In this assignment, you will begin the first component of the analysis section of your final project by examining the factors that gave rise to the violation(s) in the Wealth Management at UBS case study and their consequences, both for the case company and for the broader community. You should address the following critical elements in your Milestone Two Analysis of Laws and Controls paper:
- What specific laws, regulations, and/or ethical principles were violated? Were the violations statutory (criminal or civil), violations of industry guidelines, or both? Be sure to cite the relevant rules and regulations.
- What type of internal and external controls did the company have in place prior to the crisis? Be sure to analyze how these controls did or did not work to balance the tensions between maximizing profit and upholding legal and ethical responsibilities, giving examples from the case study.
- Were these controls compliant with current regulations for mitigating fraud or other unethical behaviors? Why or why not? Be sure to cite the relevant regulations in your response, including any differences between U.S. and international reporting requirements.
- Why were external regulations insufficient to ensure legal and ethical behavior in this case? Justify your response. For example, do some regulations carry more weight than others? How do companies guard against activities that are not illegal but are still unethical? What role does responsible self-policing play in fostering financial ethics?
This paper should be 2–3 pages, double-spaced, in 12-point Times New Roman font, not including the cover page and reference page. APA format is to be used for the reference list and all internal citations.
Special notes from the professor regarding this short paper;
In this activity, you have an opportunity to practice writing an executive summary similar to the one you must create for your final project. The executive summary is typically written after the case analysis and recommendations have been completed. This assignment introduces you to some of the questions you should ask during your analysis of the “Wealth Management Crisis at UBS” case study in the next module. The purpose of the executive summary is to highlight the principal findings and recommendations for the executive team, specifically:
What laws or principles were violated in this case?
Was there negligence by the company, or were the company’s polices sufficient at the time? Explain.
What were the real and perceived repercussions of these violations?
You should assume your audience is made up of the review board executives for your company, who will use your summary to prepare themselves for a case briefing. Refer to the Sizzling Saga of Sunbeam and Al Dunlap in your textbook, and develop an executive summary that:
Aligns with the needs and interests of the audience
Highlights principal findings and recommendations
Uses language appropriate for busy executives
THE SUNBEAM INFERNO On July 19, 1996, the day that Al Dunlap was appointed CEO of Sunbeam, the stock price jumped 56 percent, from $12.50 to $18.63. Wall Street was enthralled at the thought that this slash-and-burn downsizing specialist would quickly boost Sunbeam’s stock price as he had boosted previous companies’ share prices—irrespective of what had happened to those companies after the quick boost. The stock continued to rise after Dunlap said, in July, that he had begun a study for a downsizing plan that would produce a turnaround. By November 12, 1996, the stock price was up in the high $20s. That was the day that Sunbeam announced the actual details of the massive downsizing. This time, the stunning magnitude of the planned cuts in jobs, plant facilities, and products shocked Wall Street. The stock price dropped a little that day but remained in the high $20 range right into March 1997. It was during this first quarter of 1997 that Sunbeam began producing financial reports that made it look as though the slashing of facilities, products, jobs, and research and development could, in fact, grow sales and earnings. Early in 1997, Sunbeam began to release back into earnings the false reserves that it had created upon its restructuring in 1996. It also began to accelerate future periods’ sales into current periods via the wide array of tricks discussed earlier. Sunbeam did this for every quarter in 1997, with its earnings management reaching its greatest level in the fourth quarter of that year (AAER 1393, 2001). As previously mentioned, Sunbeam accompanied these misleading sales and earnings reports with unrealistic estimates of future growth and without any reference to the acceleration of future periods’ sales. Based on these illusory reports of earnings and sales growth, as well as unrealistic estimates of future performance, the stock price broke out of the high $20 range in March 1997 and began a steady, steep rocketlike climb until it peaked at about $52 in March 1998. This occurred a few days after