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Financial Shenanigans of Tyco: The Most Shameless Heist by Senior Management

Written by : Aqila Daffa Hakimah

Designed by : Silvia Santa 

by: Aqilla Daffa Hakimah

Financial shenanigans are defined as decisions taken by a firm’s management with the intent of distorting the reported financial performance and condition of the firm. As a result, investors are often tricked into believing that a company’s earnings are stronger, its cash flows are more robust, and its Balance Sheet position is more secure than the case. Shenanigans can range anywhere from simple changes in accounting estimates to outright criminal fraud, although many are not illegal and do not even violate Generally Accepted Accounting Principles (GAAP). Yet whether legal or not, all shenanigans are designed to conceal the true operating performance of a firm, and therefore they all have an impact on shareholder value.

Some shenanigans can be detected in the numbers presented by carefully reading a company’s Balance Sheet, Statement of Income, and Statement of Cash Flows. Proof of other shenanigans might not be explicitly provided in the numbers and therefore requires scrutinizing the narratives contained in footnotes, quarterly earnings releases, and other publicly available representation by management.

There is one example of the Financial Shenanigans scandal which is called by The Most Shameless Heist by Senior Management. It is The Tyco Scandal which was happened in 2002 by Tyco International Ltd, a security systems company incorporated in the Republic of Ireland, with operational headquarters in Princeton, New Jersey, United States. Tyco International was composed of two major business segments, security solutions, and fire protection. Tyco International Ltd. loved doing acquisitions, making hundreds of them over a few short years. From 1999 to 2002, Tyco bought more than 700 companies for a combined total of approximately $29 billion. While some of the acquired companies were large businesses, many were so small that Tyco did not even bother disclosing them to investors in its financial statements.

Tyco probably liked the businesses that it was buying, but more than that, the company loved to be able to show investors that it was growing rapidly. However, what Tyco seemed to like best about these acquisitions were the accounting loopholes that they presented. The acquisitions allowed the company to reload its dwindling reserves, providing a consistent source of artificial earnings boosts. Moreover, the frequent acquisitions allowed Tyco to show strong operating cash flow, even though it merely resulted from an accounting loophole. Indeed, Tyco loved the acquisition accounting benefits so much that it even used them when no acquisitions at all occurred.

Consider how Tyco accounted for payments that it made in soliciting new security-alarm business in its ADT subsidiary. Rather than hiring additional employees, Tyco decided to use an independent network of dealers to solicit new customers. Tyco was so enamored with acquisition accounting that it decided to use this technique to record the purchase of these contracts from agents. Tyco inflated its profits by failing to record the proper expense. Moreover, Tyco inflated its operating cash flow by recording these payments in the Investing section of the Statement of Cash Flows. But Tyco had many more tricks up its sleeve. It increased the price paid to dealers for each contract, and in return, required the dealers to pay that increased amount back to it as a “connection fee” for doing business. While this arrangement had no impact on the underlying economics of the transaction, Tyco inappropriately decided to record this connection fee as income, providing an artificial boost to both earnings and operating cash flow. The boosts added up when you consider that Tyco played this game with hundreds of thousands of contracts that it purchased.

The United States Securities and Exchange Commission (SEC) reviewed Tyco’s arrangements with dealers and gave the company a “thumbs down” for its creative accounting. As part of overall billion-dollar fraud, the SEC alleged that Tyco used inappropriate accounting for ADT contract purchases to fraudulently generate $567 million in operating income and $719 million in cash flow from operations. Moreover, the SEC charged that Tyco engaged in improper acquisition accounting practices that inflated operating income by at least $500 million. Such practices included undervaluing acquired assets, overvaluing acquired liabilities, and misusing accounting rules concerning the establishment and utilization of reserves. If that were not enough, the lawsuit charged that Tyco had improperly established and used various reserves to enhance and smooth publicly reported results and meet Wall Street expectations.

Unfortunately for Tyco and its investors, the problems were far from over. During this period, senior executives (mainly CEO Dennis Kozlowski and CFO Mark Swartz) had been using the company’s cash account as their piggy bank. The government charged that these executives had been stealing hundreds of millions of dollars from Tyco by failing to properly disclose to shareholders the existence of back-door executive compensation arrangements and related-party transactions. With the board unaware or asleep at the wheel, senior executives granted themselves loans for personal expenses, many of which were secretly forgiven, effectively producing a large unreported compensation expense.

The larcenous executives at Tyco paid an enormous price. On top of a $50 million SEC penalty, the company agreed to pay a record-breaking $3 billion in restitution to settle shareholder lawsuits. Moreover, Kozlowski and Swartz were convicted of looting the company and inflating its stock price, and both were sentenced to up to 25 years in prison.

References:

Nelson, J., & Below, S. (2012). A penny saved is a penny earned: Avoiding investment losses through the early detection of financial shenanigans. Journal of Applied Finance, 22(1), 117.

MERCHANT, K. A. (1994). Schilit, “financial shenanigans: How to detect accounting gimmicks and fraud in financial reports” (book review). Menasha, Wis: American Accounting Association.

Schilit, H. M., & Perler, J. (2010). Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. Mc Graw Hill.