Financial Accounting Blog

Sunday, October 12, 2003

This article from the WSJ talks about Tyco's recent woes over the $26 million of goodwill shown on their balance sheet and the potential impact of a write-down.

Tyco's Problems On Accounting May Not Be Over
By Mark Maremont and Jonathan Weil. Wall Street Journal. (Eastern edition).New York, N.Y.: May 5, 2003. pg. C.1
Copyright Dow Jones & Company Inc May 5, 2003

TYCO INTERNATIONAL Ltd. wants investors to think its accounting woes are over. After discovering yet another round of faulty bookkeeping, Tyco Chief Executive Edward Breen assured investors last week that "we believe we have identified all or nearly all" past accounting problems.

But some accounting experts aren't so sure. For starters, they say Tyco International didn't even correct its past errors the right way. In an attempt to set the record straight, Tyco took five years worth of problems and lumped them into one-time charges that chopped more than $1.6 billion from this year's pretax earnings. But what the company should have done, these experts say, is to restate past results -- a far more severe step.

They also believe Tyco has yet to grapple with another issue: $26 billion of "goodwill" on its balance sheet. Goodwill is the asset that a company records when it pays a premium over net asset value to buy another company. Some critics say it appears that figure was inflated by improper acquisition accounting during Tyco's go-go years under its prior management. Even if the goodwill was recorded properly, these critics argue it should be written down because it has become less valuable as Tyco's fortunes faltered. Any large write-downs could put Tyco in hot water with its lenders.

The difference between charges and restatements is more than academic. A restatement would be an admission that the numbers Tyco originally posted were materially inaccurate. That could be costly for Tyco and its auditor, PricewaterhouseCoopers LLP, in shareholder litigation. Although shareholders already are suing, primarily over allegations that former Tyco executives looted the company, attorneys say a restatement would make the plaintiffs' case much stronger.

Tyco spokesman Gary Holmes says the company, its auditors and its lawyers concluded that the accounting charges weren't material to past results, and therefore no restatement was needed. But Mr. Holmes says Tyco plans to discuss this analysis with the U.S. Securities and Exchange Commission staff, and "we will, of course, abide by their guidance." Steven Silber, a spokesman for PricewaterhouseCoopers, says, "We concurred with the company's belief that its prior financial statements do not require restatement."

As for the goodwill issue, Tyco referred to comments made by David FitzPatrick, its chief financial officer, who said last week that the matter would be reviewed July 1, but "we certainly do not expect any impairments at this stage."

Mr. Breen came to Tyco last July vowing to quickly clean up Tyco's books, but instead has dribbled out disclosures of accounting problems four times in six months, with the running total now more than $2.1 billion. By not biting the bullet on the need for a restatement, Mr. Breen raises further questions about his oft-repeated commitment to make Tyco's accounting more conservative and transparent, some critics say.

Lynn Turner, an accounting professor at Colorado State University and a former chief accountant at the SEC, says it appears that Tyco's accounting adjustments are so significant that it should "have to restate" its earnings. "Failure to do so," he adds, "will only continue to leave a cloud of doubt hanging over this company's financial reporting."

For now, at least, the marketplace is shrugging off the latest round of ugly news -- perhaps relieved that the accounting problems weren't even more significant. Tyco stock has climbed 9% since news of the new charges broke in The Wall Street Journal last Wednesday. The shares stood at $16.78 at 4 p.m. Friday in New York Stock Exchange composite trading. Based in Bermuda but managed from the U.S., Tyco is a conglomerate with about $36 billion in annual revenue and operates in electronics, fire and security products, medical supplies and other industries.

The question of when to restate financial results can be a difficult one, involving considerable judgment. The standard long has been that a restatement is required if errors would have been "material" to prior periods' results.

Concerned that companies were defining materiality too narrowly, the SEC staff in 1999 tried to tackle the issue. They said, among other things, that a number is material if it would have influenced the opinion of a "reasonable" investor had it been properly recorded to begin with. They also said that if accounting practices were intentionally misleading "to impart a sense of increased earnings power, a form of earnings management, then by definition amounts involved would be considered material."

Tyco's Mr. Holmes says that the company examined that issue, but "an intention to mislead hasn't been determined yet."

But Tyco's own statements and actions seem to belie that. In announcing the latest round of accounting problems last week, Mr. Breen said he had a "zero-tolerance policy here regarding the type of conduct that has given rise to some of the charges." He added that he planned to fire "a number of people . . . because of the issues we identified." Mr. Breen fired several others in March after a prior round of accounting discoveries.

Further, in a Tyco-commissioned report in December, attorney David Boies said he found a general "pattern of aggressive accounting" that was "undertaken with the purpose and effect of increasing reported results." Although the Boies report has since come under fire because it failed to find problems that led to the additional charges, it clearly implicated Tyco's old management in earnings manipulation.

Charles Mulford, an accounting professor at Georgia Institute of Technology in Atlanta, who examined Tyco's filings, says "any reasonable person would conclude this was earnings management," adding "that suggests that a restatement would be the appropriate accounting treatment."

In general, companies and auditors "try like the dickens to avoid restatement," says Sean Coffey, a partner at the New York law firm Bernstein Litowitz Berger & Grossmann, which represents plaintiffs in securities-fraud lawsuits but isn't involved in Tyco litigation. When a company restates, he says, plaintiffs no longer have to prove the original financial statements were wrong.

Abraham Briloff, emeritus professor of accounting at Baruch College in New York, has blasted the Boies report as a whitewash -- in part because it found nothing wrong with Tyco's goodwill accounting. In a commentary published last month in Accounting Today, Mr. Briloff pointed to Tyco's year ended Sept. 30, 2001. Aside from its purchase of the since-sold CIT Group Inc., the company that year paid $11.4 billion for acquisitions, recording $13.3 billion of goodwill.

One explanation for why goodwill would be so large, according to Mr. Briloff: When Tyco bought those companies, it may have artificially inflated the size of their liabilities and understated their hard assets. That would have the effect of depressing future depreciation and amortization expenses, thus boosting future earnings. Under new accounting rules first announced in 2000, goodwill, unlike hard assets, can remain untouched on a company's balance sheet until management concludes its value has permanently declined.

Tyco's goodwill, Mr. Briloff contends, was "severely, excessively overstated," and must be restated. Other accounting experts say several recent developments at Tyco, including the departure of top management and sharp declines in profitability and market value, are normal indicators that goodwill has declined in value. Companies that recently have taken multibillion-dollar goodwill write-downs include AOL Time Warner Inc. and Nortel Networks Corp.

To see how significant goodwill is to Tyco, look at the company's March 31 balance sheet. It shows $25.39 billion in shareholder equity, or assets minus liabilities. Of that, $26.03 billion is goodwill, meaning the company's shareholder equity would be negative without the goodwill. Any substantial write-down in goodwill would send shareholder equity plunging, potentially putting Tyco in default of one credit agreement that caps its total debt relative to total capitalization, or total debt plus shareholder equity.
Mr. Holmes, the Tyco spokesman, declines to address Mr. Briloff's analysis directly, but says the company has a "significant cushion in the ratio should any goodwill write-downs be required."