Shadow Account (10 page)

“This is bad news, Conner.
Very
bad because Company Y’s stock price has been going up over the last few months in anticipation of a great year. The great year the CFO has been bragging about to Wall Street analysts for months during those ‘off the record’ conversations CFOs aren’t supposed to have with the Street anymore. According to the lead partner, the downward revision of the earnings-per-share figure won’t be big, just a minor adjustment. But the CFO knows that these days analysts and investors are looking for any excuse to pound a company’s shares. Once one analyst puts out a ‘sell’ recommendation, they all jump on the bad news bandwagon and that’ll be that. The stock price will tank. So he’s got to do something fast.”

Jackie gazed at an old black-and-white picture of her mother and father on the credenza beside the desk. “Here’s the rub,” she said quietly. “Here’s how everything gets sideways. The CFO and the CEO of
Fortune
500 Company Y have been granted tons of free stock options. Call options the twelve Saxons have been doling out for the past few years like Italian lire. A million here and a million there and nobody notices because the details of the option grants are buried in the back of a proxy statement you’d have to pop a whole box of N¯o-D¯oz to get through. And because the stock price has been reaching new highs over the last few months, those call options are way in the money. Worth gazillions. But the CFO knows that when the officially announced earnings-per-share figure is suddenly below forecast, the stock market will punish Company Y. Even if the EPS figure is off a little,” Jackie said, holding her thumb and forefinger barely apart. “And when the stock price dives, so does the value of the CFO’s options. Maybe to zero depending on the option strike prices. But the CFO is building a ten-million-dollar beach house in Boca Raton that he’s planning to pay for by exercising the options. And the CEO is doing the same thing in West Palm. Except that his new pad is costing
thirty
million. Without the option money, both of them are out of luck and the construction on their dream homes will come to a grinding halt. They’ll be facing personal bankruptcy and the Saxons will have no choice but to boot them out of the company. Because the perception in the market is that a corporate executive who can’t run his own life profitably shouldn’t be in charge of a multibillion-dollar company.

“Our CFO is in a sticky situation. His Boca beach house is on the line. So are his career and his reputation. His whole way of life, for crying out loud. His ability to keep up the ten-thousand-dollar monthly mortgage payment on his primary residence in Greenwich or Brentwood. His ability to keep his kids in the best private schools. His country club memberships. Everything he’s worked so hard for is about to go up in flames. He’s got to do something.

“He folds his arms across his chest and doesn’t say anything for a while, staring the accountant straight in the eye after getting the bad news. When the guy can’t take the heat anymore and finally looks away, our CFO starts talking. He tells the guy he’s
very
disappointed. That his internal accountants swore to him that the way they were doing the numbers all year was technically correct. That they had actually been relying on information from the accounting firm. When the accountant mumbles something into his hundred-and-fifty-dollar silk tie about how they were wrong, our CFO tells him that the board of directors was thinking about switching accounting firms last year. But that he personally recommended to the board to stay with this firm because of the solid personal relationship they had developed.

“Now it’s the lead partner’s turn to sweat. Accounting firms make tens of millions of dollars off just
one Fortune
500 audit, and Company Y is by far this partner’s biggest grossing client. If Company Y switches its audit to another accounting firm, his personal compensation will drop like an airliner with engine failure and suddenly he won’t be able to make
his
monthly mortgage payment. Now both men have a problem. When the EPS figure is released, the CFO will be out of a job. And with the CFO out of a job, the lead partner won’t have his internal advocate at Company Y, and the accounting engagement will go to another firm.

“A shiver runs up our lead partner’s spine. He thinks back to college and how his ethics professor warned him that sooner or later this day would come. The moment of truth. His life is flashing before his eyes, and he’s sweating like he’s running a marathon in the Sahara because now we’re edging toward criminal issues. He tells the CFO that he’ll think about things for a few days and get back to him. That’s code for, ‘I’ll look the other way this time, but don’t put me in this situation again.’ Problem is, now the accountant has complied with something that doesn’t conform to generally accepted accounting principles—and the CFO knows it. The chink in the armor is tiny, but that’s enough these days.

