Few pieces of news can be as dangerous for a company as revelations about accounting irregularities – striking as these do to the very heart of a company’s strategy and business rationale. If allegations stick, the entire foundations on which a company’s strategy are founded could crumble, leaving a competitor to pick up the pieces and rebuild.
Recent examples of such events abound and many remain unresolved. Safety-Kleen, Mattel (and its 1999 acquisition, The Learning Company), Calpine Corp, EA Engineering, Asche Transportation Services – these are just a few of the many where alleged or actual problems threaten the health of the corporate body. All too often when the stigma of poor or fraudulent accounting activity is associated with such companies the share price never fully recovers, despite all efforts to find a cure.
But investor relations practitioners can take heart that there are also examples of tragedy being turned into triumph – companies that rebound thanks to an effective, sharply focused long-term strategy of revival. On other occasions lady luck just happens to smile favorably on a company.
Cendant’s saga
Cendant, the marketing and franchising company formed from the merger of HFC Inc and CUC International in 1997, hit major problems in April 1998 when it found accounting irregularities at the former CUC operation. Independent lawyers then called in accountants Arthur Andersen to conduct a forensic audit. Three months later it was concluded that revenues and earnings of the company would have to be restated for three years. The revenue and expenses data in question were later described by company chief executive John Silverman as not simply a case of stretching the facts, but ‘pure fiction’.
On the day of the announcement, shares plummeted 46 percent from around $35 to $19. It was a ‘near-death’ experience for the company, according to Silverman. But the key to survival was: ‘Tell the truth, tell it all and tell it now’. The aim was to communicate quickly and fully, taking immediate action to alleviate the problems and remove any lingering uncertainties.
After his speech at the Niri annual conference in June 1999, Silverman was asked directly how he went about getting to the bottom of the problem so quickly. His response was frank and to the point: ‘We didn’t get to the bottom of it so quickly. We communicated what we originally knew, which was that we thought earnings would have to be restated by 13 percent for 1997. It turned out to be about 30 percent. But our view was that we had to communicate something. At least I could go to the banks and say, We don’t know how bad it is, but we think it’s $180 mn pre-tax out of $2 bn pre-tax, so it’s not the end of the world. On that basis our banks continued funding us.’
Their proactive approach went as far as posting Arthur Andersen’s 700-page report on the Cendant web site as well as filing it with the Securities and Exchange Commission. The world should have known what was happening. And it did.
Hammering it home
Cendant’s investor relations manager, Sam Levenson, adds: ‘The key in this situation is to gather the facts from the people who are involved in the situation, then communicate the facts to your audience as quickly and concisely as you possibly can. You’ve got to repeat it as many times as you have to until people understand it.’
Things are now getting back to normal at Cendant. In December 1999 the company announced the preliminary settlement of a class action securities lawsuit. This June, a court will rule whether this cash settlement offer has been accepted.
Cendant’s experience has caused a major shift in its strategic focus. Levenson explains: ‘This company really changed its modus operandi as a result of this problem. It went from a company that was selling stock and buying companies to one that was selling businesses and buying stock. Any two companies that merge will go through an inventory of their businesses and look at how best to structure the company going forward. That would normally include the disposal of certain businesses. In our situation it certainly accelerated that process.’
Some shareholders have stuck with the company through thick and thin, and some who left have since come back, but others left never to return. ‘There are also some significant institutions that have taken very large positions since the announcement of the accounting irregularities because they saw it as a real buying opportunity,’ adds Levenson. ‘A lot of smart and reputable investors have come in since then and are still with us.’
The scars still show however. The stock price now fluctuates around the high teens and low 20s. This may be because of the current market conditions, but it could perhaps also be because – for some fund managers – residual doubts still linger over the company’s ability to manage its affairs.
Case by case
The head of research at stockbrokers Charles Stanley, Omar Sheikh, explains that the degree to which analysts assess the seriousness of accounting irregularities varies very much from case to case. ‘Essentially we want to know whether the problem is widespread, or does it affect a particular division somewhere? What exactly happened? Was it a management accounting failure, an information gathering problem or was it an information reporting problem?’
‘If it’s a reporting problem,’ Sheikh continues, ‘it may be that management did not know at the group level what was going on at divisional level. Or was it that the divisional level didn’t actually know what was going on in the actual business?’
Any accounting irregularity is a serious problem, he says, but the essential question is how long the problem will last. ‘It’s quite possible that despite a big share price fall in the short term, it does not make a great deal of difference in the long run because it was a local data-gathering problem in a particular division and it doesn’t have a great deal of an effect on the entire group. And often when a company is purchased, management relies on a process of due diligence – the accountants checking that the target has all its books in order. Investors usually tend to give management the benefit of the doubt on these occasions.’
Richard O’Connor, head of UK research at Clerical Medical Investment Group, agrees that each case should be assessed individually. ‘Just because the earnings are restated due to an accounting change, for example, we wouldn’t necessarily take that into account. But if a company is trying to deliberately flatter accounts it would definitely get a black mark against it and would make it even less trustworthy in our eyes.’
However, when a company states that it is investigating accounts in a particular division, O’Connor’s reaction is ‘don’t touch it with a barge pole’ unless he holds the stock already. If an institution has a significant position there’s usually not much it can do because liquidity dries up and there are no buyers, with the prognosis for a speedy restoration of earlier price levels looking dim. Sometimes the only fund management solution is to look for an exit at a lower price.
