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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.
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Oct
23
Written by:
Jack Ciesielski
10/23/2006 6:51 AM
On October 12, the SEC reached a settlement with William Beecher, the former CFO of i2 Technologies for his participation in scheme to fraudulently report revenues and earnings over a five-year period while taking part in massive insider trading while the misleading reporting occurred. Amazingly, he got off with only a cease-and-desist order and a $1.3 million settlement, and is barred from serving as an officer at a public company for five years. Beecher must have had one sharp attorney; what he and his compadres, CEO Gregory Brady and President Reagan Lancaster, did at i2 was pretty amazing by today's standards.
Maybe it wasn't so amazing by standards of the late 1990's, which is to say, no standards. According to the SEC's complaint in the matter, the trio engaged in revenue inflation from 1997 to 2002 by recognizing revenue for deliveries of software that they knew did not work, and approving "side agreements" with customers that indicated they knew the delivered software did not work. The company delivered faulty software to the likes of Nike, Kmart, Best Buy, Corporate Express and Procter & Gamble. In a strange brush with history, the firm even engaged in barter transactions for non-existent work done for Enron Broadband Services, working with Jeffrey Skilling (whose sentencing is to be announced today.) The arrangement was essentially a "you scratch my back, I'll scratch yours" deal: i2 needed revenues, so Enron Broadband Services helped them in return for help they could receive later in making their own revenues. At one point, there was even discussion of adding Ken Lay to i2's board of directors.
The trio clearly understood the accounting principles involved, as evidenced by their e-mails. Also evidenced in their e-mails was the fact that they knew they were selling useless products: in 2000, Lancaster had e-mailed Brady "about i2 building "bullshit demos" for prospective customers that showed all functions working together, which was not reality." He went on to state that "I am not pointing fingers but I will tell you that you can only sell vapor for so long and then it catches you. Right now we have vapor in CM [Customer Management, an i2 software product], Procurement, Marketplace deals, etc. .. . We are selling our stuff with a good pitch but there is no substance behind anything ..."
At one point, the company brought in Michael Cusumano, an MIT professor, "to analyze the firm's structure and processes," according to the SEC's complaint. A memorable conclusion in his findings: "Two core competencies in i2: (1) Can sell anything to anyone. And (2) delivery guys can make any piece of crap work, given enough time."
When all was said and done in the company's restatement in 2003, the revenues were overstated in 2000 by 41%; in 2001 by 14%; and understated in the first half of 2002 by 27%. For the entire period, the net earnings effect was a negative $207.1 million. During 2000 and 2001, Beecher exercised options and sold $19.9 million of stock; Brady did the same and reaped $92.1; and Lancaster cashed out $27.9 million. At the same time, CFO Beecher and CEO Brady signed off on financial statements and representation letters to auditors indicating that the financials were properly prepared.
The story has a couple of lessons in it. Lesson one: notice that this case was just settled with one of the principal players in 2006; it was the restatement in 2003, after an audit committee investigation beginning in 2002, that got the matters to the forefront. Three years later, closure arrives. So it will probably be with backdating investigations - total closure on them will not likely occur any time soon. It'll be years in the making; until then, you'll have to live with the backdating twists, turns and surprises.
Second lesson: this was a blatant case of skunky revenue recognition. You just don't hear that many instances of it these days, and it was the gimmick of choice in the late 1990's, early 2000's era. There seems to be fewer 8-K non-reliance filings on revenue recognition issues than in past years. Could it be that the auditing profession has been strengthened by the Sarbanes-Oxley reforms? That's a benefit inuring to investors that they might take for granted amid all the gabble about rolling back the act.
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Pension & Other Benefit Plans: A Look Ahead
Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.
Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.
A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.
For information about subscribing to The Analyst’s Accounting Observer, click here.
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