the announcement of Sunbeam’s acquisition of three companies in one day: Coleman, First Alert, and Signature Brands. Sunbeam’s stock price had risen 400 percent since Dunlap’s appointment in July 1996. However, Sunbeam was on the verge of a blazing disintegration. By November 1998, the stock price had tumbled to about $7 (AAER 1393, 2001). The more Sunbeam accelerated future periods’ sales into current periods, the harder it became to achieve the future periods’ sales estimates. The company was caught in an ever-intensifying vicious circle. The customers weren’t paying ahead of time for sales that were recorded ahead of time, and worse still, their inventories of Sunbeam products were building up steadily. Further, Sunbeam itself was storing massive amounts of these “sold” inventories. While so many accepted the downsizing program as an explanation for that all-too-quick turnaround, for others, the downsizing made a quick growth in sales seem implausible. Some skeptics kept a careful watch for signs of overstated sales and earnings. As early as mid-June 1997, an article in Barron’s questioned the validity of the sales growth in light of the increase in both accounts receivable and inventories (Laing, 1997). However, this went unheeded by the market, which was blinded by the dazzling stock prices. William H. Steele, an analyst for Buckingham Research Group in San Francisco, downgraded Sunbeam to a neutral rating in July 1997 based on the increase in inventories and on him noticing that “changes in cash from working capital were negative” (Byrne, 2003, p. 152). On March 2, 1998, when Dunlap’s new employment contract was announced during a conference call, a Bear Stearn’s analyst, Constance Maneaty, questioned Dunlap on whether his generous new options package would be a drag on earnings in the future. During this period, a real threat to the Sunbeam trajectory had been approaching in the form of Morgan Stanley’s “due diligence” test for the debt offering that it was underwriting to raise the cash for Sunbeam’s acquisitions of Coleman, First Alert, and Signature Brands. While Dunlap was talking up Sunbeam as part of the road show to drum up support for the debt offering, Morgan Stanley’s “due diligence” team had been speaking to Sunbeam managers as well as to Arthur Andersen, the external auditors, and to Sunbeam’s biggest customers. Everything they heard indicated that Sunbeam’s sales estimates for the first quarter of 1998 were not going to be met. Morgan Stanley then approached Sunbeam’s internal counsel, David Fannin, and its external counsel, Blaine Fogg, who investigated further. On March 18, it was agreed that a press release had to be issued the next day announcing that Sunbeam might not makes its sales estimates. When released, however, the statement did not capture the severity of the problem. The company acknowledged that sales may be lower than the range of Wall Street analysts’ estimates, but it “expected sales to exceed those of the first quarter of 1997.” It also blamed the shortfall on “changes in inventory management and order patterns.” Sunbeam’s customers had so much inventory from 1997’s accelerated sales that it was catching up with them in 1998. (Quotes from AAER 1393, 2001). The announcement represented the first crack in the armor of Sunbeam’s façade as a company whose sales and earnings were growing rapidly. Sunbeam stock fell to $45.375 on the day of the announcement. In spite of this, the company still raised $750 million on the debt offering. Later, this would be to the chagrin of those debtholders. However, the questions as to the validity of Sunbeam’s real sales growth and its estimates were now exposed, and with inventory piled up in Sunbeam’s warehouses and in its customers’ warehouses, the answers to those questions would continue to impede management’s efforts to maintain the Sunbeam illusion. One day after the Sunbeam press release, on March 20, 1998, the New York Post carried an article entitled “Sunbeam’s Cloudy Outlook: Chairman Al Warns on Profits.” The article questioned whether Dunlap would be able to deliver on Sunbeam’s estimates of sales growth. More ominously, analyst Andrew Shore was reconsidering his earlier upgrade of Sunbeam’s stock. Never a fan of Al Dunlap, Shore was again hot on the trail of stories of inventory piling up. He had also heard stories of turmoil within Sunbeam. In early April, Shore received a tip-off that Sunbeam’s head of domestic sales, Donald Uzzi, had been fired. The company was desperate to keep this quiet because Uzzi had been carrying an enormous load in trying to keep Sunbeam’s sales from falling apart altogether. With the rumors of Uzzi’s departure, as well as the resignation of Richard Goudis, head of corporate planning, Shore thought he had to take the risk of downgrading Sunbeam’s stock on a “conference call that linked analysts in New York with more than 5,000 stockbrokers around the world. It had an electrifying effect. Sunbeam’s stock began to