CHAINSAW AL
Lilly Tulip, Crown Zellerbach, and Scott Paper. In that pursuit, he pushed hard on the accounting principles to make them yield the numbers he coveted.
Later on, however, a reexamination of the company’s originally reported 1997 financial statements rejected huge chunks of earnings that the auditors had deemed consistent with GAAP.One source of Sunbeam’s supposedly robust 1997 profits, according to the accounting firm that the company’s board hired for the review, was an excessively large restructuring charge in 1996. (The Securities and Exchange Commission subsequently alleged that the massive charge-off had created “cookie jar” reserves, which Dunlap’s management team later reversed to inflate 1997 earnings.14) In addition, Sunbeam reduced its 1997 reported income by $29 million to undo the recognition of bill-and-hold sales. These were transactions in which the company booked sales while arranging to deliver merchandise to customers at a later date, rather than shipping it immediately. In one case, a distributor that (according to Sunbeam’s revenue account) bought $4 million of electric blankets was paid a one-percent-a-month fee to hold the items in storage.15 Sunbeam shipped another $10 million of blankets to a warehouse that it rented near its Hattiesburg, Mississippi, distribution center, booking a sale to Wal-Mart despite keeping the goods in the warehouse for weeks.16 A further $36 million of retroactive reductions in income resulted from invalidating sales made under such liberal return policies that they could be considered consignments, rather than bona fide sales under GAAP.
Although such practices were not previously unheard of in the corporate world, the Dunlap regime refined them to new levels.
Indeed, Chainsaw Al inspired one of the most lyrical descriptions of accounting practices we have ever encountered, in an article penned by Jonathan Laing of Barron’s shortly before Dunlap got the boot:Sunbeam’s financials under Dunlap look like an exercise in high-energy physics, in which time and space seem to fuse and bend. They are a veritable cloud chamber. Income and costs move almost imperceptibly back and forth between the income statement and balance sheet like charged ions, whose vapor trail has long since dissipated by the end of any quarter, when results are reported.17
Confronted with the overall conclusion of the board-mandated accounting review, which nullified 65% of the net income that the master of corporate turnarounds had claimed to produce in 1997, Dunlap dismissed the whole affair as a bunch of “technical accounting issues.”18 For investors, however, the fluff in the originally reported numbers had a substantial dollars-and-cents impact. On June 22, 1998, when the Wall Street Journal reported that the SEC was probing Sunbeam’s accounting practices, the company’s stock plummeted by 22% to close at S81‰. That was on top of an earlier plunge from $53 on March 4, as Sunbeam, unable to maintain the earnings momentum produced by artificial means in 1997, reported a first-quarter loss. Still worse news was to come, as the company filed for bankruptcy in February 2001.
The restatements of 1997 earnings came long after the fact, but the problems were apparent to some observers much earlier. In March 1998, three months before the board of directors ordered a reexamination of the results that the external auditors had certified for the preceding year, a 26- year-old Sunbeam internal auditor raised a red flag about the Dunlap team’s financial reporting practices. Deidra DenDanto, formerly of the accounting firm of Arthur Andersen, stated in a memo (which never reached the board) that booking the bill-and-hold transactions as sales was “clearly in violation of GAAP.”19
Even without the benefit of an inside look at the numbers, other practitioners of basic financial statement analysis voiced skepticism that ultimately proved well founded.
A year before the board authorized its review, Laing of Barron’s argued20 that the large reserves taken in 1996 for litigation and bad debts might be drawn on to boost future earnings. He further pointed out that the $90 million inventory write-down could boost 1997 earnings as the goods in question were sold. Additionally, Laing observed that after making much bigger allowances for bad debts than in the immediately preceding years, Sunbeam could potentially juice its 1997-1998 earnings by cutting back on bad-debt provisions. The Barron’s contributor also pointed out that in light of the company’s sizable write-down of property, plant, and equipment and trademarks, one would expect depreciation and amortization charges to decline in 1997, yet they were on the rise. This raised the possibility that Sunbeam was capitalizing certain advertising and product-development costs previously expensed, which would be allowed under GAAP but considered aggressive. Finally, Laing reported that a 13% surge in sales during 1997’s first quarter had prompted the press to speculate about possible “inventory stuffing” (see “Loading the Distribution Channels,” in Chapter 6).With the financial statements raising eyebrows both inside and outside the company, why did the auditors fail to curb the Dunlap regime’s aggressive reporting practices? Insight into this question is provided by the tale of the spare parts. Briefly, Sunbeam stored spare parts for the repair of its appliances in the warehouse of a company known as EPI Printers. Near the end of 1997, Dunlap’s colleagues hatched a scheme to sell the parts to EPI for $11 million and book a profit of $8 million. When EPI balked, saying that it believed the parts to be worth only $2 million, Sunbeam induced the company to sign an “agreement to agree” to pay $11 million, with a clause allowing EPI to opt out of the deal after year-end. With that contract in hand, Sunbeam booked an $8-million profit.
When the accounting firm partner in charge of the Sunbeam audit objected that GAAP did not permit such treatment, Dunlap’s minions commenced a negotiation. They agreed to knock $2 million off the recorded profit, leaving an amount that the partner deemed immaterial. In the end, the auditors provided a clean opinion on Sunbeam’s 1997 statements, despite a number of such messy little items.21Floyd Norris, the journalist who brought the spare parts tale to widespread attention, filed an even more remarkable story following Sunbeam’s bankruptcy filing in 2001.22 The New York Times columnist found that in August 1976, Al Dunlap was fired as president of Nitec, a paper mill operator in Niagara Falls, New York. Dunlap’s abrasive management style was reportedly the cause. A short while later, Nitec’s auditors concluded that far from earning a profit of nearly $5 million in the fiscal year ended September 30, 1976, as had been expected, the company had suffered a $5.5 million loss.
When Nitec canceled an agreement to repurchase Dunlap’s stock in the company, he sued and was promptly countersued by Nitec, which alleged that a fraud had occurred. According to Norris, whose employer obtained the relevant court records from the National Archives, the auditors found evidence of nonexistent sales, overstated inventory and cash figures, and unrecorded expenses. Albert J. Edwards, Nitec’s former financial vicepresident and the principal witness against Dunlap, testified that Dunlap had ordered him to falsify the financial reports to meet profit targets.
Chainsaw Al called Edwards’s testimony “outrageously false.” Indeed, the witness had denied, in an earlier deposition, that he had played any part in cooking the books. Dunlap also suggested that Nitec’s principal owner was trying to drive down earnings to reduce the amount he would have to pay him under a stock repurchase agreement.
Whatever the truth of the matter was, Dunlap omitted any mention of his Nitec stint from his self-celebratory book. The executive search firm that Sunbeam retained in connection with hiring Chainsaw Al failed to uncover the gap in his resume, a classic red flag, even though Norris turned up mentions of Dunlap’s tenure at Nitec, using electronic retrieval services. More diligent checking might have given Sunbeam’s board second thoughts about hiring a chief executive whose commitment to accurate financial reporting had been questioned.