The Accounting Cookbook

THE ACCOUNTING COOKBOOK

Part 1: INTRODUCTION
Part 2: ACCOUNTING FUNDAMENTALS
Part 3: ACCOUNTING MEASUREMENT RULES
Part 4: WHY COOK
Part 5: THE CHEFS
Part 6: NO BOOKS, BOOK COOKING
Part 7: OFF BALANCE SHEET COOKING
Part 8: ROUTINE COOKING
Part 9: NON-ROUTINE COOKING
Part 10: COMMENTARY

EPILOGUE 1 - Theorem
EPILOGUE 2 - New Law

Introduction Back to Top

Guns don't kill people, people kill people! This is the theme of the National Rifle Association in their ongoing objection to gun control. In a not dissimilar way, accounting does not distort or deceive, people distort and deceive. "Cooking The Books" is a cliche� used to describe insiders changing what would otherwise be presented to outsiders as "truth and light" in their financial reporting, to a presentation that is intended to cover up reality for any of a variety of reasons. They use many different recipes to make reality into a cooked presentation - which can look like a gourmet offering. It is the intent of this cookbook to look at some of the recipes used by these book-cooking chefs. By understanding how they cook and why they cook, and considering some disincentives for their cookery, possibly we can avoid the indigestion that all too frequently accompanies their creations.

Accounting Fundamentals Back to Top

Accounting is not a commodity or a product. In business matters, accounting is a process, a methodology of summarizing the various transactions of a business leading to a measured display of an entity's economic status and its operations presented in conformity with accepted concepts and principles of measurement. To understand how these cookers of the books operate, one must have at least a minimal level of understanding of what the books are all about. A brief refresher may be in order.

The foundation of accounting rests on two basic laws, one of nature, and the other a monetary law. The first law is that the quantity of anything, including money, at the beginning of a period of time, plus what was added to it during an intervening period, less what was taken away during that period, equals the quantity at the end of the period. Nothing overly exciting about this except to note that if you know any three of the four, the fourth can be determined, and that this is a closed ended system. Beginning quantity, plus additions, less deletions, equals the ending quantity - not some random quantity, not someone's idea as to what the ending quantity should be or could be - it is a closed and definitive system relative to change over time.

The second law which is relative to monetary matters is that every transaction has an equal and opposite reaction. That is, an "in" (plus) to something, is an "out" (minus) to something else. For example, the collection of a receivable is an "in" to cash and an "out" to receivables. The conversion of an expense to an asset is an "out" to expense and an "in" to the asset involved.

These two phenomena were first noticed in the 1400's by a Franciscan Friar, mathematician and teacher, Friar Pacioli. He wrote extensively and is considered to be the father of the double entry system. This equal and opposite reaction was first described by him in some of his writings where he observed that this methodology had been used by Venetian merchants as far back as into the 13th century. Pacioli was the first to take the diverse elements of business and put them into a coordinated system that became the foundation of the double entry system and the basis of all modern accounting.

Pacioli was not only a mathematician and an observer; he had a gift for expressing simple truths with vigor and elegance. In one of his writings relative to the double entry system and on how books and accounts should be maintained, he said that books should be closed yearly or more frequently, especially in partnerships, because frequent accountings make for long friendships. Apparently they had book cookers even in those early days.

That is the history and the concept of the double entry system, the foundation on which all accounting is performed. It's based on a natural law as to the nature of physical change over time, and the monetary law of transactions, that each transaction has an equal and opposite reaction.

Accounting Measurement Rules Back to Top

Now come the people to put their human touch on the good Friar's discovery. In their defense, however, I must admit that business and transactions have become a bit more complex since the Friar's day. The current long-term construction projects/contracts, intellectual property development and its related sales and services, and the size of business units along with the multitude of financing types would have driven the Friar back into deep meditation.
The human touch in attempting to improve on natural laws or customs in any area, not just accounting, is to set up rules of thou shalts and thou shalt nots. On balance, rules are a good thing although they do tend to be restrictive and don't leave room for unique nuances. But that is the cost of rules.
I am reminded of a meeting with a group of my partners (years ago) reviewing a new manual put out by our firm with its inevitable and irritating new rules which caused one of the partners to refer to it as "Betty Cookers Crock Book."
The evolution of accounting rules is no different from that of any other arena. Abuses swing the pendulum of acceptability to one side, which causes the establishment of rules. The new rules are then abused, requiring modification or correction (also somewhat excessive) which swings the pendulum to the other side. Eventually, the pendulum stabilizes.