plunge, falling $4 within minutes” (Byrne, 2003, pp. 241, 242). If he was wrong, Shore’s reputation would be in shreds. A few hours later, Shore was relieved to get confirmation that his call was correct when Sunbeam’s internal counsel insisted on the release of a press statement explaining the following: Sunbeam now expected to make a loss in the first quarter of 1998. Sales would not meet the amount predicted in Sunbeam’s March release a few weeks earlier. Sales would be less than in the comparative first quarter of 1997 (AAER 1393, 2001). That same day, Sunbeam’s stock fell almost 25 percent, to $34.38. Andrew Shore was vindicated and congratulated. Sunbeam’s internal auditor, Deidra DenDanto, who had been sidelined by management with her concerns about the bill and hold sales, resigned the same day. Russell Kersh, the chief financial officer of Sunbeam who had the ultimate responsibility for the accounting misstatements, could now just watch as the fireworks of falsely stated profits exploded before his eyes. As for Dunlap, he continued to “gloss over the first quarter repercussions of [Sunbeam’s] 1997 earnings management as a surprising slowdown” (AAER 1393, 2001). Wall Street analysts began to downgrade Sunbeam’s stock and investigative journalists began to search for the telltale signs of fraud: growing accounts receivable and mounting inventory. The problem with a fictitiously recorded sale is that it remains as accounts receivable. It does not turn into cash like an honest sale. Also, the inventory of a bill and hold sale must build up somewhere—either at the seller’s or the buyer’s warehouses. Furthermore, cash flow from operations (CFFO) lags the falsely reported profits and it becomes difficult to make sales in the following periods. CFFO refers to the amount of cash generated from the company’s main operating activities. It generally refers to the increase or decrease in the actual amount of cash in a period as a result of sales or services rendered or the performance of some other operating activities and the related expenses. It is more formally referred to as cash flows from operating activities. Wall Street was finally catching on to Dunlap’s “turnarounds,” and so was the media. According to an article in Forbes magazine, “Seven months ago Al Dunlap declared victory in turning around … Sunbeam…. But since the middle of March its stock has fallen nearly 50% from $52 to a recent $28…. This turnaround hasn’t turned and it isn’t likely to.” The article went on to point out how, in December 1997, Sunbeam had “sold $60 million in accounts receivable to raise cash.” Unfortunately, however, analysts had not questioned Sunbeam’s numbers. “If they had, they might have seen that Sunbeam was coming apart.” (Quotes from Schifrin, 1998) During a meeting with financial analysts on May 11, Sunbeam announced another downsizing plan. In respect of its acquisition of Coleman, Signature Brands, and First Alert, Sunbeam planned to eliminate 6,400 jobs and close 8 of 24 plants. The New York Times, on May 12, noted that in the analysts’ meeting, “Mr. Dunlap attributed the ‘early buy’ debacle to everything from a marketing executive who approved ‘stupid deals’ with retailers to El Nino…. Whatever the reason, the dismal performance was worse than investors had anticipated” (Canedy, 1998c). Worse was coming. The final blast of the explosion for Dunlap and CFO Russell Kersh came a few weeks later in the form of an article by Jonathan Laing in Barron’s magazine. Laing believed that “the earnings from Sunbeam’s supposed breakthrough year appear to be largely manufactured.” The article speculated that much of the supposed earnings had come from releasing back into earnings the overstated reserves that had been created upon Sunbeam’s restructuring charge in 1996. Furthermore, the exposé assumed that, at the time, Sunbeam had also written down property, plant, and equipment values to reduce future depreciation expenses and observed that earnings were boosted by a drop in Sunbeam’s allowance for doubtful debts and discounts. It was also suspicious that “Sunbeam’s inventories exploded by some 40% or $93 million, during 1997.” In addition, there were “indications that Sunbeam jammed as many sales as it could into 1997 to pump both the top and bottom lines.” The article in Barron’s provided the final spark that exploded the Sunbeam façade. (Quotes from Laing, 1998b, pp. 18–19) The following Monday, Sunbeam put out a press release saying that there was no factual support for the accusation in the Barron’s article that Sunbeam had largely invented its profits. The release was rather problematic, however, because it was very general and did not answer the specific questions raised. The next day, Sunbeam held a directors’ meeting to consider the accusations against the company. The gathering included internal and external counsel, as well as Russell Kersh (CFO), Robert Gluck (controller), and Phillip Harlow (external auditor from Arthur Anderson). At