False Profits

By Stephen Koepp

Crackdown on cooked books

When U.S. Surgical Corp. of Norwalk, Conn., piled up pretax profits of $32.9 million between 1979 and 1981, its top officers gave themselves rich rewards. The bosses enjoyed their bounty until earlier this year, when the Securities and Exchange Commission ordered the bonuses paid back. President Leon C. Hirsch, for one, agreed to relinquish $317,000. A probe of U.S. Surgical's books, the SEC claimed, had discovered that the company padded its 1979-81 profits by more than $18 million.

Rooting out financial-disclosure fraud has become the top priority of SEC Chairman John Shad this year. The federal agency is coming down hard on companies that sugar-coat their earnings reports to give stockholders an artificially sweetened idea of corporate performance. Says Shad: "Some companies try to hide the bad news." So far this year the SEC has brought lawsuits against 25 firms for cooking the books, compared with 23 in all of 1983. This month the SEC is also expected to impose stricter guidelines for financial disclosure. Under the new rules, companies would be required to publish separate financial figures for each of their business segments on a quarterly basis, rather than annually.

The most stunning case of SEC enforcement occurred last month when the agency ordered California's Financial Corp. of America to restate its second-quarter results to show a $107.5 million loss instead of a $31.1 million profit. After customers realized the true state of the savings-and-loan company's finances, they began a temporary run on deposits. Disillusioned investors have driven the company's stock price down 17% since the announcement. During the same week the SEC charged Stauffer Chemical of Westport, Conn., with overstating its 1982 earnings by $31 million, allegedly by recording sales that should have been booked the following year.

The SEC has assigned one-third of its 600-member enforcement staff to the task of ferreting out creative accounting. This year they will investigate about 300 companies, relying on tip-offs from company employees, complaints from investors and painstaking scrutiny of documents.

Much of the apparent increase in book cooking is cyclical. The SEC is just now catching up with firms that tried to smooth out the bumps in their performance during the last recession by borrowing from future or past profits. Government officials say they also often find shady accounting in companies where top managers have set goals that are unrealistically high. Says L. Glenn Perry, former chief accountant for the SEC's enforcement division: "The two primary reasons for book cooking are ego and greed." Perry says that at now bankrupt A.M. International, the office-equipment firm, some employees who failed to meet management's targets resorted to dubious bookkeeping to avoid being fired.

Ideally, sugar coating of profits is supposed to be corrected or protested by a company's external auditors. But since the late 1970s, increased competition among accounting firms has fostered some slack auditing. Says John Fedders, Shad's enforcement chief: "There's tremendous pressure on accounting firms to lower their prices. Some firms can, but only by cutting corners."

Several of the most prestigious accounting firms have been stunned by the failure of banks whose records they had found in good order. Peat Marwick Mitchell approved the books of Penn Square Bank in 1982 just four months before the institution failed from bad energy loans, and last year Ernst & Whinney, another leading accountant, gave an unqualified blessing to the financial records of Knoxville's United American Bank, which collapsed a month later. Auditors who have overlooked unorthodox bookkeeping risk censure by the SEC and lawsuits by stockholders.

In their defense, accountants contend that the rush of financial deregulation has resulted in too many gray areas. Some experts charge that the profession's rule-making body, the Financial Accounting Standards Board, is too slow to create new guidelines.

SEC officials point out that the great majority of accountants and company managers go by the rules. But the agency wants its crackdown to put a healthy scare into the rest. Says Fedders: "We're like a snake in the grass at a Sunday picnic. They're never quite certain where we're likely to appear next."

With reporting by Timothy Loughran, Christopher Redman