A hundred or so years ago, I am told, it was not uncommon for a subsidiary to declare a stock dividend to its parent, for the parent to record the dividend as income, and then issue non-consolidated (parent only) financial statements. Unthinkable, you say? Of course. But it was doable at that time, before the pendulum started to swing.
So don't fret excessively over evolving rules. They do tend to stabilize if they are allowed to evolve and not become politicized. Can you imagine a political partys platform having a plank of accounting rules changes that the party would prescribe as their idea of a better determination of net income?

One of the major causes for the need of accounting rules is that inflation and competitive forces live. The natural law of the beginning amount, plus input, less output equaling the ending amount is great when dealing with physical quantities, but it just doesn't work when it comes to valuation of an ending quantity. So early on, rules were established requiring that all assets that do not turn-over, such as property, plant and equipment, should be valued at original cost, and those that do turn-over, such as inventories, should be valued at current cost.

This rule took care of price level changes for inventory, but a further rule was needed and established about the same time called the "lower of cost or market." This rule was aimed at recognizing the realities when an adverse sales condition is experienced. Market, in the term "lower of cost or market is defined as what the net realization would be after considering the costs of disposing of the items. If this realizable value is less than cost, then the cost value is to be reduced to the realizable value - thus, the term "lower of cost or market." The effect of this is to expense the decline in asset value in the current year rather than carrying it (and the loss that would follow it) over into the following year.

The reason for doing this is to enable the subsequent year to not be penalized for a condition that existed in this prior year. This is one of a number of rules under the general concept of providing [charging against Profit & Loss (P&L)] in the present year for all known or reasonably determinable losses, rather than to make the ensuing year have to absorb that baggage. These are good rules and sound principles.

Although broad principles are important as a basis for specific rules, other matters also under the same broad principle not covered by a rule tend to be ignored until such time as a rule requiring a specific treatment for them is imposed.

For example, the rule regarding the "lower of cost or market" just referred to, has been in existence for some time, but the over-riding principle was not applied to long-lived assets, specifically fixed assets that are valued at original cost. In a later rule, it became required that if the value of a fixed asset or a group of assets became impaired, because of obsolescence or any of a number of other reasons, the asset value should be reduced to its unimpaired value, probably zero. That was progress. But the rule still did not require its application to other long-lived assets such as goodwill.

Then a millennium was reached in 2002 with the application of the impaired value concept being required treatment for goodwill. Slowly, the water in financial statements has been squeezed out.

It is against this backdrop of broad principles and rules that cookers concoct their nefarious recipes. The point is that it is not the principles and rules of accounting that distort and deceive. It is in some people's willingness to abuse this structure for their own purpose. But why do they feel it is necessary to cook the books?

Why Cook? Back to Top

As long as people are people and it would be advantageous for the business reality to be perceived by others more advantageously, a few people will cook the books and produce a dish I call gruel. Their reasons for cooking are multitudinal, but the major reasons for gruel making is the trilogy of - v bnm

� Excessive Optimism - Alan Greenspan of the Federal Reserve used the term "Irrational Exuberance" to describe the stock market of a few years ago. It is the same kind of exuberance that causes a management to believe that a present downturn is only temporary, that this blip in their trend is undesirable, and an expected future reversal of the present adversity, which will clearly take place, will allow the gruel to be buried. If not, any fortuitous future circumstance can provide an offset to the gruel, or, as a last resort, to take actions to create a fortuitous situation, such as selling off a product line or a facility, which might not otherwise be disposed of, to create a gain against which to offset the gruel. These chefs believe they are serving a greater good by not allowing the present adversity to distort their track record. This is like the fellow who says that a man who won't lie to his wife has no regard for her feelings.