the meeting, the directors found no comfort from the answers they received about the accounting numbers or about the strength of the current quarter. Further, Dunlap and Kersh indicated that if they didn’t get more support from the board of directors, they might tender their resignations. After the meeting broke up, the external directors discussed the situation and concluded that it looked like the end of the line for Dunlap—and possibly for Sunbeam as well. In the next few days, Fannin, the general counsel, met with the external counsel. They carried out further internal investigations. In his book, Chainsaw, John Byrne (2003) explained how, on Saturday, June 13, Fannin and the outside directors met secretly. They decided that they should get rid of Dunlap and Kersh by accepting their offers to resign as tendered at the previous board meeting. Another board meeting was convened, and telephone calls were made to Dunlap and Kersh. With the jobs of the two men on the line, Peter Langerman, one of the directors, read to them from a prepared statement: Here is what we propose: You be removed from all positions with the company and its subsidiaries immediately. You may continue to serve as a director of Sunbeam unless you choose to resign from that position. The board names a new Chairman of the Board and we expand our ongoing search to encompass a search for your successor…. (Qtd. in Byrne, 2003, p. 324) After firing Dunlap and Kersh, Langerman continued to investigate the depth of Sunbeam’s problems. He learned that Sunbeam might contravene its debt covenants by the end of the month and that huge loans could become repayable. The board of directors realized that bankruptcy was a possibility and they decided to ask Ron Perelman (of Revlon Cosmetics) if he would arrange for Jerry Levin (who had been the CEO of Coleman) to run Sunbeam for a while. (Perelman had acquired a significant amount of Sunbeam stock on the sale of his company, Coleman, to Sunbeam.) Levin agreed to the request and began by rehiring executives who had quit under Dunlap. Then he initiated a thorough analysis of the financial statements. The SEC also began an investigation of Sunbeam in June. Arthur Andersen, the external auditors, began a review of Sunbeam’s previous financial statements. It was immediately apparent to Levin, Arthur Andersen, and the SEC that Sunbeam’s financial statements would have to be restated. An ongoing investigation would have to determine the amount of the restatements. In November 1998, as a result of the investigations, Sunbeam “issued substantially restated financial statements for the six quarters from the fourth quarter of 1996 through the first quarter of 1998. As a result of the restatement for 1997, Sunbeam reported $93 million in income, approximately one half of the amount it had previously reported” (AAER 1393, 2001). Sunbeam had inflated its 1997 income alone by close to 100 percent. Sunbeam’s amazing resurrection had been nothing more than a “manufactured illusion” (Byrne, 2003, p. 345). Within weeks of the firing of Dunlap, the stock price had fallen to below $10 per share. After the October announcements of the required restatements, Sunbeam was trading in the $7 range, a spectacular plunge from its peak of about $52 per share a mere eight months earlier (AAER 1393, 2001). Although Jerry Levin did a valiant job in attempting to reverse the destruction of Sunbeam, the company filed for Chapter 11 bankruptcy protection in 2001, after suffering heavy losses in the previous year. Under the reorganization plan, most of the bank debt would be converted to equity and shareholders would receive nothing (“Bankruptcy Judge,” 2002). SIGNALS OF SUNBEAM’S SCHEMES There were several indications that Sunbeam may have engaged in fictitious financial reporting. Here is an examination of some of these signals. Signals of Sunbeam’s Fictitious Reporting Scheme #1—Improper Timing of Revenue Recognition via Bill and Hold Sales, Consignment Sales, and Other Contingency Sales Numerous signals could have alerted investors to the fictitious reporting schemes associated with improper timing of revenue recognition. SIGNAL #1: QUALITY OF LEADERSHIP The quality of a company’s leadership is an important signal with regard to whether its financial statements are likely to be fraudulently reported. The ethics, ability, management style, and track record of the leadership of the company should be the first piece of evidence an analyst or investor looks at in conjunction with examining financial reports for credibility. The track record of the companies that Dunlap had managed before joining Sunbeam, most notably Scott Paper, made Andrew Shore a skeptic of Sunbeam’s reported “turnaround” right from the start. Because of his long-term doubts about Dunlap, on the morning of April 3, 1998, just before Sunbeam’s press release that it was not going to make its estimates for the first quarter of 1998, Shore was the first analyst to put in a downgrade on