Far-flung fault
Balance sheet problems often arise when a recently purchased subsidiary has unforeseen accounting irregularities. And sometimes the problem is that it is difficult to ensure due diligence is conducted with the same rigor all around the world. US standards are usually fine, but for purchases like the Standard Chartered-Bank Bali deal, it’s much less easy to check that due diligence has picked up on all the relevant factors, says O’Connor. The culpability of a company’s auditors also has to be factored into the equation.
‘There is an informal league table of auditors,’ O’Connor explains. ‘Where there’s an audit company we have never heard of – say a local firm auditing a big company – then that would cause problems. It would definitely be something we would look at.’
One of the top five accountancy practices – Arthur Andersen – would no doubt consider themselves to be at or near the very top of any such league table. Robert Hodgkinson, a partner in Arthur Andersen’s professional standards group, says that a lot of the problem with accounting irregularities comes after an acquisition when the ‘disconnect’ between what the numbers say and reality comes to light. This is when the superstructure of information systems and the people controlling them change.
To spot such irregularities, Hodgkinson suggests ‘a fraud triangle’ that has to be considered by the acquiring company to minimize the chance of such damaging problems affecting the health of the corporate body. At the three points of this triangle are motive, integrity and opportunity.
He explains: ‘In terms of motives, there will always be pressure on people who are selling to make the figures attractive. You should be very wary about continuing if you have doubts about the target or selling management’s integrity. And when things like poor underlying operational information systems make it hard to get real explanations about what’s happening in the real world, then you have the opportunity for something irregular to occur.’
‘The key point,’ the Arthur Andersen accountant adds, ‘is that it is very easy to start with the numbers and rationalize back, ending up believing a story that would be consistent with the numbers. What you need to do is start from the beginning and say, Do I know what’s happening in the real business? Does that accord with the numbers coming out at the other end?’
Recovery mode
Clearly some things did not accord properly at the other end for Telxon, which makes wireless networks. Its accounts restatement goes back as far as December 1998 and the company is still in recovery mode. The company’s vice president of investor relations and PR, Alex Csiszar, says problems arose because the company had shipped inventory off to several new distributors and booked the revenue immediately rather than when the distributor shipped to the end user.
‘It really became a timing issue,’ Csiszar explains, ‘because if we pulled back the revenue, it then just took a few more quarters to work itself through the channel and then be recognized. Once investors understood and put it in perspective, that helped. The other thing that helped is being able to organize the facts and articulate the materiality.’
The company ‘addressed the matter proactively,’ quickly announcing it would restate two quarters of financials. A press release issued that morning was swiftly followed by a conference call with the analyst community. ‘We were just coming off of a period when we were involved with a hostile takeover bid, and it helped to still have outside advisors with public relations and investor relations experience to help out the team,’ he says.
But it took some time for the stock to rebound, with the board looking deeper into other transactions – a review that ran on to February 1999. In the end a dozen or so quarters were studied, not necessarily for revenue recognition problems, Csiszar stresses, but because of certain acquisitions that had to be revalued.
All these events culminated in both the chief executive and the chief financial officer leaving in March 1999 . The arrival of a new management team definitely had an effect on stock valuation. ‘I saw a rebound in the stock after it had been to a low of around $6, but it made its way back up to the teens after the new management was announced,’ the IRO explains.
The change in management represented a fundamental shift in the perception of Telxon. The new CEO, John Paxton, had spent some time in the same industry during the late 1980s and had turned other companies around. He had a pedigree which the market responded to. Csiszar recalls: ‘He changed the culture of the company. We had always been a sales driven company going after the big opportunity, but we ended up creating a product that had too many features and was too cost inhibitive. Now we are a market driven company and conduct thorough research to match product development against market needs.’
Enter lady luck
The Telxon share price is now back in the mid-teens, but such a roller-coaster ride is not always the outcome of such events. Sometimes an element of luck can also play its part. This was the case at Crown Inc, a company with its fingers in many different pies including car sales, finance, manufacturing and casinos. Last July it was announced that account irregularities were being investigated at Crown’s subsidiary, the Paaco Automotive Group.
VP of corporate development Harlan Foster says Crown had just acquired Paaco and had not uncovered the accounting irregularities at the time of the purchase. After a subsequent audit some problems arose. ‘Ultimately it didn’t hurt Crown very much and the effect on our share price was minimal. There was a period of suspended trading by Nasdaq for three days which has actually been beneficial because there tends to be such over reaction when you see news about earnings restatements or accounting irregularities.’
Trading was suspended in time for Crown to put out a release and fully explain the issues. While the company lost some value in its stock because it had clearly overpaid for Paaco, these losses were recouped. ‘Paaco has actually performed very well, so we didn’t have to downwardly revise our projections. I think we were very lucky that it didn’t significantly affect our share price,’ says Foster.
Again, the key principle applied on the investor relations front was ‘tell the truth about everything,’ Foster concludes. Clearly, at times when the situation looks terminal, top-level communication which is on time, to the point and unequivocal is as beneficial to the patient as any surgeon’s scalpel can ever be.