� Fear - Not the emboldening type of fear that President Roosevelt referred to when he said, "We have nothing to fear but fear itself," but rather, the fear of the perceived consequences of not cooking. This would include such items as the cook's loss of employment, loss of income, the negative effects on the entity, his stocks value, his options, his bonuses, his prestige and many other fear-based reasons to delay the consequences of reality. Who knows, something good could happen. There is a story of a thief a century or so ago about to be sentenced to death by the king. The thief appealed to the king to delay his death for two years during which time he would teach the king's horse to talk and, if successful, the king would commute his sentence. The king was enthralled by this idea - of having the only horse in the world that could talk - so he agreed. Later, a friend inquired of the thief as to how he was going to achieve this miracle. The thief responded that he at least had two more years to live, and who knows, the horse might talk.

� Greed - The only too much is ever enough syndrome. This has two faces. One is structural cooking of the board (rather than numbers) and involves loading the board with cronies and followers and voting yourself a massive compensation package. This is visible if one reads the SEC filings, but hard to find otherwise. A $10,000,000 compensation package is $4,800 per hour, which is somewhat higher than the minimum hourly wage. All this does is to set up the potential fear of losing the wage package in a downturn which the cook may feel needs to be protected.

My dad once said as we were listening and watching an orchestra and its baton-wielding leader, "He follows the orchestra very well."

A $10,000,000 wage package, and some are higher, is equivalent to 100 people each making $100,000. No one person is worth that level of compensation even if the orchestra is following his baton. This is so even while in a business upswing, and more so, in a downturn. A good base level of compensation assumes that the person is expected to do his best job - this is so for all other employees, so why not for the CEO? Or alternately, go private and eliminate the question.

The other face of greed is to cook the books making enough gruel to provide time for the cook to bail out. This, before the situation is generally known and the consequences of reality take over, leaving the remaining company and the public to eat this mess. This should be criminal.

This trilogy of causes - excessive optimism, fear and greed - are exacerbated by:

�         An equity market that punishes performance, which does not meet or exceed the announced short-term expectations. It seems as though the market has little concern for long-term objectives and performance,

�         A management concept of incentives which establishes a framework for conflicts of interest which can be the catalyst to cooking,

�         Rapidly changing and expanding technology which can shorten the life cycle of a product or a business from what the founders expected and promised, with the unfulfilled expectations establishing a need for cooking, and

�         At least up until now, limited risk of being punished for cooking except for having to take some verbal abuse. Several bills have now been signed into law that will change this drastically - see Epilogue 2.

The Chefs    Back to Top

The captain of a ship is totally responsible for anything and everything that happens on his ship. So it is for the generals with their armies. And so it is, or should be, with a CEO and the business he directs.

The CEO of an entity, where the books are cooked by subordinates, either knows or should know that gruel is being produced. If he does not know, he is clearly inadequate for the position he holds and certainly does not deserve premium pay. More likely, he knows and is directing the activity. The sad thing is that his subordinates are accomplices to his conduct. And it is also sad that the board permitted a CEO and a structure of conflicts of interest that would allow these people to be put in harm's way.

Many entities are so large that gruel producers at a lower level, such as a subsidiary or a plant that is trying to make itself look good, may produce its own gruel. But every large public company has, or should have, a strong internal audit function, which the CEO should have as his eyes and ears to preclude such production, along with the eyes and ears of the outside auditors. If not confident in the assurances provided by these resources, the CEO has the entire resources of the company to protect him and the business from LLG (Lower Level Gruel). So I will stick with my premise that the CEO knew or should have known.

No Books, Book Cooking    Back to Top

All public enterprises are required by law to report their financial affairs to its constituencies and to the Federal government to be monitored for rules compliance and enforcement. All, that is, except one - the Federal government itself. And right along with it, most of the states and local governments.