Sunbeam stock. This general signal of the quality and track record of company leaders should be combined with an analysis of whether the business plan outlined by management is likely to produce the reported results as published in the financial statements. Sunbeam’s vicious cost-cutting plan of closing production plants and cutting products, jobs, and R&D expenditure was not likely to lead to fast sales growth as reported in record numbers in 1997. The implausibility of the reported financial results in relation to Sunbeam’s major downsizing plan was a major signal of fictitious financial reporting. SIGNAL #2: INCREASE IN ACCOUNTS RECEIVABLE AS A PERCENTAGE OF SALES The leading sign of an overstatement of sales is when accounts receivable increase as a percentage of sales, which is often measured as days sales outstanding (DSO). If the next period’s sales have been accelerated into the current period or if the sales are completely fictitious, the company will debit accounts receivable and credit sales, as for legitimate sales. However, whereas legitimate sales will be paid relatively soon by the customers and will turn into cash, the next period’s sales will probably be paid only in the next period and will remain on the balance sheet in the current period as accounts receivable instead of turning into cash. This signal of an overstatement of sales (and the accompanying profit) is easy to spot. We simply look at the income statement, extract the sales figures, look at the balance sheet and extract the accounts receivable amounts, and then calculate accounts receivable as a percentage of sales. To illustrate the validity of this technique, let us examine an extract from Sunbeam’s income statements in Table 3.1 and an extract from its balance sheet in Table 3.2. If we divide accounts receivable at the end of any quarter by the addition of the sales for the four quarters ending on that date (i.e. the trailing twelve months’ sales), we see the trend of accounts receivable growing as a percentage of sales, as shown in Table 3.3, from 29 percent of sales in the first quarter of 1997 to almost 49 percent of sales in the first quarter of 1998. SIGNAL #3: SUDDEN CHANGE IN GROSS MARGIN PERCENTAGE The third sign to look for as an indicator of illegitimately reported sales is a sudden change in the gross margin percentage—sales less the cost of goods sold expressed as a percentage of sales. It is difficult for a manufacturer suddenly to increase the company’s gross margin percentage; it is also suspicious if the gross margin fluctuates downward suddenly. It is easy to find this signal. A simple perusal of the income statements over a number of quarters will alert the investor to suspicious changes in the gross margin percentage. Look at extracts from Sunbeam’s quarterly income statements in Table 3.1. Calculating gross margin as a percentage of sales, as shown in Table 3.4, reveals sudden changes in the gross margin over the quarters, from 19 percent in the second quarter of 1996 to negative 15 percent in the fourth quarter of 1996. This was followed by a suspicious improvement in 1997 (after the so-called “turnaround”) to 27 percent in the first quarter of 1997 to 31 percent in the third quarter of 1997, then falling to 13 percent in the first quarter of 1998 and to negative 9 percent in the second quarter of 1998. These sudden changes in gross margins were probably due, in part, to practices such as selling inventory in 1997 at higher prices than the restructuring purported to anticipate because some inventory had been valued at incorrectly low amounts. Also, Sunbeam’s schemes—for example, understating the reserve for returns and taking the benefits of rebates for future purchases into the current period—would have falsely boosted the gross margins in 1997 and in the first quarter of 1998. SIGNAL #4: CFFO FALLING BEHIND OPERATING INCOME The fourth signal of inappropriately recorded sales is when CFFO lags behind operating income or when CFFO falls relative to operating income. For this information, once again we simply look at the financial statements filed with the SEC. For the first three quarters of 1997, we see that Sunbeam reported operating income of $132 million in its income statement. However, looking at the statement of cash flows, we see that Sunbeam’s CFFO for the same period 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 statement of cash flows is separated into three segments: the cash flows from operating activities, the cash flows from investing activities, and the cash flows from financing the business. So the “cash flow from operations” (CFFO) should not show an amount of cash generated that is significantly less than the profit from operations—listed as “operating income” or “operating earnings” in the income statement—without a very specific explanation. Certainly, from the first four signals alone, anybody reading Sunbeam’s financial statements at the end of 1997 should have been alerted to the fact that