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Fraud, by -- and With -- the Numbers

Tish Williams

SANTA CLARA, Calif. -- Consider them the cleaners from " La Femme Nikita."

If you're lucky, they come in at that moment when you drop your head in your hands and realize that as a corporate executive, you have ruined the company's finances, the stock, your good reputation and the ability to move forward as a viable corporation. Unfortunately, they can't pour battery acid on your earnings restatements and dissolve them.

Perfectly timed on the day after Cisco (CSCO - Cramer's Take - Stockpickr) missed earnings by a penny, corporate insurer American International Group (AIG - Cramer's Take - Stockpickr) hosted a morning-long seminar on finance-related crisis management in Silicon Valley. Specifically the kind of ulcer-busting, hairline-eroding terror caused by the discovery of accounting discrepancies and irregularities -- the two terms referring to number errors and fraud, respectively. The audience learned from the emergency masters -- Bill Clinton's PR counsel (pre-Monica), one of MicroStrategy's (MSTR - Cramer's Take - Stockpickr) legal advisors, prominent crisis lawyers and a forensic accountant who instead of cleaning up numbers fraud, looks for the signs of bleach and intense scrubbing.

Lesson No. 1: Have a plan. This isn't going to be a pleasant experience, as the growing number of troubled companies can tell you.

The Environment

Host for the day Paul Ferrillo, a vice president at National Union Fire Insurance, mapped out an environment in which the climbing amount of securities fraud cases caused by accounting problems have mimicked the technology boom during the past several years. Even before the recent scrutiny surrounding earnings management, the number of cases of earnings restatement had climbed dramatically toward the end of the 1990s. Wedged together in the manila folder of executive agony are an increase in suits seeking class-action status against high-tech companies and the cost of settling those suits. Surprise, surprise, suits that allege accounting fraud evoke the most costly settlements.

You know the names of the class-action all-stars (not all of which were accused of accounting fraud): Cendant (CD - Cramer's Take - Stockpickr) with $2.8 billion in settlements so far, Drexel Burnham Lambert's $1.3 billion, Miniscribe for $550 million, Waste Management's (WMI - Cramer's Take - Stockpickr) $220 million, Informix with $142 million, 3Com (COMS - Cramer's Take - Stockpickr) for $259 million and most recently MicroStrategy with $137 million. Those numbers don't include Securities and Exchange Commission, National Association of Securities Dealers Regulation and stock exchange fines or possible criminal settlements. They also don't include the cost of stock declines.

And there is always the incalculable cost of infamy.

"The SEC has made no secret of the fact that it wants to take on securities fraud cases in Northern California. There's not as big a tradition here," says Lee Althschuler of Deloitte and Touche, comparing quieter Silicon Valley to the hopping legal front New York.

Avoidance

While the morning dealt extensively with the measures to take to right a company once accounting problems come to light -- dealing with the press smartly, gathering the facts about the problem, dismissing the right people -- it focused equally on avoiding prickly situations altogether. The assembled experts put the onus on executives, boards of directors and auditors to keep accounting on the up-and-up.

Lawyer Michael Young of Willkie Farr & Gallagher explained that most earnings manipulation starts not with beady-eyed, parking space stealing villains. Instead, he sketched out a scenario in which a well-meaning president stretches to gain a penny in earnings to meet the Street's expectation. A one-time thing, the president hires some overtime help to accelerate shipments. No biggie, in the next quarter the company will breeze past expectations and make back the penny. The company makes the numbers, hooray.

Lo and behold, next quarter that penny doesn't materialize, so the president accelerates shipments again, and also needs to reduce the amount he or she usually saves to account for returned product. At that point the yearly audit rolls around, but with little to alert a audit team, Young hypothesizes that the president proceeds directly to go with the blessing of the bean counters.

That's when the crowd began to sweat. Young described the rapid-fire spiral from that one penny to booking bad accounts receivable, delaying expense recognition, adjusting acquisition reserves and booking inventory "in transit." At that point the whole accounting department has trouble understanding the numbers, the president erases and reinvents numbers he doesn't like and when the annual audit comes around, the staff is having secret meetings about handling the auditors.

Is That Chocolate?

Then everyone gets caught with hands in the cookie jar.

Young cautioned against a culture that's unforgiving of failure, pinpointing excessively demanding management as the root of most accounting evils. His fellow speakers suggested that audit committees and boards of directors take interest in and hold regular meetings with corporate controllers and other key accounting personnel to make sure they feel no undue pressure to meet earnings expectations.

Because when the cleaner comes, getting rid of accounting messes is graphically painful, for executives and investors alike. Better to avoid dirty play altogether.