The citizenry is required by law, with its related enforcement, to annually report their affairs to the government via the annual tax returns. And what do we get from the government of a financial nature relative to their performance? Words! Biased words, politically aimed words, harangue between the parties' words, accusatory words, defensive words, ad nauseam with a second ad nauseam.

Periodically we might see a pie or bar chart, but this doesn't help. The problem is that there is no framework against which to have an appreciation of the words or charts.

Living on a steady diet of government words sets up a condition in government ripe for hiding distortions and deceptions, and the truth of the matter is that they don't, and can't even produce financial statements.

What if today's headline cooking entities had not had to issue regulated financial statements and could have done it all by words? There is no question that their cooking would never have been discovered, at least until they had to file bankruptcy, and even then, they would not have been discovered if the court relied on words. But wouldn't it be great if we were to get -

�         an annual consolidated balance sheet in comparative form showing the assets, debts and equity of the government,

�         a statement of their operations in comparative form showing the elements of revenues and expenses, and

�         a statement of cash sources and uses of funds also in comparative form.

Unfortunately, we must dream on because no political party wants the government to be held to the same standard as public companies, and with no one pressing the issue, it is not likely that any change will take place. If you don't put out a financial report, you can't be accused of its inclusion of distortions or deceptions. Everyone has heard of "off balance sheet" transactions. What we have here with the government is "No Balance Sheet" for anything to be off of - everything is "Off Balance Sheet."

So the government's contribution to this book-cooking cookbook is -

          Mix dry ingredients:

          -        Words of insult to the other party                                                 1 cup

          -        Words to indicate a high order of
                   ethics in one's own conduct                                                       1 cup

          -        Words of shocked anger at any
                   transgressions in the business community                                   1 cup

          -        Words intended to involve the other
                   party in these transgressions if at all
                   possible, and even if it isn't.                                                        1 cup

          Mix with incendiary coverage by the media,
          looking for someone, anyone, to blame                                              1 gallon

          Add a pinch of redundancy to make sure
          credit is given where it belongs                                                         To Taste

          Slowly heat and stir.

After the explosion, focus will be totally on the transgressor, and the game of King of the Mountain, Mount Washington, DC, that is, can be continued. And the fact that the government can't comply with the same standards as caused the outrage, won't even be a passing thought.

Serve this dish as frequently as the opportunity presents itself. It will also serve well as text material in the ubiquitous campaign contribution requests.

Enough beating of this dead horse, so I'll move on to recipes of book cooking where there really are books to cook.

Off Balance Sheet Cooking Back to Top

Despite assertions to the contrary, the only real reason for an off balance sheet transaction to be "off" is because it is advantageous for it to be "off." If it were advantageous for it to be "on", one could be certain that it would not be excluded. Or, if it doesn't make any difference, why exclude it?

In general, there are two types of offerings. One is to pretty up the picture. This is not "off balance sheet" in the classical sense - it is a controlled rearrangement of the balance sheet by transactions, which temporarily changes the balance sheet reality to something that will be more acceptable to an outside reader. It does not affect the P&L but it changes the balance sheet structure so that those who look at such things will conclude the structure is better than it really is for example: pay down short-term loans just prior to year-end and re-borrow early in the following year. This will improve the year-end debt to equity ratio as well as the current and quick ratios. Sell some receivables just prior to year-end - it will reduce the investment in receivables and increase cash. Delay delivery of inventory until after year-end to reduce the investment in inventory and reduce payables.

The other type of offering is more permanent - i.e., set up a new entity to be owned by others with no relationship to the prime entity as an illustration, to factor or buy the receivables on a continuing basis. This will reduce receivables and provide cash to pay down debt. If the relationship is really at arm's length and the transactions are non-recourse, it might not be too objectionable. But there are a lot of things that have to be just right for it to be so, and if they are not, the prime entity may be exposed to off-balance sheet risks. But why the need to set up a new entity to do what is already commercially available? And why would anyone put his or her own money at risk in this factoring entity to serve one customer? It probably is a matter of relationships and influence, and that is not without its risks. As a minimum, the relationship is not one to build confidence in the integrity of management and its financial reports. I think it reasonable to put me down as not neutral when it comes to "off balance sheet" items for, even if legitimate, it is counter productive to building trust.

