The Big Lie: Reality Check for Dealmakers

In his excellent book, Kreuger, Genius and Swindler, author and journalist Robert Shaplen limns the literary abilities of infamous “match king” Ivar Kreuger. Far from an irrelevant indulgence, Shaplen reports, Kreuger’s writing talents helped camouflage the intricate manipulations and shaky finances at his worldwide match-making empire, which eventually crashed early in the Great Depression. Kreuger personally prepared the group’s annual reports, always offering a glowing picture that rarely squared with the grim facts or the real figures. As Shaplen puts it, Kreuger maintained that investors, bondholders, lenders, and governments wanted not the truth but a feel-good story that they could bet on, an attitude that he shared with many other high-flying tycoons and financial wizards of the 1920s. Sound familiar? It’s been 70 years since Kreuger apparently killed himself (there’s a school that says he pulled off the ultimate con by faking his own death) as the match empire disintegrated. Since then, American and foreign governments have erected pervasive investor protection networks based on full and accurate disclosure, fraud-detection technology has consistently advanced, and armies of highly skilled financial sleuths have honed their crook-catching craft to a fine art. Yet, Kreuger acolytes have continued to maneuver with frightening regularity in boardrooms and management suites across the world. And, as the latest outburst of corporate scandals demonstrates, putting the best public face on dismal performance and jerking the numbers to inflate basically reasonable results are still primary devices for concocting the best possible story. In the deals world, lying, shading the truth, and cooking the books are inescapable realities that have resisted all legal and regulatory efforts to eradicate them, say advisers with wide experience in the m&a market. But the latest disclosures ratchet up the investigatory stakes for both acquirers and sellers, they add. Even the canniest dealmakers have been taken before and risk being bilked again if they don’t know precisely whom they are negotiating with or what’s on sale. Beyond the proverbial caveat to do intensive homework before closing a deal, the pros offer no magic bullet for burrowing to the truth. But they expect both buyers and sellers to spend a lot more time in areas that were seldom visited in the past, starting with more intensive investigation of the people at the other side of the table – even before the numbers are checked out. Unlike Pinocchio, the negotiator’s nose doesn’t grow as the lies get bigger. And actually fingering a miscreant who may be involved in anything from shaking down vendors to fabricating assets can require a lot more work than examining the public record for criminal or suspicious behavior. “In any fraud investigation, we recommend that the client not only do the forensic accounting work but also do a background investigation, because our team can identify prior criminal problems or companies that a person has been affiliated with, including those that appear on a company’s vendor list,” says Wendy Schmidt, a partner at Deloitte & Touche and part of the firm’s Forensic & Investigative Services Group. “You would never be able to tie the two together unless you had information linking these people to the vendor, for example. It’s important to do both kinds of investigative work to find evidence, for example, that a person is living beyond his or her means. This often provides you with circumstantial evidence of fraud,” she adds. A higher state of alert triggered by the scandals also is expected to result in: * More intensive examination of a company’s corporate governance mechanisms; * Increased testing of the effectiveness of internal financial controls; * Tougher questioning of audited financial statements as presented; * Demands for greater documentation of balance sheet and profit-and-loss numbers, especially where accounting rules permit wide discretion on treating and classifying them; * More sparring on financial entries that traditionally received modest consideration; * Heavily detailed presentations by seller companies – supported and documented by extensive backup information – at the very outset of the deal process; * More fairness opinions by independent third parties not related to the deal; and * A longer period of time to complete a deal. For popular consumption, the 2001-2002 round of corporate scandals falls beneath the rubric of accounting irregularities. But they come packaged in a variety of flavors and guises, ranging from outright fraud to suspect but within-bounds doctoring of numbers. Enron Corp., the biggest disaster of all, collapsed under the weight of off-the-books fundraising partnerships, exacerbated by highly aggressive accounting for its energy trading and other operations. Telecom giant WorldCom Inc. belatedly reported that nearly $4 billion in expenses were inappropriately classified as capital expenditures. Diversified Tyco International Ltd. has been pilloried for not coming clean on how it accounted for its myriad acquisitions, while managers and directors also have been accused of self-dealing. Adelphia Communications Corp., the big cable TV operator, stands accused of self-dealing and possible exaggeration of its subscriber base. Revenue recognition controversies have staggered a host of companies, including Xerox Corp., Halliburton Co., and the Medco Health Solutions Inc. unit of Merck & Co. as it was about to be taken public. Former Rite Aid Corp. executives are charged with using a variety of gimmicks to inflate earnings. On the surface, the diversity of the corporate rogue’s gallery seemingly gives acquirers and sellers interested in protecting themselves a lot to worry about. In reality, they probably won’t be confronted much by the more complex schemes. But the genuine teeth rattlers, the pros says, are the more basic machinations, like WorldCom’s treatment of expenses and the ever controversial matter of recording revenues as well as some other entries where accounting treatment can vary without breaking any rules. The best medicine, according to the advisers, is the two-pronged inquiry enunciated by Schmidt that checks out the people and numbers and interconnects them. “The very first thing to probe at a target is the control structure, the senior management, the board of directors, and how they interact,” says veteran forensic accountant Howard Schilit. “Is there a culture in that organization to always play by the rules?” The second thing to check, he says, is the accounting policies and whether the company has been consistent in “using the same assumptions over time.” “When a company where things are not going well starts to change some of its accounting assumptions, that’s a dishonest company,” Schilit asserts. In the sequence outlined by Schilit, president of the Rockville, Md.