“They shake hands and the lead partner leaves, bouncing off walls on his way out of Company Y’s headquarters. Wondering all the way home how in the hell he got sucked into the fraud vortex so quickly.

“The CFO pats himself on the back, chuckling as he watches the accountant stumble away. He’s played it perfectly, he thinks to himself as he sits back down at his desk. He calls the builder down in Boca and tells the guy to get started on that wine cellar the wife wants. He’d been holding off on that extra because it’s going to cost another hundred grand and, somehow, it didn’t feel right. But now he’s confident about his personal financial situation again. The accounting firm has been corrupted. Life is beautiful.”

Jackie put the wrist exerciser down. “Next year, there’s a whole different issue with Company Y’s books and once again a junior person on the audit raises the issue with the lead partner. The lead partner politely thanks the junior guy, then tells him to keep his goddamned mouth shut. The web is expanding. And, this year, the issue isn’t up for interpretation. It
is
black-and-white this time, and it’ll have a
huge
downward impact on Company Y’s earnings-per-share figure if the books are revised. Fifteen to twenty percent negative. But the young guy doesn’t say anything either, because he’s got school loans he’s still paying off, and his first child is on the way—all of which the lead partner knows. This past weekend, the junior guy realized it’s going to take ten grand he doesn’t have to set up the nursery the way his wife wants it. Now he’s in the vortex, too.

“For a while, the junior guy doesn’t sleep well. His wife asks him what’s wrong, but, before he can answer, she puts his hand on her tummy because the baby is moving. He’s totally screwed now, and he’s thinking he’s headed straight for Leavenworth without passing ‘Go.’ He’s just waiting for the SEC to show up on his doorstep and lead him away in shackles like those poor bastards he’s seen on the evening news.

“But Company Y’s annual report comes out and nobody blinks an eye. The stock price keeps going up and nobody questions the numbers. Our junior guy starts doing better. He isn’t up at three in the morning watching Nick at Nite reruns. He’s in bed by eleven again, just like he used to be. Nestled beneath the covers next to his lovely wife who only has a month to go before she delivers. The nursery is even nicer than what she wanted thanks to the twenty-five-thousand-dollar ‘special’ bonus the lead partner surprised our young guy with.

“The only major change to our young guy’s routine is that he’s started to drink when he gets home. One or two glasses of red wine at first. Sometimes three. Suddenly, he’s draining an entire bottle every night. Suddenly, he understands those three scotches his father guzzled.”

Jackie glanced out the window at the building across Thirty-third Street. “The lead partner never even bothers to raise the big issue with Company Y’s CFO this year. He’s been sucked way down into the vortex, and now he’s just as guilty as the CFO. They’re clearly defrauding the shareholders, but making a mint at it. The CFO has exercised truckloads of options at stratospheric prices, and he’s loving his vacations to Boca. The house turned out great and the wine cellar is stocked with vintage bottles. The lead partner got a year-end bonus that’s twice what it was last year—over half a million—from which he personally gave the junior guy the twenty-five-thousand-dollar cut.

“And why is that, you ask? Why was the lead partner’s bonus so big this year? Because Company Y’s CFO handed the lead partner a big Christmas present. He retained Accounting Firm X’s consulting group to recommend strategic acquisitions, and he agreed to pay them five million dollars for a six-month engagement. The CFO has no intention of listening to mergers and acquisitions advice from Accounting Firm X’s consulting group—he has New York investment bankers for that and no savvy CFO would ever listen to a bunch of accountants about merger and aquisition advice. But it sounds good. And it isn’t as if the board is going to question him. The CFO roped
them
in, too. A few months ago, he proposed to the CEO that the Saxons and the two poster kids start getting options, too. The board took a vote on it, and what do you know? It’s unanimous. They think it’s a great idea. It’s like Congress considering a raise for themselves. Think that vote would ever fail?