its reported sales and operating profits were unreliable. The sales were simply not turning into cash received at the rate they should have been if they were legitimate sales, and the gross margin percentages were fluctuating wildly, without a clear explanation for the volatility. SIGNAL #5: ADOPTING A MORE AGGRESSIVE REVENUE RECOGNITION POLICY The fifth signal that a company is overstating its sales is when it begins a policy of more aggressively recognizing revenue. The leading example of such an aggressive policy is the practice of recognizing sales revenue before the goods are shipped to the customer. The two major accounting strategies for doing this are “bill and hold sales” and “percentage of completion” accounting for contracts in progress. For Sunbeam, the relevant method in this category of overstatement of sales and profit was its bill and hold sales to get customers to place later periods’ orders long before they would pay for the goods and long before Sunbeam delivered the goods to the customers. Of $35 million of bill and hold sales that Sunbeam recognized in the fourth quarter of 1997, $29 million was later reversed and restated as future periods’ sales. In the case of Sunbeam, this signal was easy to spot. One of the notes to the financial statements in the company’s 1997 Annual Report mentioned this policy. The lesson here is to read the notes and footnotes to quarterly and annual financial statements and search for any new, aggressive policies indicating that the company records sales before the goods are delivered. SIGNAL #6: LARGE DISCOUNTS AND EXTENDED PAYMENT TERMS When a company offers large discounts and extended payment terms to entice its customers to order early, it is a signal that the reported sales for the current period are overstated and that future sales will be impoverished by the early placement of the orders. The notes to the financial statements in Sunbeam’s quarterly reports (Form 10-Q) should have disclosed this under Regulation S-K, items 101 and 103. However, Sunbeam failed to divulge this information (AAER 1393, 2001). To get information on this kind of channel stuffing, analysts and investors should scan the 10-Q and 10-K reports and conduct article searches via search engines such as Google and databases such as LexisNexis or ProQuest. They should search for data indicating that the company is offering unusually generous payment terms or discounts. If necessary, one could even interview the company’s staff and customers, as was done in the due diligence tests by the underwriters of Sunbeam’s debt offering in 1998. In addition, any news reports of large warehouses being built to house the company’s inventory (as was the case with Sunbeam) or of a company’s major customers building warehouses or “reclamation centers” to store unsold or returnable inventory should be taken as huge red flags that companies may have accelerated current sales at the expense of future sales. SIGNAL #7: GUARANTEED SALES The recording of sales when the customer has a right to return the product is a signal of the overstatement of sales. Such sales are often known as “guaranteed sales,” where the customers can return goods if they are unable to resell them or they can get a reimbursement if they cannot achieve a certain resale selling price or a guaranteed markup. In Sunbeam’s case, the SEC found that “in total, $24.7 million in fourth quarter  sales to distributors were subject to rights of return” (AAER 1393, 2001). A reserve for such returns should be accounted for in the financial statements according to the Financial Accounting Standards Board’s SFAS 484. However, the SEC reported that because such sales were a significant change in approach for Sunbeam and the likely return amounts were not known, it should not have reported these sales. 4 Statement of Financial Accounting Standards No. 48. www.fasb.org. An investor or analyst should search the financial statements for any disclosure of recording such sales (although in some cases, like that of Sunbeam, a change in approach may not be properly disclosed). One should also look for media reports about significant changes in company policy or about either the company or its customers building reclamation centers or warehouses. Again, these are all telltale signs of returns waiting to happen. SIGNAL #8: PRESS RELEASES STATING INABILITY TO MEET SALES ESTIMATES Press releases indicating that previous sales growth estimates will not be met are clear warning signals. It is a strong indication of a desperate overstatement of sales and sales estimates when a company issues a second press release, downwardly revising the numbers of an earlier press release that was, itself, a downward revision of sales estimates. This was the case with Sunbeam’s March and April press releases discussed earlier. Perform Internet or database searches for press releases or for articles referring to press releases that revise earlier public statements in quick succession. Signals of