-based Center for Financial Research & Analysis, he will focus initially on senior executives, their relationships, and “checks and balances,” including whether the internal audit is working and how the board and audit committee function. “We are really trying to determine whether the company has been operating with loosey-goosey controls where anything could happen or whether there has been a dictatorial CEO who no one has been strong enough or independent enough to question,” he says. “Almost every one of the accounting stories we’ve read about in the past year has involved a company that had a horrendous control environment,” he notes. Many of the manipulations spotlighted by the recent scandals are old wine in new bottles, according to the advisers. Robert Filek, a transaction services partner at PricewaterhouseCoopers and an accountant, says he and his peers rarely have taken audited financials at face value. “You have to get behind the audited financials,” he says. “That fundamental fact hasn’t changed. The audited financial statements are not sufficient for the purpose of the dealmaker. The valuation issues, what you are going to do with the company, and what your value drivers are have nothing to do with the purpose of an audit. We’ve been saying for years – and it’s dealmaking 101 – that you can’t rely on financial statements.” A key problem is that the value of an acquisition is driven by the buyer’s strategy and its operational plan for recapturing the investment. Those goals, Filek notes, are beyond the auditor’s scope. “Fundamentally, a good dealmaker knows that audited financials aren’t enough,” he says. “If anything, now that you’ve got some high-profile cases, you would think anyone who says audited financials are enough would look kind of goofy.” Agreement comes from Edward Rial, a principal in the Forensic & Investigative Services Group at Deloitte & Touche. “In business, it is always dangerous to accept at face value any financial information that is presented to you,” he says. “The recent accounting scandals raise the bar with regard to the level of due diligence that needs to be done in deals today.” Rial notes that the bulk of acquisitions aren’t “at the level” of the big, well-known companies involved in the controversies so dealmakers will have to look at each deal on its own and weigh the particular risk factors that might exist. Lawrence Ross, president of Washington-based Ross Financial Services Inc. and a former tax lawyer, says that accountants are responsible for seeing that rules are complied with but deeper investigation may be needed to check the veracity of the figures. “Firms need someone with an investigative background to determine whether the facts are as presented,” he says. “You have to be willing to question every item, and you can’t be intimidated. If you don’t understand the answer to your question, you have to continue to ask the question until you understand the answer.” However, even battle-hardened veterans think the chutzpah displayed recently in the more envelope-pushing machinations, as well as so-called “no-brainers” like classifying revenues and costs, are signs of the times. “The world is changing in that business relationships no longer consist of old boys’ networks in which people knew who they were dealing with,” Schmidt says. “Globalization has changed that. People are now working and doing deals with other people that they don’t know well. They are seeking assistance from us to help them get a better comfort level with those people.” Schilit says that accounting tricks are not new but that opportunities for capitalizing on chicanery have increased. Tricksters are lured by everything from having management compensation based on corporate performance to the reality that they could get away with fudging for a long time, especially during the late ’90s economic and stock market boom. “There were incentives to use accounting trickery because there was little prospect that you would get caught, and even if you did, the fine or penalty was disproportionate to the crime,” he states. Much like WorldCom’s recent practice, the old America Online, Schilit says, put hundreds of millions in marketing expenses on the balance sheet in the mid-1990s, which boosted earnings and inflated its stock price, which helped it to “make acquisition after acquisition.” “When the SEC finally got around to looking at AOL’s accounting practices, the company was fined only $3.5 million,” Schilit notes. “The upside of manipulating the accounting was so enormous and the downside was so miniscule,” Schilit comments in describing the climate of a few years ago. Given the exposure of the expense and revenue recognition controversies, the pros expect buyers and sellers to zero in on these areas with greater gusto, at least for openers. The WorldCom technique, which touched off a civil fraud complaint by the Securities and Exchange Commission (SEC), involved booking some $3.8 billion in apparent marketing expenses as capital expenditures, thereby avoiding an immediate hit to cash flow and the bottom line by spreading the impact over a period of years. The revelation stunned proponents of conventional wisdom who long ago concluded that while earnings could be manipulated, a company