“The pattern is established. You scratch my back, I’ll scratch yours. The CFO and the lead partner get even chummier. The wives become friends and the couples take vacations together at the Boca beach house.”

Conner stopped scrawling notes for a moment. The e-mail was starting to make perfect sense. Rusty was the junior person and Victor was the lead partner. “You haven’t painted a pretty picture of the accounting profession,” he commented.

“Understand,” Jackie replied, “I’ve described the exception, not the rule. But it happens. Enron and WorldCom are excellent examples. And I guarantee you there are more big companies out there with problems. Some will be exposed and some won’t. But you better believe those problems usually involve complicity between the company and its outside auditors. I don’t like throwing stones at my profession, but you asked me how it could happen. That’s how.”

“Why wouldn’t accounting firms do something to address these problems?” Conner asked. “Like rotate lead partners? If that lead partner you described automatically had to transfer to another client every two years, the scenario would be less likely. Don’t you think? He wouldn’t want the next partner to discover what he’d been doing.”

“Some firms do implement that kind of rotation. But what you have to appreciate is that it takes a great deal of time to fully understand a
Fortune
500 Company. They’re so huge. So many divisions, products, and locations. At the point a lead partner on an audit is just getting his hands around the company, and is best prepared to identify problems like fraud—if he’s honest—he’d be moved on. If you believe your people are ethical, it’s better to keep them in place. You can’t assume your people are dishonest. That creates a terrible culture.”

“What’s the answer?”

“Accounting firms have to do their best to hire ethical employees. Then have checks and balances that aren’t overly invasive. Two lead partners on every client. An audit department within the accounting firm constantly doing internal spot checks on their people just like the IRS performs random audits on taxpayers. So that it’s expected, not unusual.”

“Which would add costs,” Conner observed. “A great deal of overhead burden.”

“Exactly. And that’s the last thing a professional services firm wants. So if one firm doesn’t do it, then the others can’t either because they won’t be able to compete on price. It’s a very difficult problem,” she acknowledged.

Conner held up one hand. “Okay, I understand your point on the big picture. But now I want specifics. How does that CFO who’s building the vacation home in Boca actually manipulate the company’s EPS number so he can keep paying the construction crew to build the wine cellar? Where’s the sleight of hand?”

“The easiest thing to do in the short run is book fraudulent revenues,” Jackie answered without hesitation. “Just claim you sold more products than you actually did. It sounds simple, but, executed the right way, it can be very effective.”

“Explain,” Conner said, beginning to take notes again.

“Let’s use a one-product company for this discussion. It’ll make things easier to explain. And to understand. Let’s say we’re talking about a T-shirt company. They have to buy machines to knit the T-shirts, and yarn to feed into the knitting machines. They have to pay people to service the machines, a sales department to sell the T-shirts, and they have overhead. Executives, a finance staff, human resources people, et cetera. Let’s say they sell each shirt to the retail stores for a dollar, and, after all their costs, the company makes ten cents a shirt. If they sell thirty million shirts a year, their annual revenue is thirty million dollars, and their net income is three million. That three million is what’s left over for shareholders after everything else is paid. As I’m sure you can appreciate, there’s a lot of hard work and risk involved in making that three million dollars, too.”

Conner shrugged. “Yeah, so?”

“If the T-shirt company’s CFO wants to turn three million dollars of net income into six million real quick, to double it, the easiest way is just report that the company sold another three million shirts. That would add another three million dollars to the bottom line at a dollar a shirt because there haven’t been any costs associated with those fraudulent revenues. It’s pure profit at a dollar a shirt. The CFO would be more than happy to open the books and dare anybody to find those additional expenses, because he knows nobody could. They really aren’t there, because they weren’t incurred. The only thing the CFO would have to worry about is that someone finds out that the revenues aren’t real. That those extra three million shirts weren’t really shipped to stores.”

“Exactly,” Conner agreed. “Which is a big risk.”

“Not as big as you might think,” Jackie cautioned. “Not in the short term anyway.”

“Why not?”

“How can anybody figure out how many T-shirts the company actually sold?” Jackie asked.