Routine Cooking Back to Top
The creativity of the entrepreneurial mind in finding ways to cook the books, where reality is bleak and will be badly received if not improved upon, is mind-boggling. Rather than providing lengthy variations on a theme, I will address some of the basic methods these cookers of books use to produce their routine gruel.

But before we do that, we need to have a further accounting lesson to better understand the arena in which the gruel is being produced. Everyone is familiar with the structure of a balance sheet in which Assets on the left side equals Liabilities plus Stockholders' Equity on the right side. This is the classic format, which are the pots and pans of gruel making. But this requires a bit more delineation. Follow the following:

Assets =     Liabilities + Stockholders' Equity

And Stockholders' Equity = Capital + Retained Earnings

So,

Assets = Liabilities + Capital + Retained Earnings

And Retained Earnings = Beginning Amount + Current P&L

So,

Assets = Liabilities + Capital + Beg. Amt. Retained Earnings + Current P&L

And Capital + Beg. Amt. Ret. Earnings = Non-gruel Areas

So,

Assets = Liabilities + Current P&L + Non-gruel Areas

So, dropping off the non-gruel areas, the real arena for gruel making is,

Assets = Liabilities + Current P&L

The primary reason for routine cooking, of course, is to increase profits. The matrix that follows attempts to indicate some of the methods that are or could be used for this purpose in routine operations.

Current

                                                                               Assets    = Liabilities + P & L

Overstate Receivables

Fictitious billings; advance billings; delayed
    credits; delayed bad debt recording; sales
    terms not meeting the test of sales; flood
    the market with sales having liberal terms
    as to payment and/or return privileges.(*)                       +                                  +

(*)      Generally by private side agreement
          not reflected in the records.

Overstate Inventory

Inclusion of non-existing inventory; duplicate
    (or more) physical counts*; overpricing the
    physical counts; neglecting to apply lower
    of cost or market; underestimating costs to
    complete construction or other long-term
    contracts.                                                                    +                                  +

(*) 18-wheelers are great to move large quantities
    of counted inventory to another plant to be
    counted again.

                                                                                                                  Current

                                                                               Assets    = Liabilities   + P & L

Overstate Other Assets

Capitalize expenses as fixed assets or as a
    deferred asset; delay recognition of the
    loss in impaired assets.                                                 +                                  +

Understate Liabilities

Delay processing and recording expenses; quick
    closing of books so as to avoid much of the
    expense(*); recording debt as revenues.                                          -                 +

(*) Unrecorded inventory purchases for which the
    inventory has been received and included in
    the physical count of inventory and excluded
    from payables goes directly into income.

The unfortunate thing about routine cooking, from the cooker's point of view, is that any artificial increase in the current P&L makes a hole in the ensuing year's P&L. This will either have to be absorbed in the ensuing year, or be replicated at that year-end. The point is that once gruel is produced, it doesn't go away. It either has to be absorbed in the following year's P&L or regrueled (and probably be expanded upon) until something fortuitous happens or is made to happen against which it can be absorbed.

A number of years ago early in my audit staff days, I was assigned to an audit of a company that had made $1.50 a share in the prior year, had advised their stockholders several months earlier that the present year, of which they were justly proud, should reach $2.00, but for the following year they were not confident that they would exceed the prior year's $1.50. The year-end closing data indicated earnings of $1.95, which brought on a frantic search for "adjustments to make $2.00 a share." Their accounting staff came up with a number of adjustments squeezed out of the P&L to accomplish this objective, mainly deferring expenses and reducing reserves, most of which were not absolutely wrong, but less right than they had been. We call this "Gruel Lite."

