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http://www.securitiessleuth.com/corporatefraud/bull.html

BULL ACCOUNTING: Long Stock Run Encourages Accounting Fraud

By Michael Lange, Partner
Berman DeValerio & Pease LLP


It has never been tougher to be the chief financial officer of a publicly traded company in America. Put another way, it has never been more tempting for CFOs to fudge the numbers.

Soaring stocks, demanding investors and a generation of corporate leaders whose fortunes are tied to company stock have led to a dramatic increase in the types of accounting sleight-of-hand that undermine the reporting standards at the heart of our financial markets.

Call it bull accounting.

Since 1997, the Securities and Exchange Commission says nearly 400 companies have restated financial results - approximately 1% of those making public filings. Accounting and financial fraud cases made up one-fifth of the SEC's caseload in fiscal 2000. And the number of cases is rising.

Financial restatements also figure prominently in a growing share of private shareholder lawsuits. More than half of securities class actions filed in the last five years involve allegations of "accounting irregularities," up from an average of 38% in the four preceding years, according to National Economic Research Associates (NERA).

The cost to shareholders of financial fraud is staggering. Three recent accounting scandals alone - involving Cendant Corporation, MicroStrategy Incorporated and McKesson HBOC, Inc. - cost investors $30 billion in lost share value.

Corporations, too, can pay a high price for their misdeeds. Earlier this year, Cendant agreed to pay $3.2 billion to settle investor lawsuits. Last year, the average settlement for securities fraud class actions was $12.9 million, NERA said. That amount has risen steadily since 1995, when Congress amended the federal securities laws to make it harder for shareholders to recover damages in private litigation.

Massachusetts companies are not immune to restatements. Those announcing restatements this fall include Interspeed, Inc. of North Andover and Lernout & Hauspie Speech Products N.V. of Burlington.

On occasion, Bay State companies have been as innovative with their bookkeeping as they have been with their technology. Take the case of Centennial Technologies, Inc., where former CEO Emanuel Pinez sent fruit baskets to clients and tallied the shipments as sales of fictitious products. The scheme worked, for a while. Centennial was the New Stock Exchange's top performer in 1996 before news of the fraud sent its stock tumbling.

Pinez eventually was sentenced to five years in prison for his part in the fraud. In September of this year, he agreed to pay $5.3 million to settle the government's case against him. The company also paid $35 million in cash and stock to settle a class action lawsuit brought on behalf of defrauded shareholders. Centennial's auditors, Coopers & Lybrand L.L.P., agreed to pay another $20 million.

With so many companies getting caught with their hands in the proverbial cookie jar, why do so many others continue to take the risks associated with accounting fraud?

The answer is that the penalties for falling short of Wall Street's expectations can be severe. If a company misses analyst projections, even by a little, its stock price takes a beating. A company that disappoints Wall Street too often can fall right off the board.

The "new economy" also encourages accounting shenanigans in other ways. Top executives have an extra incentive to pump up their company's stock price, since many of them receive a sizeable percentage of their compensation in the form of equity, including stock options, which become worthless if the share price falls. Indeed, their careers are often on the line if they fail to make their numbers.

No less an authority than Lynn Turner, the SEC's chief accountant, says: "the temptation for a CEO or CFO to play the ŒNumbers Game' today is great. The average shelf life of a CEO today is fewer years than you can count on one hand. And CFOs seem to come and go all too often when a company misses its target."

Speaking to a group of corporate attorneys, Turner cited surveys in which CFOs say they have been pressured by their bosses to cheat. "Rather than managing the business, they chose to manage the numbers," he said.

Most of the time, the journey to accounting fraud begins with a small step: a sale booked prematurely and counted toward quarterly results, a "creative" accounting method too good to pass up. But the slope is both steep and slippery. The sale that was improperly booked, even if it doesn't fall through, leaves the company scrambling the next quarter.

Sooner or later, the auditors catch the improper accounting. When that happens, the wrath of the markets - not to mention regulators and private litigants - wipes out whatever gain there was in the first place.

But the harm goes far beyond the monetary losses suffered by that company's shareholders. The U.S. stock markets are the biggest and strongest in the world because of their reputation for fairness, liquidity and transparency. The ultimate cost of accounting fraud is the erosion of that trust, which affects the entire economy and hurts us all.