An Alarming Decline in the Quality of Financial Reporting [Updated]

By William S. Lerach

I'm here today to discuss a serious problem affecting our securities markets – the dramatic decline in the quality of financial reporting by public companies in the last few years. An explosion of new, smaller "high-growth" public companies – including the Dot-Com IPO craze – plus a virtually universal executive compensation and annual bonus system based on meeting pre-determined earnings targets, and stock options to be exercised and sold quarterly, have created powerful incentives to falsify results. This is exacerbated by a market increasingly dominated by momentum investors who instantly crush a stock just for missing the "whisper" earnings number by a penny or two. This phenomenon appears to be creating a "race to the bottom" in financial reporting, which unless arrested, will undermine a core value in our capital markets – the integrity of public company financial reports which is essential to informed investor decisions, investor confidence and the efficient allocation of capital.

While we have always had occasional high-profile financial frauds – Equity Funding, National Student Marketing and Miniscribe come to mind – these were isolated instances. Historically, public company accounting in this country has been of high quality and one of the major factors that has led to investor confidence in our markets, made them the envy of the world and helped fuel the strong capital formation and economic growth we have enjoyed here now for many years.

However, over the past decade, important changes have occurred which are now resulting in an increase in fraudulent financial reporting. Over 9,000 new public companies have been created by the ongoing initial public offering ("IPO") boom – that's more than half of all existing public companies. Many of these new public companies are smaller high-growth, high-tech or bio-tech companies where the pressure to show earnings growth is intense. Others are Dot-Com enterprises which have no earnings and so are under pressure to show revenue increases. Another large batch of new public companies are in the for-profit healthcare area – an area where The Wall Street Journal described the Chief Financial Officer as an "endangered species" and where the quality of financial accounting reminds one of the public real estate companies in the "go-go" era of the 1960s and 1970s. Bringing these companies public creates billions in investment banking fees and cash flows and gargantuan returns to venture capital investors – as well as instant insider multi-millionaires. Executive compensation has also changed. Virtually all corporate executives now get cash bonuses only if a year's earnings reach pre-set targets, and they receive stock options, not to hold for the long-term, but rather to exercise and sell each quarter for cash, most often in a trading window that opens a day or two after the company reports its closely watched quarterly numbers. It is not hard to see the temptation to manipulate reported results to meet internal targets and investor expectations under these circumstances – especially when the efficient market (it's really a ruthless market) will savage the stock for the slightest earnings disappointment. These are important structural changes that have altered the type of public companies dominating our financial markets, and the incentives that shape the behavior of their executives. Adam Smith's invisible hand guides us all. When there is so much to be gained by those who create the financial results of public companies by meeting expectations, and so much to be lost by missing them, we should not be surprised that corporate managers and their professional assistors yield to temptation.

Many investors are overwhelmed by the superficially impressive appearance of the reams of data in corporate financial reports, where all the numbers always "add up" in a maze of difficult to comprehend small print. They defer to these financial statements as if they were the product of some rigorous scientific inquiry and discipline. But we know they are not. Virtually every number in a corporate financial report is created by judgments and estimates made by corporate insiders whose cash bonuses depend upon meeting pre-set earnings targets and whose ability to pocket millions from option-related stock sales is dependent upon meeting public earnings expectations.

When is revenue properly recognized? Well, the truth is, corporate managers decide when a sale or the earnings process is complete – a decision fraught with subjective determinations regarding future obligations to the customer, easily masked by side agreements for return rights, price protections, re-stocking privileges and other contingencies affecting the obligation to pay. It is oh so easy to sweeten these contingent arrangements at quarter end to induce a "sale." What expenses have really been incurred against revenue in this reporting period? Well again, it depends upon how corporate insiders value existing inventory and product development costs. What reserves are needed for returns of products already shipped? Or where price protection has been given? How about reserves for doubtful accounts receivable from new customers with unknown credit histories or customers of dubious payment ability? Or the expenses or losses incurred but not reported of healthcare or insurance companies?