Sunbeam’s Fictitious Reporting Scheme #2—Overstating Earnings via Improper Use of Restructuring Reserves There were also signals that should have uncovered the overstatement of earnings through the improper use of restructuring reserves. SIGNAL #1: LARGE ONE-TIME CHARGES Large one-time charges in the income statement, such as restructuring charges and the creation of reserves on the balance sheet, should alert the reader to the possibility that future periods’ earnings may be inflated as the reserves are released back into profits or as the written-down assets are sold at normal prices. Sunbeam’s income statement showed a massive restructuring charge of $154.9 million in the last quarter of 1996 that included the over-accruals for items such as the advertising reserve and the litigation reserve. SIGNAL #2: RESTRUCTURING RESERVES If restructuring reserves or reserves resulting from other one-time charges appear in the financial statements upon the arrival of a new CEO, it is an even stronger alert that future expenses are possibly being recognized early with the creation of improper reserves. Al Dunlap was appointed CEO of Sunbeam on July 18, 1996, and the massive restructuring reserves were created in the last quarter of 1996. SIGNAL #3: RAPID DECREASE IN RESERVES When reserves decrease rapidly, it is an indication that earnings in the period may have been inflated by avoiding expenses through the reversal of the reserves. One has to consider how the company will be able to continue showing profits in the future when it can no longer release reserves to bolster profits. Sunbeam’s restructuring accrual decreased from $63.8 million in the last quarter of 1996 to $45.3 million in the first quarter of 1997, and then it was released steadily until it reached zero at the end of the first quarter of 1998. SIGNAL #4: CFFO SIGNIFICANTLY LESS THAN OPERATING INCOME The release of cookie-jar reserves boosts operating income but does not produce cash flow. Therefore, once again, CFFO lagging or falling behind operating income is a signal of this method of fictitious reporting. In Sunbeam’s financial statements, the effect of releasing cookie-jar reserves together with accelerating sales (as discussed in Scheme 1), combined to provide a very strong signal of its extremely aggressive earnings management. To discover this manipulation, search the financial statements for large one-time charges in the income statement or for reserves decreasing in later periods on the balance sheet. When Sunbeam simultaneously reported large operating profits in 1997 but negative CFFO, it was a signal to bail out of the company and its stock as quickly as possible. ARE THEY LIVING HAPPILY EVER AFTER?5 5 The “Are They Living Happily Ever After?” sections in this book present selected information about certain people and companies and are not meant to be definitive or exhaustive lists. Al Dunlap, Sunbeam’s former CEO and chairman, settled a $15 million class-action lawsuit with Sunbeam shareholders in 2002. In a civil settlement with the SEC that same year, and without admitting or denying the allegations, Dunlap agreed to a civil penalty of $500,000 and was prevented from ever again acting as an officer or a director of a public company (LR 17710, 2002). Dunlap and his wife Judy are reportedly living on a horse farm in Ocala, Florida, and have a summer home in Hilton Head, South Carolina. In 2006, the Dunlaps gave a substantial gift to Florida State University (Murphy & Ray, 2006). In September 2007, Dunlap received an honorary doctorate from Florida State University, one year after his $5 million donation to the university. He was soon dubbed “Dr. Chainsaw” (Porter & Dizik, 2007). In 2009, Dunlap was named the sixth worst CEO of all time (“Portfolio’s Worst American CEOs of All Time”). Now in his late 70s, Dunlap insists that he is not the ferocious person the media reported him to be while he was at Sunbeam. He is described as a lifelong German shepherd lover and apparently despises his infamous nickname of Chainsaw Al (Florian & Adamo, 2010). Russell Kersh, Sunbeam’s former chief financial officer, agreed to a civil penalty of $200,000 without admitting or denying the allegations. He was barred from ever again acting as an officer or director of a public company (LR 17710, 2002). Morgan Stanley was found liable for fraud by a jury in May 2005. The investment firm was ordered to pay a total of over $1.4 billion in “compensatory and punitive damages” in respect of the sale of Ron Perelman’s Coleman Company to Sunbeam in 1998. Perelman had lost close to $1 billion when Sunbeam collapsed. Morgan Stanley appealed the verdict, claiming that it too was “a victim of the Sunbeam fraud” (“Morgan Stanley …,” 2005). In 2007, an appeals court in Florida reversed the jury verdict against Morgan Stanley (Thomas, Jr., 2007). Sunbeam emerged from bankruptcy in 2002 as American Household, Inc., which was then acquired by Jarden Corporation in January 2005 (“Jarden,” 2005).