, while the Manville Personal Injury Settlement Trust–set up by former asbestos product maker Johns Manville Corp.–says it could possibly see as many as 2.7 million. For many, those revised numbers came too late.

When vehicle-parts maker Federal-Mogul Corp. bought brake-pad manufacturer T&N Plc in 1998, outside experts predicted T&N’s annual cash payment for asbestos-related liabilities would remain steady at $80 million. The next year, however, it more than doubled, to $180 million–then jumped to $340 million in 2000. “It was on track for $500 million” when Federal-Mogul sought Chapter 11 protection, declares former CEO Robert S. “Steve” Miller. “The asbestos time bomb that came with the T&N acquisition totally destroyed [Federal-Mogul.]”

Why were liability estimates so inaccurate? One reason, says Bhagavatula, is that statutes of limitation encourage plaintiffs to file claims without waiting to see if they become ill. As claims grew, Chapter 11 protection created a snowball effect.

The good news, says Bhagavatula, is that the frenzy has probably peaked, and fledgling reform efforts are under way in the courts and Congress to focus on those who are truly sick. But anyone hoping to slake the enthusiasm of trial lawyers would do well to remember that the word “asbestos” actually comes from the Greek–and means “unquenchable.” –T.R.

Dust In the Wind

Asbestos-related bankruptcies in 2002

  • A.P. Green Industries
  • Harbison-Walker
  • Kaiser Aluminum & Chemical
  • North American Refractories
  • Plibrico
  • Porter Hayden

Source: Milliman USA

Auditor Independence

Capitalizing on the Chains That Bind

Talk about turning lemons into lemonade. As regulators and shareholders probe Arthur Andersen LLP for suspect profits gained from violating Securities and Exchange Commission auditor independence rules, there’s at least one accounting services firm that has profited because of SEC restrictions.

Three years ago, auditors at Deloitte & Touche Tohmatsu estimated that the Big Five accounting firm was turning away about $30 million annually in corporate bookkeeping business to stay within SEC auditor independence guidelines (Release No. 33-7919). The jobs it turned down included reconciliation statements, development of accounting policy and procedures, securing credit lines, and preparing SEC filings. Aware that big fees were just out of reach, a group of Deloitte partners led a management buyout of one of the firm’s consulting divisions–Resources Connections Inc.–in April 1999 to fill the accounting service void.

The $190 million (in revenues) Costa Mesa, Calif.-based firm pulled in more than $70 million in revenues that first year, says ex-Deloitte partner and current Resources CFO Stephen J. Giusto. The company, which Giusto took public in December 2000, currently trades at around $28, more than double its initial public offering price. What’s more, the start-up with the Big Five pedigree posted a 50 percent sales growth rate over the past year. In contrast, Deloitte’s sales growth rate was only 11 percent, while temporary-employment services giant Robert Half International–which receives 40 percent of its sales revenue from Resources competitor Accountemps–posted no growth over the past 12 months.

Apparently, no other big public accounting firm has spun off a firm to capitalize on SEC restrictions. KPMG LLP, PricewaterhouseCoopers, and Ernst & Young International spokespersons say they haven’t seen anything like Resources Connections born out of their firms. Nor has Arthur Andersen spun out a firm to handle business that falls into the violation of auditor independence category. Maybe it should have. – M.L.

Corporate bonds can yield strong returns, despite a rise in bankruptcies, if yield spreads narrow as they did in 1991, says Moody’s.

SEC Shakeup

Who’s Keeping the Dogs In?

The recent reassignment of a top Securities and Exchange Commission official has some SEC insiders wondering if the commission is putting a muzzle on its own members. And it seems one lawmaker may have similar questions about the abrupt transfer of former divisional chief accountant Robert Bayless.

In October, Bayless quietly resigned his post at the commission’s Division of Corporation Finance, which reviews corporate filings and is often the driving force behind SEC requests for corporate restatements. At the time of his resignation, Bayless told CFO magazine that new SEC chairman Harvey Pitt had not forced him to step down.

But CFO has since learned that Rep. Edward Markey’s (D-Mass.) staff is apparently looking into whether the chief accountant for the commission, Robert Herdman, forced Bayless to take a lower-grade position. Since his resignation, Bayless had been reassigned as a special adviser to Herdman, and is now in the office of the SEC’s Division of Enforcement. Surmises one source close to the SEC: “[Markey’s staff is] probably looking to see if someone inappropriately put constraints on the Division of Corporation Finance.”

Bayless, who had gained a reputation for pushing companies to restate earnings following accounting disputes, apparently requested a transfer soon after a blowup with deputy chief accountant John Morrissey. The focus of the alleged disagreement, say sources, is that Bayless objected to the exclusion of some of his comments in a letter to a corporate issuer. One insider claims Markey’s inquiry was triggered by an internal memo Bayless sent to his boss, Division of Corporation Finance director David Martin. (Martin has since left the agency.)