Insiders make these judgments. In secrecy – behind closed doors. And, with many companies dependent on a growth-by-acquisition strategy, the ability to hide current expenses in the one-time special charges that accompany each acquisition are other opportunities for insiders to exercise judgment in a way that has a dramatic impact on reported results of ongoing operations. In truth, there are countless "discretionary accruals" available to corporate managers to shape reported corporate results. While we all recognize that corporate managers may "manage" their company's earnings, none of us should tolerate – and certainly our securities laws do not permit – the use of accrual judgments to manipulate reported results.

Stanford Professor Grundfest's analysis of securities suits filed since the Private Securities Litigation Reform Act of 1995 concluded that investors are alleging financial fraud and manipulation much more frequently, suggesting a sharp increase in fraudulent financial accounting. Since my firm filed more than half of these cases, I can personally attest to the accuracy of Grundfest's analyses. But allegations by the disgruntled investors I represent are one thing. Objective academic studies are another. And here important new evidence seems to be stacking up strongly in support of the view that there has been a substantial increase in financial fraud by public companies. Four recent academic studies confirm that financial manipulation by corporate insiders is now widespread.

"Earnings Management and Long-Run Market Performance of Initial Public Offerings," published in 1998 by the University of Michigan, is best summed up by The Wall Street Journal's headline reporting its release: "IPOs Often Come Dressed Up With Best Figures!!" No kidding! This study documented that most companies boost their pre-IPO results by discretionary accounting accruals and that the companies that engage in the most aggressive pre-IPO dress-up show the worst post-IPO aftermarket performance. You still can't rob Peter to pay Paul. Of course, borrowing from future results to boost current ones only increases the pressure for follow-on manipulations to meet investor expectations after the IPO. That is the conclusion of a 1997 study entitled, "Earnings Management and the '97 Performance of Seasoned Equity Offerings," by the University of California, which documented widespread earnings manipulation in front of "secondary" public offerings. Significantly, it also observed the phenomenon of statistically significant post-offering underperformance by the companies that were most aggressive in boosting pre-secondary offering financial results.

"Earnings Manipulation to Exceed Thresholds," published in 1997 by Harvard University, concluded: "[M]anagers have both the incentive and flexibility to manipulate earnings" and "we have no doubt that short-term earnings are being manipulated by many, if not all, companies." It found that "manipulation was most frequently present when needed to meet bright-line tests," i.e., earnings estimates, and occurred most often in the fourth quarter – just when the supposedly independent auditors are arriving on the scene for the annual audit. What does this conclusion suggest about the effectiveness of annual audits by so-called independent accountants?

Finally, "Earnings Management to Avoid Earnings Decreases and Losses," published in 1997 by Michigan University, found that "evidence of earnings management is clear and pervasive across years and industries ... (to avoid earnings decreases and losses)," noting "widespread evidence that earnings are borrowed from the future to increase current earnings."

Now, let me see if I have this right. One study says companies goose their earnings before their IPO, while another says they goose them before secondary offerings also. The two other studies say they are manipulating their earnings higher on an ongoing basis to meet forecasted results and avoid earnings decreases or shortfalls. Isn't that all the time?

According to Fortune Magazine:

Speaking at a recent investor-relations conference, one stock analyst, Gary Balter of DLJ, baldly urged that companies consider "hiding earnings" "for future use. "If you don't play the game," he said, "you're going to get hurt."

Two years ago I addressed the “Business Weak” [sic] CFO Conference in Phoenix. I spoke to 100 CFOs of top U.S. companies – major American corporations. After I had challenged the quality of current corporate financial reports, the moderator used an interactive question-and-answer system to ask the CFOs to respond anonymously to the question: "Has your CEO ever asked you to falsify the financial results?" Astonishingly, 67% said yes – and 12% admitted they had done it. I later heard the SEC had sought – and obtained – the attendance list for this Conference.

The popular financial press is catching on. The New York Times ran a story headlined "Falsifying Corporate Data Becomes Fraud of the 90s," noting a "sharp resurgence of fraud" in financial accounting, saying "the motive for tinkering is clear. The pressure to deliver ever higher earnings can be intense because rising earnings translate into rising stock prices and missing a Wall Street earnings per share estimate by as little as a penny can send stocks into a freefall."

