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Holiday on Ice: Financial Fraud, Accounting Scandals and CFOs

One CFO barred for life, two CFOs resign, and three companies admit SEC investigations. Also, Tyco CFO's huge windfall.
Stephen Taub, CFO.com | US
January 2, 2002

Remember the Saturday Night Massacre, when President Richard Nixon quietly canned Watergate special prosecutor Archibald Cox under the cover of a weekend press release in October 1973?

Well, while many of you were distracted by the holiday week, at least six companies were quietly embroiled in accounting controversies.

Once the ink dried on the SEC filings and the press releases, one CFO was banned for life from serving at a publicly-traded company, two others resigned, the reasons for another CFO's recent resignation became more apparent, three companies said they were being investigated for possible accounting irregularities, and one company said it will restate prior results because its auditor gave wrong advice.

Here's the rundown:

On Dec. 27, the SEC filed a civil injunctive action in US District Court against Nelson Barber, the former Chief Financial Officer of Fine Host Corp., alleging that he caused the company to engage in extensive financial fraud.

Barber, without admitting or denying the allegations, agreed to be permanently barred from acting as an officer or director of a public company and agreed to pay a $20,000 civil penalty.

Fine Host, a provider of food and beverage services to sports arenas, prisons, and schools, was at that time a public company trading on the Nasdaq National Market System with a market capitalization that reached nearly $390 million. When the fraud was detected, the stock lost essentially all of its value.

The SEC also settled administrative proceedings against Rachel Eckhaus, the former assistant controller of Fine Host, Jeffrey Bascik, the engagement partner for the Deloitte & Touche audits of Fine Host's financial statements for the affected periods, and Barbara Horvath, the Deloitte & Touche manager on certain of those audit engagements.

Without admitting or denying the Commission's findings, each respondent consented to the entry of a Commission Order finding, among other things, that the respondent engaged in improper professional conduct. Horvath was censured while Eckhaus and Bacsik have been barred from appearing or practicing before the Commission as an accountant, with the right to request reinstatement after two years.

On Dec. 21--the Friday prior to Christmas--at least three companies announced that they were being investigated for possible accounting wrongdoings.

Suprema Specialties, Inc.. which makes and sells gourmet Italian cheeses, said that its Chief Financial Officer Steven Venechanos and its controller had resigned.

It also said that the company has initiated an internal investigation of its prior reported financial results and has instructed its auditors to review the company's financial records.

The same day, Homestore.com, Inc. said it will restate certain, financial statements.

"The extent of the restatement and the periods it will cover has not yet been determined," the company said in a statement.

It added that the Audit Committee of its Board of Directors is conducting an inquiry and retained independent counsel and independent accountants to assist it in connection with the inquiry.

Investors have been suspicious of the online real estate company since November when it announced a sharper-than-expected drop in earnings and warned that future results would come in below expectations.

On Dec. 6, Homestore's CFO Joseph Shew resigned for "personal reasons," according to the company, at the time. Shew became CFO in February 2001 and, prior to that, served as Vice President, Finance of the company.

Also on Dec. 21, business telephony provider MCK Communications said certain sales practices in its European operations were found to not be in accordance with accounting standards, forcing the company to restate revenues for the first quarter of fiscal year 2002 and for the second and third quarters of fiscal 2001.

The company said the sales adjustments amount to about one percent of its total revenues.

"The company is not amending its annual report, but in order to more properly reflect its interim results in accordance with applicable accounting standards, the company has elected to amend its quarterly reports," it said in a statement.

Meanwhile, earlier this week mobile power systems developer Aura Systems Inc. said in an SEC filing that the Commission has brought a civil action against Aura, NewCom (a former subsidiary of Aura), Zvi Kurtzman, Aura's co-founder; Gerald Papazian, president; and Steven Veen, chief financial officer for violations of the antifraud and books and records provisions of the securities laws.

The three executives have agreed to leave the company at the end of February.

In addition, the company and the individuals are currently discussing a possible settlement, according to the filing. "The company has engaged in conversations with the staff of the SEC regarding settlement of the matter but no agreements have yet been reached," the company said in its filing.

The action stems from an investigation into the company's financial statements for various transactions during fiscal years 1996 through 1999, the company said. The company added in the filing that it originally disclosed the investigation with a press release back in January 1999.


"The Staff advised the company that it would recommend that the SEC seek civil penalties and enjoin the companies and the individuals from future violations," Aura said in its filing. "In addition, the SEC staff would recommend that the SEC impose director and officer bars against Messrs. Kurtzman and Veen and a bar against Veen to prohibit his practicing as an accountant before the SEC."

Aura also said its Audit Committee will conduct a full review of the company's accounting controls and procedures.