According to the source, Bayless states in the memo that he was resigning his post due to conflict with Herdman’s office. While the actual points of contention are not mentioned in the letter, insiders believe Bayless chafed at Pitt’s mandate for a more corporate-friendly–and less strident—SEC.

Certainly Pitt has given many indications that he would prefer to work out agreements with companies behind the scenes rather than have them make a public restatement. “I am very much in favor of a vigorous enforcement program,” he said in an interview with the New York Times last fall, “but I am not in favor of having investors barraged by conflicting statements and restatements.”

That raises the question: Is Pitt in any way pressuring the corporation finance division to limit requests for corporate restatements? Recall that Pitt was nominated by President Bush and was approved by the Senate Finance and Banking Committee. To be sure, the raft of recent corporate restatements has undermined investor confidence in corporate accounting–and roiled the major stock markets.

Aides to Markey did not respond to CFO’s calls and questions. Bayless and the SEC declined to discuss the circumstances surrounding his transfer.

Insiders say such constraint in requesting restatements can be seen in the case of Cornell Cos. Apparently, the Division of Corporation Finance had wanted the correctional-facilities operator to restate its third-quarter earnings for 2001. The sources claim the chief accountant’s office scotched the request–even though members of the corporation finance division believed Cornell’s numbers merited a restatement.

As it turns out, the corporation finance division was right. In February, Cornell set up its own special committee of independent directors, and later announced it would rejigger earnings for seven quarters. The reason for the restatement: Cornell management wanted to put a 2001 sale/leaseback agreement and a 2000 synthetic property lease onto the company’s balance sheet.

Due to a shareholder lawsuit, a Cornell spokesman declined to comment on what sparked the internal investigation. Instead, the spokesman referred to a press release, which says the company’s restatement followed “discussions with its independent auditors and outside advisers.” The press release makes no mention of the SEC. –Alix Nyberg

100 More, Or Less?

SEC commissioner Harvey Pitt wants to increase his staffing level by 100 to handle the “enormous surge in [SEC] enforcement, accounting, and disclosure activities.” In April, he ordered a four-month internal study of the agency to back up his request.

Corporate giants–including Intel and Microsoft–are rallying to fight legislation that would require stock options to be expensed.

Stock Transfer Fraud

A Matter of Trust

CFOs will have to monitor the activities of stock transfer agents more closely if a recent case of fraud proves to be a harbinger. Transfer agents normally issue and store paper certificates that represent the stock holdings of investors. But when direct digital marketing software maker MindArrow Systems Inc. replaced RTT Transfers Inc. with U.S. Stock Transfer Corp., a firm the new CEO had previously worked with, MindArrow executives found that RTT had issued 1.1 million counterfeit shares, representing additional equity MindArrow had not authorized but that threatened to dilute existing shares.

Once the new agent raised the matter last February, CFO Michael Friedl and CEO Robert Webber swung into action, notifying Nasdaq, the U.S Attorney, and the Securities and Exchange Commission. “We found our situation was virtually unprecedented–we had never seen anything like it, and neither had any of the agencies,” says Friedl.

The SEC registers and oversees transfer agents, but historically has taken few actions against them, according to SEC spokesman John Heine. And those in the stock transfer industry, such as Leon Urbaitel, CEO of advisory service, say that such fraud is rare, if not unprecedented.

Nasdaq immediately suspended the company’s shares, then trading at $4.50, and the FBI swooped in to investigate the fraud. Two RTT agents later pleaded guilty to fraudulently issuing the additional shares to companies they owned, reselling them, and pocketing $16 million in proceeds. RTT is no longer in business.

The fraud didn’t affect MindArrow’s net worth, since its two founders surrendered 1.1 million of their own shares for cancellation to keep outside investors whole. However, to document the event, the SEC required MindArrow to take an $18.7 million noncash, nonoperating charge in the quarter ending March 31, 2001, increasing its loss-per-share for the quarter from $1.24 to $3. –A.N.

Workin’ It

Executives put in at least 11 hours of work a day, which, for 36% of them, is more time then they spent at the office five years ago, says Robert Half International.

Credit Squeeze

Turning the Screws

Here’s empirical evidence to support what every financial executive already knows but won’t discuss openly: banks pressure short-term credit customers to buy other products and services in exchange for a loan commitment or attractive terms. And on the flip side, corporate customers expect better treatment from banks if they place additional business with the lender.

A new survey, conducted by the Bethesda, Md.-based Association for Financial Professionals (AFP) and Georgetown University, reports that half of the 427 corporate financial professionals polled say they are “required” or “strongly encouraged” by their commercial bank to purchase high-margin cash-management services to secure short-term credit instruments. Among other findings, the survey also concluded that 27 percent say they were pushed to use the debt underwriting services of their short-term provider.