couldn’t monkey with cash flow. Until WorldCom’s disclosure, acquirers usually did not go deeply into classification of expenses, but that’s due for a change, says Robert Willens, a managing director and tax expert at Lehman Brothers. “The issue wasn’t raised that much before,” he says. “Now, I expect it to be raised much more frequently.” Although there are different ways of classifying expenses under the rules, Willens says, some are clearly ordinary expenses and some are capital expenditures that finance long-term additions to the company. “This one (WorldCom’s) is about as clear-cut as you can get.” Other expenses that likely will be debated as to how they should be classified, Willens says, include customer acquisition costs, maintenance costs, interest costs for construction, and restructuring costs. Revenue recognition, another area where accounting rules provide great discretion, may be even more squiggly, even though it is constantly being addressed by the Financial Accounting Standards Board (FASB) and the SEC. While cognizant of the wide latitude, many advisers still scratch their heads over revenue-booking practices that got spotlighted companies in hot water – Xerox’s accounting for leases, Halliburton’s inclusion of construction contract overruns, and Medco’s recording of revenues it would never bring in and offsetting expenses it never would pay out. Filek expects tugs-of-war in those and other areas, such as absorption of overhead in manufacturing operations, accrual policies, and working capital levels. He says he and his teammates constantly look at the way these and other matters impact the purity of earnings, and in fact keep an inventory of them to apply during the investigation and analysis process. “There are probably 18 or 20 adjustments in the quality of earnings schedule on any given day,” he states. And Schilit warns buyers to watch for the old trick of fiddling with in-process research and development costs. One stunt to beware of is moving future expenses into an earlier fiscal period so they are written off long before that future period arrives. That may depress current earnings but inflate results – at a time when the company may be on the block. Rial says that evaluation of earnings quality should include a weather eye for all kinds of manipulations. One source of discomfort is telescoping future sales into the current quarter. “If you see a large amount of sales at the end of that quarter, that would be a red flag to investigate further,” he says. “Although that may not be improper, it would give me a reason to investigate further to make sure that those sales are real.” Ross says a good investigator, among other things, probes the relationship between various numbers to see if there is any disharmony. “If you see that the accounts receivable are rising and the sales are falling, you really have to dig in and see why that’s happening,” he says. A target’s growth strategy can be critical to the success or failure of a deal, Schilit says. The issue is whether the growth is generated internally from good products, large market share, solid margins, and strong pricing – “an attractive company to buy” – or has mushroomed mainly through acquisitions – “a nightmare for an acquirer.” “A company in the short run could make it appear that it is growing by adding company A, company B, etc. But if it’s buying crummy companies where sales are not growing and margins are weak, that would be trouble for a buyer,” he asserts. Private and family-controlled companies will get an especially intense going over, advisers maintain, because of the potential for self-enrichment of owners and managers, an issue at several of the prominent scandal-ridden companies. “There is a level of control that enables family members to bypass controls,” Rial says. The question of avoiding arm’s-length dealing also should prompt inquiry into whether a company has “a lot of related-party transactions.” “If companies that are owned by the owners or principals of one company are dealing with that other company, that is clearly something that requires a lot of investigation,” Rial says. “A lot of the sales’ generated by those parties may or may not be actual sales.” Considerable pressure now is falling on sellers to help get a deal done in timely fashion. That requires going beyond a cursory offering circular and providing whatever information is needed to document numbers and other information, Filek states. “Sellers have to do a better job of getting themselves ready to sell,” he remarks. “One of the things we’re doing a lot now is helping sellers get their numbers in order to sell the company. If the sellers don’t do their homework in today’s environment, you will have a longer process that isn’t good for anybody. The documentation has to be ready to go. It’s nave in today’s environment to think that somebody is going to gloss over the offering memorandum and do no more due diligence than that.” While their clients seem to be gung-ho about getting to the bottom of everything now that the scandals are at their hottest, many deal advisers worry that the desire for truth may cool when dealmaking heats up and there is a rush to buy and sell. Ross says he is shocked after all his years as an investigator at how many potential clients are willing to shell out huge sums without really knowing what they are buying. “If you are satisfied to bet millions of dollars on flipping a coin, than don’t do any investigative due diligence,” he says. Filek says sloppy deals, the type that often turn into failed acquisitions, occur when managements are so eager to seal “so-called strategic acquisitions” that they let good investigative work fall through the cracks. That, he says, creates an “expectation gap,” i.e., the target didn’t live up to what was expected. “There are two sides to that coin,” Filek comments. “The target didn’t do what we thought it would do. But the first side of the coin is that what we thought wasn’t reality. That says that the expectations were wrong. Every deal that fails has a set of expectations that didn’t work out.”