As I See It: Manipulating Money

by Victor Rozek

"The first known accountants," reports Tim Reason, writing in CFO Magazine, "were pairs of scribes who independently recorded daily transactions for the pharaohs of ancient Egypt. If their numbers didn't match at the end of the day...both were put to death." Now, the more compassionate and fair-minded readers will no doubt feign outrage. But, exacting as it may seem, it was a system that provided both incentive for ethical behavior and control when it was lacking. Both of which have been compromised today. Rumor has it that a good many Enron stockholders would like to see the system reinstated.

These days, we eschew death in favor of damages. No small matter. Arthur Andersen is offering three quarters of a billion dollars to the employees, stockholders, and creditors of Enron if they will only forgive and forget. But that may not even cover the lawyers' fees. And that's on top of the $110 million Andersen paid Sunbeam's jilted investors, and the quarter billion it will be paying to angry Baptists. The nonprofit Phoenix Baptist Foundation was also an Andersen client, which, like Enron, unexpectedly filed for bankruptcy. When the smoke cleared, it was discovered that the operation was little more than a Ponzi scheme. Furious investors, many of whom lost their life savings, wondered how an accounting firm could have missed that ruinous fact. Suspecting incompetence or collusion, they sued.

But collusion, as we have seen, is built directly into the system. Accounting firms lobbied furiously and successfully to rid themselves of bothersome restrictions that prescribed limits on their activities. While crunching numbers offered a generous flow of revenue, it could not compare to drinking deeply from the inexhaustible well of consulting.

Double-dipping put accounting firms in the position of inventing the same semi-legal, quasi-ethical schemes that they would later be asked to audit. Such inventions as off-balance-sheet partnerships may be legal, but their intention is clearly to deceive. Accounting firms had put themselves in an impossible position: They could not simultaneously hide loses and report them.

But collusion takes two, and the other culprits in this financial slight-of-hand are CFOs. Traditionally, the CFO's job was to impose financial discipline. But as investors began to demand double-digit returns, everyone searched for ways to bolster the balance sheet. If money could not be earned, it could certainly be manipulated. Financial gimmicks bloomed like algae. Junk bonds, hedge funds, derivatives, convertible bonds, off-shore leasing, deferred compensation, stock buy-backs, pension fund exploitation, off-balance- sheet partnerships, and creative accounting adjustments--all designed, some at great risk, to either enhance the bottom line or hide the losses.

Although Enron's accounting practices were disastrous, they were by no means unique. Global Crossing lost nearly $50 billion in market capital while its chairman cashed out to the avaricious tune of $734 million just before the company filed Chapter 11. Tyco, Cisco Systems, AT&T, and GE have also recently come under fire for questionable accounting practices. One financial reporter who tried to untangle GE's finances called its reporting "accounting in Wonderland."

Money manipulation was the primary reason that IBM was able to grow its earnings five times faster than revenues. To grow earnings per share, you can do one of two things: either generate more revenue or buy back your own shares to take them out of circulation. From 1995 through 2001, IBM spent a bank-breaking $44 billion buying back its own stock. "To put that in perspective," our own Timothy Prickett Morgan says, "that's almost as much money as IBM has generated selling AS/400s since 1988. They could have given away the systems and still had money left over."

IBM's other favorite profit enhancer is counting pension fund investment income. While well-managed pension funds are laudable and the income derived from them looks good on the books, they have nothing to do with shareholders. Pensioners, not investors, profit from the fund, so critics argue the income should not be used to inflate a company's stock value.

Creative accounting is not new, but the difficult lessons it teaches are quickly forgotten. A decade ago, Andersen gave its seal of approval to Charles Keating's infamous Lincoln Savings and Loan, which bilked the elderly of their life savings. Only the scale has changed and now threatens to disrupt the nation's entire economy.

Simmering--if not outright cooking--the books is so pervasive that at least one study concluded the Dow Jones Industrial Average was overvalued by 2,500 to 5,000 points. Financial reporter Dave Lindroff writes: "The London think tank reports that after comparing the earnings reports of companies listed in the New York Stock Exchange with statistics from the U.S. Commerce Department's Bureau of Economic Analysis (in which some of the more commonly used accounting 'adjustments' are pared away), it appears that U.S. corporate profits in 2001 were overstated by 27 percent, or about $130 billion."

All of this soft fraud has resurrected the dormant art of forensic accounting. It is described by Tim Reason as being "a mix of accounting, law, technology, ethics, and criminology." But although all of the big firms employ a stable of fraud examiners, they are apparently woefully out of practice. Reason reports that PricewaterhouseCooper's audit division "is under investigation for possible negligence in failing to detect fraud at MicroStrategy and Allegheny Health Education and Research Foundation. PwC, incidentally, is the same accounting firm that signed off on $679 million in inflated earnings at Lucent. Richard McGinn, the company's CEO departed, as is the fashion in such cases, with an $11.3 million severance package before the company tanked. Old habits die hard.

The fact that the need for fraud examiners is so great suggests that the problem is structural and systemic. The accounting industry and its regulatory agencies have become inbred. Executives move freely between accounting firms, clients, government, and the regulatory agencies assigned to safeguard the public interest. The public, of course, is not represented. The foxes have taken over the hen house.

Nowhere is that more apparent than at the top where political contributions have created a quid-pro-quo understanding that drives deregulation even when it's clearly contrary to the public interest.

The Securities and Exchange Commission has as its primary mission "to protect investors and maintain the integrity of the securities markets." Two years ago, former SEC Chairman Arthur Levitt saw the writing on the wall and proposed legislation that would have forced accounting firms to chose between providing auditing or consulting. The proposal was squashed by fierce congressional opposition. No one, I suspect, will be shocked to discover that the most outspoken opponents were also the most highly compensated: Senator Charles Schumer received $329,631 from the accounting industry (1995-2000), Senator Phil Gramm (whose wife sat on the Enron board and dumped her stock before the crash) pocketed a tidy $200,950 (1995-2000). Billy Tauzin, a congressman of lesser influence, settled for $143,424. These payouts do not include the revised estimate of $2.5 million that Enron now admits it also spent in the first six months of last year to ensure its candidates would be appointed to the SEC, the Energy Regulatory Commission, and the Commodity Futures Trading Commission. Who received the money is not yet clear.

But simply having somebody in the SEC who might actually be watching the foxes was not acceptable. Enron's Ken Lay went to his friends in the administration and had Levitt removed. In his place Lay installed Harvey Pitt, a man who never met a form of deregulation he didn't like. Not coincidentally, Pitt is an attorney whose firm has represented Arthur Andersen and the other Big Five accounting firms. It also defended such ethical giants as Ivan Boesky, who was forced to pay $100 million in another fraud settlement. Thus Pitt profited both from championing deregulation and defending those who abuse it. The net result is William Greider's assessment that "corrupt accountants and investment bankers now have a friendlier commissioner at the SEC."

Oh what a tangled web.

The system of checks and balances has clearly been corrupted, and the dilemma for reformers is the same, whether addressing the practices of mega accounting firms, desperate CFOs, purchasable politicians, or rubber-stamp regulatory agencies. Upton Sinclair, who wrote extensively on corruption in his own time, framed the challenge this way: "It is difficult to get a man to understand something when his salary depends on him not understanding it."

In the meantime, we can enjoy the spectacle of all the major players doing their qubit imitations, spinning in both directions at once, assuring us of their innocence while pocketing the cash.