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SEC Turns Up the Heat

Regulators are taking action amid a rash of cases of companies allegedly playing fast and loose with financial results. Some experts say managements feel pressure to put sparkle in earnings data.


NEW YORK — Cadillac inflates sales numbers to edge out Lincoln for the luxury car crown. W.R. Grace & Co. allegedly creates a fiscal "cookie jar" to dip into when it needs a boost in profits.

Sensormatic Electronics Corp. backdates shipping documents to tweak revenue. Donnkenny Apparel Co. is accused of hiding piled-up inventory in an idle warehouse.

What's going on here? Many American investors have long believed that U.S. companiesoperate under the most rigorous and informative accounting standards in the world.

But in recent months, a rash of allegations of phony accounting has stung business boardrooms--and raised troubling questions about the corporate profit boom of the 1990s upon which Wall Street's spectacular bull market is largely based.

Accounting-related blowups at companies such as Cendant Corp., McKesson HBOC Inc., Sunbeam Corp. and Oxford Health Plans Inc. have spawned investor lawsuits and devastated stock values.

Can investors trust the financial information they're getting from U.S. firms?

The Securities and Exchange Commission is worried enough that it has, over the last eight months, devoted major resources to blowing the whistle on the accounting tricks that companies use to fluff up their earnings--and, by direct connection, their stock prices.

SEC Chairman Arthur Levitt and his deputies have given no fewer than a dozen speeches since last fall denouncing "managed earnings," misleading accounting of merger deals, dubious restructuring charges, and conflicts of interest between auditors and their clients.

Besides jawboning and soliciting advice from a blue-ribbon panel, the SEC also has filed fraud lawsuits against chemical giant W.R. Grace and other firms, and has delivered blunt warnings to many others.

No one is suggesting that the U.S. accounting system overall has suddenly become corrupt. Indeed, much of what Levitt has complained about falls well short of outright fraud.

And in many cases, such as that of W.R. Grace, the issue is interpretation rather than concealment, said Edmund L. Jenkins, new chairman of the Financial Accounting Standards Board, a private rule-making body of the accounting profession.

"The fact is, the information is there to be discovered," he said of U.S. corporate accounting. "With financial reporting in much of the rest of the world, you don't even get a shot at it."

Still, Levitt worries that the cumulative effect of accounting controversies is an erosion of trust.

"Today, American markets enjoy the confidence of the world," Levitt said in September in a speech kicking off the SEC's campaign. "How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?"

The stock market's lofty heights are both cause and effect in the number-twisting game that the SEC is targeting.

Strong earnings growth at many companies from 1994 to 1997 helped push stocks dramatically higher--which in turn leaves managers, typically loaded with stock options, now fearful of a share price plunge if they fail to meet Wall Street's profit expectations.

"The pressure to meet analysts' expectations to the penny belies the very nature of the estimation process," Jenkins said.


The climate in which a firm's stock is eviscerated because of a barely missed profit target is itself responsible for some accounting abuses, Jenkins said in an interview at FASB's Norwalk, Conn., headquarters.

The desire to keep earnings flowing smoothly was at the heart of W.R. Grace's alleged infractions, according to the SEC. In its lawsuit, filed in December, the agency charged Grace with improper use of financial reserves and abuse of the doctrine of "materiality"--both sore spots with Levitt.

The SEC charged that the firm understated earnings in 1991 and '92, diverting up to $20 million into a reserve account to be used to boost profits in leaner years.

When the process was reversed and reserves were added into earnings in 1995, Grace failed to spell out what it was doing, the SEC alleges. Investors might easily have assumed that all of 1995 earnings growth stemmed from Grace's basic businesses.


Grace, which is contesting the SEC's charges, previously explained to the agency that the effect on earnings was too small to be "material."

Abraham Briloff, retired accounting professor at Baruch College of the City University of New York, faults analysts for spending so much energy trying to predict quarterly earnings to the penny, inciting company managements to jump through hoops to make the numbers.

Corporate accounting is not an exact science, Briloff said, adding, "It involves judgment calls with respect to an enterprise that doesn't exist for quarterly earnings."

Analysts "ought to stop riding herd on the quarterly numbers" and focus on their real job, which is evaluating the total business enterprise in order to help investors make informed decisions, he argues.

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