Conversely, 80 percent of the respondents classify the availability of short-term credit as either “very important” or “important” in selecting cash-management banking relationships, while 51 percent view credit provision as a determining factor in their selection of a debt underwriter.

“It’s all a leverage game: whoever has more leverage applies the most pressure,” says a treasury executive at a $2.5 billion retailer who requested anonymity. But that doesn’t cut off corporate options. Recently, the executive’s company switched from a traditional credit line to an asset-based lending facility. In the process, a different bank was selected to lead the new facility–which upset executives at a major bank involved in the original credit deal. The offended bank punished the retailer by changing its disbursement-services rules and making it more expensive and difficult for the retailer to do business. “So I took my disbursement business elsewhere,” declares the executive.

According to AFP president and CEO Jim Kaitz, the survey is a benchmark that quantifies the normal pressures of doing business. However, next year’s poll will provide comparative data on whether these funding pressures are a result of a sluggish economy, bank consolidation, or just business as usual. – M.L.

A new anti-money-laundering law expands the “financial institution” definition to include investment firms, says Cooley & Godward.

Earnings Management

Follow the Crumbs

The “cookie jar” reserves approach to earnings management may crumble if new research penned by a triad of accounting professors gets the attention of regulators. The study, conducted by Mark W. Nelson and John A. Elliott of Cornell’s Johnson Graduate School of Management, and Robin L. Tarpley of George Washington University, provides insight into subtle earnings-manipulation techniques–such as cookie-jar reserves.

The research, which is based on confidential interviews with 253 audit partners and managers from one Big Five firm, also gives the inside dope on pre-audit release decisions that lead to managed earnings. For instance, auditors waived adjustments of 56 percent of the earnings-management attempts (EMAs) in the study sample–21 percent because the auditors believed the client demonstrated compliance with GAAP, 17 percent because the auditors didn’t have convincing evidence that the client’s position was incorrect, and the remaining 18 percent because of other reasons, usually immateriality.

Of the 515 EMAs analyzed in the study, 25 percent involved reserve transactions, which ranked first among EMA techniques. Revenue recognition (15 percent) and business combinations transactions (14 percent) were next in line. “Cookie-jar reserves are popular because they provide a method of moving earnings from one year to the next,” says Nelson. In abusive situations, companies take excessive acquisition-related charges when business is good, to create a contingency reserve that can be used to boost earnings when things go sour.

The latest high-profile cookie-jar case involves Xerox Corp. The document-management giant reached a settlement agreement in April with the Securities and Exchange Commission to restate earnings going back to 1997 in connection with improper revenue-allocation allegations. The restatement could include more than $300 million worth of adjustments based on the establishment and release of certain reserves.

What impels management to manipulate earnings? Analyst expectations and stock price, executive bonuses and incentives, debt covenant compliance, and concern about the parent company’s reaction–in that order, says the study. –M.L.

Staggering Evidence

Harvard University says that staggering the terms of board members lowered shareholder returns as much as 10% for takeover targets between 1996 and 2000.

Real Options

Hard Assets for Hard Times

As the appeal of asset-light balance sheets fades in the wake of accounting scams, many executives are heading for the cover of tangible assets. “Hard assets are really all that matters when valuing a company,” argues Stephen Wright, an economics professor at the University of London and co-author of Valuing Wall Street. Wright and co-author Andrew Smithers make a case for measuring the profitability of tangible assets by asserting that the underlying value of a company’s stock resides in its hard assets.

One way to measure the profitability of real assets, say some pundits, is to use real options. Interested in how it would play out? Keep an eye on the electric-power industry, which will act like a petri dish for testing real options theory in an unregulated marketplace.

As deregulation takes hold, power-station owners will run their plant assets only when the price of electricity makes it profitable, notes Paul Craven, executive vice president of Innogy America LLC in Chicago, a unit of U.K.-based energy company Innogy Holdings Plc. Craven also expects that the owners may mimic his U.K. parent company and use real options to make such market-based decisions. This is an enormous departure from operating in a regulated market in which these huge plants are often run continuously–sometimes regardless of price signals.

Why shy away from price signals? Regulated markets never put a premium on profitability, says Craven, adding that to follow the electricity price curve, assets will have to be run differently. Others agree. “Companies that are forced by the market to operate with higher profit margins also will be forced, in some cases, into the ‘run-to-wreck’ strategy that real options facilitates,” says Jason Makansi, president of technology consulting firm Pearl Street Inc. and author of An Investor’s Guide to the Electricity Economy.

The strategy, explains Craven, means that a plant owner can use real options to quantify technical risk–such as the wear and tear on a machine caused by quick starts and stops. Once the risk is quantified, owners can chance damaging a plant with a cold start-up, provided that the price of electricity sold covers maintenance and the profit margin. In other words, it will run only when it is “in the money,” notes Craven. – M.L.

A new stimulus law encourages investment in equipment by increasing the proportion of an asset that can be immediately expensed.

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