Worth Magazine ran a story, "Taking the Lies Out Of Earnings," which concluded, "earnings are becoming an increasingly less reliable tool for investors, as changes in executive compensation and accounting practices give corporate officials both a reason to bend the rules and greater leeway in doing so."

And Forbes, under the headline "Pick A Number, Any Number," noted, "it's getting to the point where reported earnings in many cases are whatever management wants them to be." Forbes concluded, "accounting tricks are always going on ... what's changed is the companies are getting away with more now. It's been a great bull market. One that's full of dangers and getting more dangerous all the time."

Even Fortune Magazine gets it. In an August 1999 article entitled "Lies, Damned Lies, and Managed Earnings" Fortune wrote:

What has sparked Chairman Levitt's war on falsified earnings reports, however, isn't the occasional distracted CEO. It's the continual eruption of accounting frauds. The accumulation of cases, in fact, keeps suggesting that beneath corporate America's uncannily disciplined march of profits during this decade lie great expanses of accounting rot, just waiting to be revealed.

Bloomberg Personal Finance, in "10 Ways Earnings Lie," borrowed from Gilbert and Sullivan to conclude: "Things are seldom what they seem. Skim milk masquerades as cream. Storks turn out to be but logs. Bulls are but inflated frogs."

I'm afraid that those revered Generally Accepted Accounting Principles ("GAAP") are increasingly turning into Cleverly Rigged Accounting Ploys (I'll let you figure out the acronym). Ploys of corporate insiders tempted by the huge financial gains their bonus and stock options programs promise them if internal and public expectations are met.

Shakespeare told us: "Oh how courtesy would seem to cover sin," and so do great bull markets and economic boom times cover financial sin. At least for a while.

Something is very wrong here. Even a casual reader of The Wall Street Journal will have noted the massive upsurge in accounting restatements by public companies in the last few years. When I began representing investors 20-some years ago, you could count the number of accounting irregularities or restatements in a year on the fingers of one hand. Today, in some weeks you would use up the fingers on both hands.

Informix, a large software seller, incurred over $200 million in restatements and paid $145 million to settle class action suits. Waste Management, a New York Stock Exchange company, restated results and paid $220 million to settle class action suits. Then, Waste Management did it again – only worse. Its stock fell from over $60 to under $15 and it is again mired in stockholder suits. Livent, a large Canadian company, admitted years of financial irregularities. Rite-Aid, the huge drug store chain also restated. Columbia HCA, MedPartners, FPA Medical and Oxford Health symbolize a for-profit medical care industry where reported results reflect reality only by accident. Then there was the sub-prime automobile lending industry – that's the Mercury Finance-type companies, almost all of which have restated earnings, causing their stocks to crash and resulting in numerous bankruptcies. Vesta Insurance in Georgia coughed up several quarters of accounting irregularities and the stock is down 24 points in a day. Then there is Sunbeam – where it turns out that loud-mouthed Al Dunlap's "turnaround" was more due to accounting tricks than any great management skills. Sybase, S3, Fine Host, Versatility, Physicians' Computer, Medaphis, Centennial Technology, Norland Medical, Premier Laser, Altris Software, Micro Warehouse, Transcrypt, Paracelsus, DonnKenny, Raster Graphics, TriTeal and the list could go on and on and on.

In fact, accounting irregularities have become the order of the day. And how about that Cendant? A $100 million restatement caused its stock to plunge $17 per share in one day, vaporizing $15 billion of shareholders' equity, and subsequent revelations confirm a widespread falsification of results going back several years, resulting in a $3 billion cash settlement of a securities fraud class action. I recently read that Cendant's Board of Directors repriced (lowered) the stock option exercise prices for its top executives, some of whom were present when that huge accounting fraud was perpetrated, no doubt to retain them and incentivize them for another round of stock-boosting antics.