In a meeting to review these adjustments held by the client with the audit partner, he (the audit partner) complemented them on their amazing year compared to the $1.50 of the prior year. But, assuming the 5 cents was taken into income this year, he pointed out that they would be starting next year 5 cents in the hole; that to make the normal $1.50 next year they would have to make $1.55 and he asked which would be easier to explain to the stockholders, $1.95 vs. $2.00 in a banner year, or $1.45 vs. the normal $1.50 next year. Earnings were reported at $1.95. Logic can prevail, sometimes.

Gruel doesn't create earnings; it pushes earnings from one period to another. If managements have an adequate long-term view of their self-interest, Gruel Lite should not exist. And, this equally applies to any gruel. Enlightened self-interest is a hard thing to perceive when you're in the midst of reality in conflict with expectations and the anticipated reaction to even a near miss. But people of integrity make this decision every day.

Non-Routine Cooking Back to Top

The major non-routine gruel area is in the field of mergers and acquisitions. The way an acquisition or sale is recorded on the books at the time of the transaction can set up potential cushions that can be transferred into income in a future year of need to preclude the later need for cooking. We call that "Anticipatory Gruel."

Another non-routine gruel is to sell an asset, subsidiary, or product line at an inflated and profitable (gruel for this year) price (which you finance with a side agreement as to how much should actually be paid), and in a later year, (when you have some better results, can afford to absorb it, and memories are weak), write off the bad debt.

A different type of non-routine gruel is in conjunction with a write-off which is required because of a change in accounting rules, and for it to be used as a base on which to over provide so that, at a later date, the excess can be returned into income at a time of need. The 2002 required write-offs of impaired goodwill and other intangible values (which will be very large numbers) will provide an excellent opportunity for a present-day potential cooker to write-off more than what is actually required (anticipatory gruel) which will enable him to take the excess into income at some future time of need. So be prepared and watchful. As a side note, AOL Time Warner reported a P&L charge for 2002 of approximately $54.2 billion write down of goodwill, and WorldCom announced that in all likelihood, it may determine all existing goodwill and intangible assets, currently recorded at $50.6 billion, should be written off. So, we are talking about some big numbers.

A further matter that should not be overlooked is that gruel of any type, which artificially inflates the P&L, can produce a real increase in income taxes. This can rob the entity of the related cash until such time as the gruel is reversed.

Commentary Back to Top

Integrity abounds. It is unfortunate, however, that the conduct of a few are of such magnitude as to tilt the trust the public has had or has assumed in the senior managements of public entities, built up over many years, to one trending toward distrust. To a certain extent this could have been anticipated with the increasing concentration of business along with the old adage that it only takes one bad apple to spoil a barrel full. Of course we are all expert in everything if given 20-20 hindsight, so we need to put that behind us and move on to rebuilding that trust.

Management's cooking of the books, of course, is the main culprit in losing the trust, and that trust can only be rebuilt with time for the wounds to heal. But this can be accelerated by undertaking some harsh structural changes, which should be made in any event, to cause the making of gruel an offense punishable by nothing less than that for bank robbery.

It is recognized that financial statements involve estimates and judgment. In some matters, these estimates can be based on solid historical experience. But, circumstances may change and the base for the estimates may need to move down a new trail. Some matters can only be based on the judgment of the management. If the estimates are virtually certain, and my experience is that there is no such thing, the softness of the estimate needs to be assessed and, depending on the circumstances and financial impact, disclosed. There is nothing wrong with being wrong if you are trying to do right, if the amount is not material, and/or is disclosed.

Even disclosure frequently doesn't get the job done. Risk disclosures tend to get buried in detailed explanations of depreciation and the other routine footnotes. We may have reached a point where footnotes need to be reported in two parts. Part I would be for informational disclosures such as basis of consolidation, basis of inventory valuation, etc., and a Part II for disclosure of matters involving financial risks. I believe this would be a major assist to an outside reader's ability to at least find the risk disclosures in the footnotes and, hopefully, to better appreciate the financial situation being reported.

But, if a management lacks the integrity to face the reality of realities, some may decide to cook. Relative to the trilogy of Excess Optimism, Fear and Greed, their optimism may, in their minds, justify the cooking. Fear of a backlash from exposing reality may reinforce the need to cook. But greed may make it essential. Cook now so as to be able to get the time to get yours while the getting is good.

