Accounting's Perfect Storm


WorldCom's revelation in June that it improperly allocated $3.9 billion in expenses during the past five quarters, or longer, set a low-water mark in the current tide of accounting scandals. Most likely it's not the lowest. And identifying the next scandal may simply be a process of wading through the risk factors.

Robert Simons, a professor at Harvard Business School, suggests that a confluence of events has created a climate in which accounting fraud isn't just possible, it's likely. This, he says, is accounting's perfect storm: the conjunction of unprecedented growth with inordinate incentive compensation, executive inexperience, and an extremely aggressive management culture. "Taken individually, some of these may be good news. But when they all come together, it's a disaster waiting to happen," says Simons, who has developed a Risk Exposure Calculator to gauge the degree of each factor.

There's no denying that many of these risk factors exist today. The intense growth of the late 1990s, coupled with investors' keen focus on profits, has placed a strain on many corporate officers. "As management comes under increasing pressure, a mentality develops of 'make the numbers at almost any cost,'" says Simons. At companies that didn't make the numbers, even by as little as a penny, the stock price tanked and put CEOs' and CFOs' jobs at risk, he adds.

Pressure to make the numbers was especially intense at WorldCom, which was growing at breakneck speed (an average of 58 percent per year from 1996­2000), mostly through acquisitions. In fact, CFO magazine singled out then-CFO Scott Sullivan in 1998 for excellence in M&A, after he and then-CEO Bernard Ebbers pulled off the biggest merger up until that time with the purchase of the much-larger MCI.

That kind of growth is exceedingly difficult to manage. "When a company is growing that fast, [managers] are struggling to keep their heads above water just to run the business," says Peter McLean, an executive recruiter at Spencer Stuart. "It comes at the expense of good, solid operating procedures."

At WorldCom, the pressure for growth was compounded by management inexperience. While still in his mid-30s, Sullivan was suddenly controlling the finances of one of the largest companies in the United States. "There is a sense of hubris that develops among managers that they are these great heroic figures, and that they are almost invincible," says Simons.

In addition, WorldCom's faulty information systems made it far from invincible. The firm completed more than 60 acquisitions in a short period of time. "Accounting for those gets complex," says Simons. "It's difficult to do trend analysis." Moreover, assimilating so many firms often leads to a culture in which information doesn't flow up, because managers have different allegiances. "At a broken company, people don't tell the truth," says Steve Priest, president of the Ethical Leadership Group. "They either fear retaliation or think that no one will listen."

Greed And Ego

Still, despite all of these risk factors, individual executives have a responsibility to conduct themselves with integrity. And while plenty of CFOs feel pressure to fudge the numbers, only a small minority do so. "Ultimately, it comes down to greed and ego," says Frank Borelli, retired CFO of insurer Marsh Inc. "In these cases [of accounting fraud], CEOs and CFOs lost sight of their fiduciary responsibility to shareholders and focused on building wealth for themselves." Indeed, Sullivan received a $10 million retention bonus in 2000, and reportedly cashed in stock worth $30 million during his tenure at WorldCom.

While Sullivan's actions are indefensible, clearly the system of checks and balances broke down around him as well. "Our free-market system does not depend on executives being saintly or altruistic," says Simons. "But markets do rely on institutional mechanisms, such as auditing and independent boards, to offset opportunistic, not to mention illegal, behavior." Perfect those controls, and companies should be able to weather any storm.


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