SIMPLE ANALYSIS FOILS ELABORATE DECEPTION

Encouragingly, elementary techniques of financial statement analysis can often expose chicanery, as demonstrated by the case of Wickes PLC.

On June 25, 1996, the British building materials retailer’s management disclosed that its 1995 profits and year-end shareholders’ equity were over­stated.

Wickes’s management explained that the accounting problem involved rebates offered by suppliers, conditioned on sales of their products reaching agreed-on levels. Llewellyn’s successor as finance director, Stuart Stradling, said that the company had credited rebates (thereby reducing its cost of goods sold) before selling enough merchandise to qualify for the discounts. At the same time, Wickes assured investors that no fraud had occurred and that the company had no plans to bring in outsiders to conduct a probe to supplement its own internal investigation. Wickes added that there was lit­tle likelihood of chairman and chief executive officer Henry Sweetbaum being compelled to repay part of the bonus he had recently received, even though it was linked to both earnings and stock performance.¹¹

Quickly reversing its earlier stance, Wickes hired both an accounting and a legal firm to examine its books and report on the company’s financial position. Chairman Sweetbaum soon resigned, but the company said that there was no evidence that he was involved in the inaccurate accounting.

Over the next two months, additional details of the financial reporting problem emerged. The prematurely booked items included not only volume­based discounts, but also payments in support of advertising and store openings. In some instances, new suppliers gave Wickes legitimate rebates as part of multiyear agreements. Instead of amortizing the amounts of the lives of the contracts, the company booked them entirely in the first year. Along with every formal contract, according to sources close to the com­pany, there was a side letter containing the true terms of the deal.¹³

As the investigation continued, analysts’ estimates of the potential over­statement of profits escalated from £15 million to £25 million. As it turned out, the overstatement totaled £26 million in 1995 alone, according to the report of the specially hired outside lawyers and accountants, which Wickes summarized for its shareholders in October 1996. Prematurely booked re­bates had also inflated earnings by £14 million in 1994 and £11 million in earlier years, producing a grand total of £51 million.

In the wake of the report, former finance director Llewellyn paid back £485,000, or 92%, of his 1995 bonus, which was directly related to Wickes’s share price. Chairman and Chief Executive Henry Sweetbaum, who had re­signed shortly after the scandal broke in June, returned £720,000, represent­ing about two-thirds of the payments he received under Wickes’s long-term incentive plan, while denying any knowledge of the scheme to overstate prof­its. The company said that Sweetbaum was not directly responsible for the system, implemented within the purchasing department, to conceal the terms on which suppliers had made the rebates.¹⁴ At the same time, Wickes de­clared that senior management had been aware of the accounting irregulari­ties at least six months before the problems became public and “should have reacted more positively to [the] warning signals.”¹⁵

As a further outgrowth of Wickes’s October 1996 report, Britain’s Se­rious Fraud Office (SFO) launched a formal investigation into the com­pany’s overstatement of profits.

According to Stuart Stradling, Llewellyn’s successor as finance director, the financial misrepresentations were “extremely well concealed and diffi­cult to find.”¹⁶ He added that the deception would have remained unde­tected even longer if the company had not chanced on some previously unavailable documentation. The investigating accountants and lawyers in­terviewed more than 200 suppliers of Wickes to determine how many had paid rebates ahead of schedule. Outside analysts, working only with public statements, could not have pieced together all of the details of the scheme.

Interestingly, though, it was a simple income statement relationship that first aroused Stradling’s suspicions. During the second quarter of 1996, sales improved, yet profits failed to rise in sympathy. Wickes had booked the upturn earnings earlier, through its premature recognition of rebates. Once Stradling joined the company in August 1995 and tightened up the company’s audit procedures, the scam had ceased to be sustainable. Wickes’s purchasing managers kept outside analysts in the dark, yet the af­fair underscores the analytical power of the elementary ratios described in Chapter 13. In other instances, such ratios, appearing in published finan­cials, have signaled the breakdown of a similar ruse to borrow profits from future periods.