What is needed are rules to punish and/or remove the economic incentive to cooking. We don't need much more in the rules of accounting, but possibly need some further rules relative to accountants. But the major need for rules is relative to managements.& It is the managements that make the gruel, which the auditors are supposed to find. The only rules needed for auditors are to make sure that their client relationship is not in conflict with the publics expectations and to strengthen the auditors' position in this "hide and seek". Then, require them to report any findings in this regard in writing to the Audit Committee and put it squarely on their backs for disposition.

The rule changes for management should not freeze out the use of good judgment, but should not allow the cooking to hide behind something alleged to be good judgment. This should keep the lawyers busy for a few years.

In addressing the need for rules to remove or at least reduce the greed motivation, some of the following might be considered:

·         Inconceivably high compensation packages for CEO's (which may also be an indicator of excessive influence of the CEO over the Board of Directors) can set up an entitlement that they may feel needs to be protected if in a downturn of financial fortunes. This compensation needs to be brought into line with some reality that will not be unacceptable to the public. Possibly, guidance more than rules is needed in this area.

�         Eliminate stock options in public companies that are financed by the company, either directly or indirectly.

�         Eliminate all golden parachute agreements with top managements in public companies. These tend to put the individuals above the entity.

�         Recovery of the proceeds on the sales of stock or any other bail-out money by top level management for at least a year subsequent to any cooking subsequently discovered.

�         Strengthen the role of the Audit Committee by giving them the authority to call a special meeting of the Board or a special meeting of the Stockholders if, in their sole discretion, the financial affairs are distorted and/or deceiving.

�         Strengthen management's responsibility for the financial statements by having them appropriately certified by the CEO and CFO, and as an additional matter, in some form, an Audit Committee Certification.

Doing right can be a gut-wrenching experience. Since I have always been in public practice, I have never had to experience these struggles from the inside of a company, but I have had my share as an audit partner from the outside. As a new audit partner years ago, I faced a situation following a change in ownership of a reasonably large client where the new owner would deal with me only through his CFO. He had some interesting ideas as to proper accounting, one of which was totally wrong and also was of a type of transaction that had to show in the text of the financials. After numerous transmissions through the CFO, I was told that they had resolved to do it his way. I sent back the message that it was his prerogative to do so, but that we would have an exception in our opinion letter which was our prerogative. This was a major fee client and he sent back the message that my partners would not support me in this matter.

Following a hurried meeting with my new partners, I returned that same day with a letter signed by our managing partner supporting my position. The client then decided to follow my recommendations. Although successful in getting them to follow the rules, it was a most stomach-churning experience until a few days later when the CFO told me that the new owner had said, "It's nice to deal with someone who has guts."

I am absolutely certain that every CPA auditor has had similar types of experiences. And those on the inside, experiencing a downturn in financial affairs, need to have a double order of guts to maintain their integrity. To all whose integrity is being tested, and to bring this writing to an end, I counsel you with Julius Caesar's admonition to his generals as they were about to take to the field, or so I have been told.

                                        "Illegitimi Non Carborundum"

It has been some time since I studied Latin, but I think he said, "Don't let the bastards wear you down."

Epilogue I - Theorem Back to Top

My main man, Galileo, would be distressed if I completed this writing without reducing cooking to some type of formulation:

Theorem -

The extent of the spin is directly proportional to the extent of the sin.

Definitions -

Sin - Gruel production.

Spin - The cover used to hide the existence of gruel.

Example:

�         Conditions - Company has had increases in sales year after year, but has now leveled off as the market has matured. The management had not expected this leveling off and had failed to introduce new products to continue the upward direction. Outsiders are expecting the sales growth to continue and management has performance-based compensations.