And the Dot-Com phenomenon has taken this foolishness to even new heights. Billions in underwriting fees have been made from IPOs of Dot-Com companies that instantly created thousands of 20-year-old multi-millionaires and enabled venture capitalists to reap returns measured in thousands of percent – literally billions of dollars. And yet it appears that many of these "new-economy" companies are engaging in age-old tricks to create phony revenues and boost operating margins – premature revenue recognition, use of gross, not net revenues, and swaps and barter transactions. Bob Samuelson wrote in Newsweek last month that "the Internet boom" has inspired accounting practices that "look ethically suspect." U.S. News & World Report recently chronicled Wall Street's abuse of Internet IPOs in "The Anatomy of Sickly IPOs – How Wall Street Learned to Love Flimsy Internet Companies Like"

Samuelson focused on MicroStrategy, which collapsed from over $300 to $19, wiping out $20 billion in market capitalization, after it restated its results to eliminate millions in improperly recognized revenues. But MicroStrategy is just a worst-case example. Over 30 other Dot-Coms have restated – and many, many more are on the way. As Business Week said, "Earth to Dot-Com Accountants."

We may well have recently seen the greatest wealth transfer in history from public investors to Wall Street financiers, venture capitalists and corporate entrepreneurs! And it may well have been accomplished, in large part, via phony financial reporting.

And remember, these shenanigans are occurring in the midst of the longest, most successful economic expansion and the greatest bull market in history. What is going to happen when the economy slows, as it may well be doing now? What antics will these insiders resort to when the true weight of an economic slowdown weighs in on their corporations' operations – as it undoubtedly will when this longest business expansion of all time finally yields to the weight of the Fed's interest rate increases?

Why does this go on? Well, one reason is the structural changes discussed earlier that have altered the incentives for and pressures on corporate managers to engage in this kind of behavior. But also in the mix with these pressures, corporate managers have friendlier faces looking over their shoulders as they prepare their financial results. As Big Five accounting firms increasingly look to consulting fees rather than audit and accounting fees as their principal source of revenues (consulting fees increased as a percentage of Big Five revenues from 15% in 1978 to 24% in 1990 and to 38% in 1996), auditors are more reticent than ever to disagree with corporate managers on financial reporting issues. As Douglas Carmichael, an accounting professor at Baruch College, stated, "the pressures to keep the clients are now so powerful" that auditors are abandoning their traditional role as "watchdogs" to become advocates for their clients' accounting positions.

And it now appears that the independent accountants have been a lot less independent than we thought – or than SEC rules require. It turns out that PricewaterhouseCoopers ("PWC") – perhaps the most prestigious accounting firm in the world – has grossly violated the independence rules:

  • Independence violations occurred involving two-thirds of the firms' SEC audit clients.
  • Fifty percent of PWC's U.S. partners owned stock in companies the firm audits.
  • Six of eleven senior partners who oversaw PWC's independence program violated it.
  • All twelve regional partners who oversaw PWC's independence program violated it.
  • Thirty-one of forty-three partners on PWC's Board of Partners violated the independence rules.
  • Overall, 86% of PWC's partners violated the independence rules.

Now, even conceding that many of the independence violations were "technical," these findings remain shocking – especially since the SEC concluded the firm "made little or no effort to comply with independence rules." The other mega-accounting firms are now being investigated, but everyone knows the results will be very much the same. Business Week concluded in February 2000 – "This scandal changes everything." But not so far. And note the accounting professionals' reaction – not "we are sorry" or any mea culpa. No. Rather, the rules are "outmoded" and too technical or restrictive. The SEC is trying "to bomb the profession back into the Stone Age." Again, the race toward laxity and away from principle is evident. Business Week just editorialized "The Auditors Need Auditing," writing:

Instead of cleaning up their act, at least some of the big accounting firms are using political clout to get the SEC off their backs. They lobbied House Commerce Committee Chairman Tom Bliley (R-Va.) to send a letter to SEC Chairman Arthur Levitt questioning the regulatory agency's entire oversight of the accounting profession. Responses "will help to determine if hearings on the SEC's oversight of the accounting profession are warranted," Bliley threatened.

The accounting profession needs to shape up. The first step is for the firms themselves to create a set of sensible rules and internal controls concerning investments and consulting. Clear lines must be drawn up against possible conflicts of interest to guarantee independent audits.

Corporate audit committees are, in the recent words of The Wall Street Journal, "toothless tigers." They simply are not doing their jobs. The new chairman of Waste Management – on inheriting that accounting debacle – said when the CEO picks the audit committee members they are "willing to go along with the flow – and not rock the boat too much." Disappointingly, virtually every one of the companies involved in the recent rash of restatements had audit committees!