And finally, KCS Energy Inc. said it is restating its 2001 quarterly financial statements after its outside auditors said that their earlier advice regarding the company's treatment of the adoption of SFAS 133--Accounting for Derivative Instruments--was incorrect.

Upon adoption of SFAS No. 133 on January 1, 2001, the company said it recorded a liability of $43.8 million representing the fair market value of its derivative instruments. All of its derivative instruments that existed at January 1, 2001 were scheduled to expire during the first quarter of 2001 or were terminated in connection with the company's emergence from Chapter 11 in February 2001, the company explained. KCS elected not to designate its existing derivatives as hedges and reported the $43.8 million ($28.5 million after-tax) currently through earnings, as a cumulative effect of an accounting change.

"The outside auditors now believe that the company's initial adoption of SFAS No. 133 was incorrectly reported through earnings as a traditional cumulative- effect type component of net income at January 1, 2001," the company said in a statement. "Rather, the outside auditors have advised the company that their current view is that SFAS No. 133 requires the company's derivative instruments that had been designated as cash flow hedges under accounting principles generally accepted prior to the initial application of SFAS No. 133 continue to be accounted for as cash flow hedges with a transition adjustment reported as a cumulative- effect-type adjustment to accumulated other comprehensive income, a component of stockholders' equity, and not recognized currently through earnings.

Under the provisions of SFAS No. 133, if a derivative instrument accounted for as a flow hedge is sold, terminated or exercised, the net gain or loss shall remain in accumulated other comprehensive income and be reclassified into earnings in the same period or periods during which the hedged anticipated transaction affects earnings, the company explained. "Accordingly, even though all of the company's derivatives that existed at January 1, 2001 either expired or were terminated during the first quarter of 2001, accumulated other comprehensive income will be reclassified into earnings over the original term of the derivative instruments, which extended through August 2005."

Downgrades Trounced Upgrades in 2001
Moody's Investors Service said that rating downgrades nearly tripled upgrades for US corporations in 2001.

This marked the fourth year in a row in which US corporate rating downgrades outpaced upgrades. It also was the steepest decline in corporate credit worth since 1991.

The reason for this trend: Rapid increases in corporate debt growth and overly optimistic profit forecasts in the late 1990s coupled with a steep slide in corporate earnings in 2001 as well as special events such as the terrorist attacks, says Moody's.

"Moody's expects that the deterioration in US corporate credit quality will begin to ease next year, although, rating reviews and rating outlooks hint that rating downgrades will again lead upgrades in 2002," it says in a press release.

The rating agency adds that a modest rebound in corporate cash flow, slower debt growth, and declining interest expense should create a more favorable credit environment in 2002. It says that improvement will likely be limited by excess global capacity and a possible increase in borrowing costs in the second half of the year.

Specifically, through December 17, Moody's says that ratings of 616 corporations were downgraded in 2001, affecting $825 billion of debt. Ratings of 214 corporations were upgraded, affecting $412 billion of debt.

Moody's says the industries that suffered the most downgrades were the airlines, high-tech, manufacturing, and utilities sectors, which were negatively affected by excess capacity, but also special events including the California energy crisis, and the September 11 terrorist attacks.

In the speculative-grade sector, Moody's says that downgrades exceeded upgrades by a factor of 3.6-to-1 last year, versus 2.2-to-1 among investment-grade credits.

On the positive side, Moody's says credit quality strengthened among US banks and financial institutions, which experienced 54 upgrades on $261 billion of debt versus 36 downgrades affecting $47 billion of debt. "Good core earnings and greater revenue diversity enabled financial institutions to withstand weaker asset quality and economic shocks without having to cut back on credit availability," Moody's says in its press release. "The health of financial institutions could well be the crucial factor distancing the US economy from a broad credit crunch."

The credit quality of corporations and governments outside the US did not suffer as badly.

Downgrades outnumbered upgrades by a margin of more than two-to-one, the rating agency says. "This represents a turnaround from 2000, when rating upgrades exceeded downgrades by a more than two-to-one margin outside the US," it adds.


Hardest hit: Borrowers in Western Europe, Japan, Canada, and Argentina.

However, markets in Eastern Europe, Asia, Mexico, and Russia benefited from more credit rating upgrades than downgrades.

"Weak capital spending, a modest rebound in global trade, and sluggish developed economies will continue to sustain pressure on credit quality in 2002 outside the US," Moody's says in a statement.

Through December 21, Moody's reports that the ratings of 510 issuers outside the US were downgraded affecting $3.8 trillion of debt while ratings of 222 issuers were upgraded, affecting $738 billion of debt.

In Brief

Citigroup also beat out Merrill for the top spot for global debt, equity and equity-related underwriting, a more than $4 trillion market.




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