No more, says the clinical accounting professor in USC’s Leventhal School of Accounting. His new book, Business Fairy Tales: Grim Realities of Fictitious Financial Reporting, looks at the top 20 methods companies used to manipulate their financial reports. Jackson analyzes the fraudulent accounting and other practices that led to meltdowns at Enron, WorldCom, Sunbeam, Adelphia and other formerly high-flying companies.

You don’t have to be an accountant or a lawyer to figure out how unethical some of the schemes were, although a JD or CPA license would help. To guide wary investors with neither credential, but willing to read corporate reports, Jackson offers signals that may indicate you are approaching the castle gates of financial fiction. 

›› Beware top executives with suspicious track records, particularly when their former employers reported swift earnings turnarounds that suddenly evaporated. A prime example is Albert J. Dunlap, known as “Chainsaw Al” for the drastic cuts he made at the companies he helmed. As CEO of Scott Paper, he slashed jobs and plants and made a great show of turning the company around. Dunlap made a fortune when Scott Paper was sold to Kimberley Clark. The new owners, however, soon discovered that Scott Paper was a mess; Scott Paper lost money after Dunlap left. Amazingly enough, no one seemed to make the connection. A year later, Dunlap became CEO of Sunbeam. The company experienced a miraculous turnaround, but declared bankruptcy a few years later.

Jackson advises potential investors to be wary of dramatic “turnarounds” and to do some research on the quality of a company’s leadership, because this could be a sign of potential problems.

›› A cautious investor must read not only a company’s income statement but also its cash flow statement. (The income statement records revenue and expenses for a particular time period even if the cash isn’t actually received or spent yet, only promised. The cash flow statement contains cash actually received and spent during the period.) Since analysts pay attention to the income statements, a company seeking to look good can inflate its operating revenue, as Sunbeam did. In 1997, it reported operating income of $132 million.

“However, looking at the statement of cash flows,” Jackson writes, “we see that Sunbeam’s cash flow from operations” – what it spent operating its business – “was negative. This signal is a huge red flag. If Sunbeam was operating at such a great profit, why would it be burning through operating cash?”

The amount of cash generated should not be significantly less than the operating income “without a very specific explanation,” he adds. Sunbeam could not provide such an explanation because much of the operating revenue was not legitimate.

›› Sometimes a large company sets up organizations or partnerships called “special purpose entities” (SPEs) and does legitimate business with these entities. On the other hand, it may use these entities to hide enormous cash losses or generate false profits –  or do both.

The most notable example is the fraud at Enron, a company that started out operating gas pipelines and then tried many other money-losing ventures. To hide its failed business ventures, Enron would create special purpose entities and “sell” the unprofitable projects to the SPEs at a profit. In effect, Enron sold its own failures to itself – at high prices. In this way, Enron was able to hide its losses and create false profits.  When SPEs are used to generate a significant portion of a company’s profit, Jackson warns, the potential investor must examine these partnerships very closely and look carefully at the footnotes in the financial statements – which often cryptically refer to these SPEs.

Enron’s footnotes revealed it was selling many of its assets to SPEs, but no one examined these SPEs very closely. Be especially wary if the SPEs have too close a relationship with the main company. In the case of Enron, CFO Andrew Fastow controlled many of the SPEs. This was a clear conflict of interest; however, investors didn’t seem to care who controlled these SPEs, they only seemed to care about Enron’s rising stock price. Enron, once the biggest energy-trading company in the world, was worth over $68 billion before it went bankrupt in December 2001.

FOR HAPPY ENDINGS, Jackson believes not only government and companies must help restore the corporate environment to health.

Private individuals also must be involved.

“Anyone who relies on a company for employment, retirement or investment,” he says,  “should be actively engaged in scrutinizing not only the quality of the company’s management but its financial statements as well.”

– Kay Mills

Source: Business Fairy Tales: Grim Realities of Fictitious Financial Reporting, by Cecil W. Jackson (Thomson/South-Western, 2006).