Also in the mix is the utter failure of the SEC – the supposed "cop on the beat" – to do its job. The resources of the SEC have long been outstripped by our surging markets. And since the SEC was turned over to that quintessential corporate man from Wall Street, Arthur Levitt, the SEC has been anything but interested in cracking down on corporate financial manipulation or executive insider trading. In none of the high profile restatement cases mentioned earlier has the SEC taken enforcement action. Yet private class action lawsuits have recovered billions in damages for defrauded investors. How about AOL? AOL falsified eight quarters of results to report profits rather than losses in 1995-1996 as insiders sold $95 million of their AOL stock. AOL then restated to wipe out all those profits. A private class action suit successfully recovered millions for investors. Five years later, the SEC got a meaningless consent decree and a $3.5 million penalty payment from AOL. Today, the SEC both speaks softly and carries a small stick.

But, most importantly, this kind of conduct goes on because of the failure of people in positions of responsibility to behave responsibly. A 1996 study in The Journal of Business Ethics put corporate executives in play-acting roles and found that 80% of them were willing to commit fraud by understating charges that cut earnings in order to meet targets which impacted their cash bonuses or stock options – an academic finding consistent with the responses at the Business Week CFOs Conference that, in the real world, 67% of CEOs pressed their CFOs to cook the books, and 12% did it.

Some may think it is too early to answer the question of whether the impact of the 1995 amendments to the securities laws making it more difficult for investors to hold corporate executives and accountants liable for fraud has contributed to this upsurge in financial irregularities by breeding increased arrogance among corporate executives, who now feel more insulated from the threat of liability under the securities laws. But, it is certainly time to ask the question. And I suggest the answer is obvious.

And, I wonder – I wonder if the accumulating weight of these financial frauds isn't playing a role also in the increasing instability of our securities markets. Only time will tell – but if our markets lose their image/reputation for core honesty, recent scary declines could be looked back on with fondness.

But of course, with the stock market still not far from its all-time highs and executive compensation still out of control with the stock option craze generating billions of dollars for insiders annually, and allowing even under-performing executives to become multi-millionaires, my kind of carping doesn't seem to matter. At least for now.

But all good things do come to an end. It is worth remembering that one of the excesses of the 1920s which contributed to the '29 Crash was the widespread falsification of corporate earnings. One of the first ideas of Roosevelt's brain trust was to nationalize public accounting and have it performed by employees of the Federal Trade Commission. We would all agree that probably the only thing worse than the situation we now have would have been to have government bureaucrats auditing the books of public companies. The accounting professionals avoided nationalization by going to Washington on bended knee, begging for forgiveness and promising to be public watchdogs and remain independent from their clients. As a result, the Big Five accounting firms have built a massive and incredibly profitable worldwide oligarchy over accounting work for public companies. Whether the accounting industry kept its end of the bargain with American investors is more dubious. The truth is, the integrity of public company financial reports are being increasingly undermined at the same time as the IPO boom continues and the greatest bull market clings to life – attracting all-time record levels of individual investors and their retirement savings. We have a combustible mixture at hand here, and it's one that, if ignited, will inflict grave harm on countless investors. And when the party stops, the corporate executives won't have to pay back either their huge cash bonuses or their billions in stock option profits generated by the phony earnings they created and reported. Nor will the venture capitalists and investment bankers have to give back their take. It will be long-term investors and current stock buyers who pay the price. But, if and when that happens – as in '29 – the cries from Main Street will be for the scalps of those corporate insiders, Wall Street financiers and accountants who will be seen as causes of all this by the victims. And, when political winds shift, formerly passive prosecutors can turn into real tigers.

I often think of a cartoon I saw several years ago. Two prisoners in their striped suits are in a jail cell, one on his bunk, the other standing and saying: "You know, it turns out that those Generally Accepted Accounting Principles weren't quite as generally accepted as I thought." Corporate executives ought to keep in mind the old Biblical admonition: "What would it benefit a man to gain the whole world and lose his own soul?" – or, I might add – "even his own freedom."

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