�         Insider Actions - If the cause of the leveling off is not yet fully appreciated and if they want their incentive money, to record some bogus sales to show a modest increase with the expectation of offsetting this gruel with good sales as the market returns to normal next year. The results wouldn't require much explanation as it generally matches the outsiders' expectations. Next year is the problem, however. Or, if the sales leveling off is recognized as permanent, to do the same bogus billing to buy some time to acquire a company with the products needed to continue the sales increase, but to book the acquisition in a manner to make the bogus billing disappear. The current spin is to announce that "a leveling off of sales is anticipated next year and your management is undertaking strenuous efforts to find a compatible company or products to acquire to continue our historical high growth level," albeit at a lower level of profits which is not mentioned. Magic is based on misdirection. In a similar manner, a high level of focus on sales along with statements such as "investing in the future" can keep the natives from becoming restless.

Axiom

There is nothing like a good dose of apprehension and fear to keep a potentially wayward management on the straight and narrow.

Epilogue II - New Law Back to Top

On July 30, 2002, at the same time that I was writing this cookbook, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Act") with the stated goal being to protect investors by improving the accuracy and reliability of corporate disclosures required under Federal securities laws relative to all public companies. The Act has many features, the major elements of which are outlined below.

�         The CEO and CFO are required to provide a written statement, to accompany each periodic report containing financial statements, that it presents fairly in all material respects the financial condition and results of operations of the company.

-          If false, they are subject to fines of up to $1,000,000 and/or imprisonment up to 10 years, and, if willful, fines up to $5,000,000 and/or 20 years.

�         A new report by a company assessing the effectiveness of their internal controls.

�         Speedier reporting of transactions - an officer, director, and principal stockholder must report transactions, such as the sale of stock, by the second business day after the transaction. Also that the company must promptly display such transactions on the company's website by the end of the day following the transaction.

�         Each company must develop a code of ethics.

�         Prohibition of direct or indirect loans to officers and directors.

�         Prohibition of officers or directors from trading during so-called "Blackout" periods.

�         Forfeiture of (1) bonuses and equity-based compensation if a company is required to restate financials due to gruel production, and (2) any profits realized from the sale of the Company's securities, both for the 12 months following the first financial statements in which gruel is found.

�         The Act provides whistle blower protection.

�         And the Act provides criminal penalties for violations of ERISA [401(k) plans are administered under ERISA].

In addition, the Act also impacts auditors of public companies.

�         It provides for Federal regulation of the public accounting profession through the newly created "Public Company Accounting Oversight Board." The SEC has "oversight and enforcement authority" over the Board.

�         Prohibition of a firm auditing public companies from providing a number of non-audit services.

�         The selection of auditors is to be a function of the Audit Committee of the Board. (I would add to this the need for the Committee to have sole authority for all fees from the auditors, in this way to avoid the auditors being whipsawed between the Committee and management.)

�         The Act delineates a number of matters on which the auditors are required to report to the Audit Committee.

�         The Audit Partner must be rotated after five years.

The above is not intended to be an exhaustive listing of the Act's requirements. There are many other provisions that will require significant study to understand their impact. But the impact of the Act should be shock therapy to all involved in the finances of public companies and I am confident that it will be just that.

As mentioned earlier in this writing, abuses lead to rules and start the pendulum of acceptability swinging. It is the natural order of things for these rules to be modified and/or additional rules developed as experience with the rules becomes understood. The Act should be an awakening and be a major step toward a re-establishment of the needed public trust.

My guess is that the number of managements that might have a tendency toward producing gruel will be significantly reduced. And, of course, they will proclaim their self-righteousness to the world, as there is nothing as vocal on misdeeds as a reformed roué'. But don't fool yourself, there will always be someone out there who thinks he is smarter than the rest of the world who will try to do his dirty deeds. The Act cannot stop all gruel, but it certainly will provide a good dose of apprehension and fear.

One matter that gives me some pause, however, is that with the emphasis the Act places on reliability of financial statements, it may cause the CEO positions to increasingly be filled by financial types. I don't think this would be a good trend. Non-technical CEO's lack the technical background and the ability to dream the dreams that are necessary to evolving high-tech entities and could stultify their development. And this could be true in other types of entities as well. We need to be watchful of this trend.

In any event, Cookers beware - the Gruel is poison.