Study Finds Link Between Aggressive Accounting, Non-AccountingLawsuits

A bent toward aggressive accounting is a red flag for directorsand officers insurers looking to spot future defendants insecurities class actions--including those that have nothing to dowith accounting restatements, according to a research group.

In fact, a report published by Criterion Research Group earlierthis year found that the heaviest users of accounting accruals facefour times more non-accounting securities class actions--thosewithout any accounting allegations--than companies with the lowestlevels of accruals on their financial statements.

Neil Baron, chairman of the New York- based research firm,explained that accruals are non-cash items on accountingstatements. "They affect earnings, but there's no cash in and nocash out," he said. A simple way to look at it is to say thataccruals are the difference between earnings and cash flow, heexplained.

(Editor's Note: Under accrual accounting, companies attempt torecord revenue and other income items when they are earned orincurred, instead of when they are received or paid as under a cashaccounting approach.)

Criterion and other research firms have previously demonstrateda strong correlation between accounting-related class actions andoveruse of accruals. (See NU, Oct. 14, 2004, for a report onsimilar research by New York-based Advisen.)

Explaining the less intuitive, recently discovered link betweenaggressive use of accruals and non-accounting securities classactions, Mr. Baron said: "You can have a securities class actionthat's based on misrepresentation that has nothing to do withaccounting. If investors bought stock based on some touting of anapproval of a drug," for example, "and it turns out that was wrong,then you're going to have a securities action" on behalf ofstockholders when the stock drops in response to news that the drugwasn't approved.

Executive teams that rush products to market before they'refully tested--resulting in products liability lawsuits--and thosethat make overly optimistic pronouncements about product approvals,are often the same executives who feel pressured to meet WallStreet earnings targets and resort to aggressive revenuerecognition, he said.

Non-accounting securities class actions are by no means atrivial matter for D&O liability insurance underwriters.

According to litigation statistics compiled byPricewaterhouseCoopers (available at www.10b5.com), there have been79 non-accounting securities class actions this year. (In total,securities class actions as of Nov. 1--both accounting andnon-accounting cases--numbered about 145, according to PWC. Othersources--such as Stanford Law School in cooperation withCornerstone Research--put filings to date at 160, but do not splitout non-accounting cases.)

Accounting missteps, of course, have been the big news--and thebig driver of securities suits in recent years, with executives ofEnron and Worldcom serving as the poster boys for bad accountingbehavior. In fact, the steady stream of accounting blow-ups thatresulted in a surge of securities lawsuits helped coax Mr. Baronout of the retirement some years back to start the researchgroup.

The former general counsel of Fitch couldn't help but beintrigued by developments in corporate America. "We went back andlooked at the 10Ks and 10Qs of companies that blew up, and nine outof 10 times, it was there," he said, referring to evidence ofearnings manipulation through non-cash accruals. "You could see it,if you looked in the right place.

Providing an example of one area ripe for abuse, he said acompany might have a five-year contract with the government, forwhich revenue is booked based on the percentage of work completedunder generally accepted accounting principles.

"You might have a situation where the executives have options,but they're about to run out and the stock price is below thestrike price," he continued. When the CFO tells the CEO that oneyear's worth of work has been completed, the CEO may persuade theCFO, instead, to book two years under such a scenario, he said.

"That increases current earnings even though you haven'treceived the cash," Mr. Baron explained. "And what happens the nextyear? Obviously, net earnings are going to suffer," he added.Similarly, companies can abuse the reporting of bad debt reservesby underreporting them, he said, noting that companies that do thisalso borrow from next year to bolster current earnings.

Mr. Baron noted that all companies use accruals, and overaccruedrevenues or underaccrued debts can result from honest mistakes"Nevertheless, it creates poor earnings quality because yourearnings are not going to persist," he said.

For its studies, Criterion quantifies the portion of accruals inthe earnings of 5,400 public companies. It then ranks the companiesin 10 categories--or deciles--putting those having the highestaccrual components in the 10th decile, and those with the lowest inthe first decile.

According to Criterion's latest research, there were nearly sixtimes more accounting-related securities class actions againstcompanies in Criterion's 10th decile than in the first accrualdecile as of the class start date--the date on which the lawsuitalleges misleading information was first in the market. There werealso four times more non-accounting securities class actionsagainst companies in the 10th decile than in the first as of theclass start date.

"When we identified a class action, we went back and saw whataccrual decile the company was in for the period it got sued," Mr.Baron said, noting that all class action securities cases from 1996through April 2005 were studied. If a company got sued in 2005 foractions in 2003, Criterion looked to see what decile the companywas in for 2003, he said. The correlations were revealed throughthese hindsight tests.

Working in the reverse direction, D&O insurers can useinformation about deciles to underwrite and price policies forpotential insureds going forward. "We found that 90 percent of theclass actions are brought within three years of the bad behavior,"Mr. Baron said.

For one type of forward test, Criterion put companies intohigh-risk and low-risk buckets based on the time frames they stayedin high or low deciles. Companies that remained in the ninth or10th deciles for four consecutive quarters at some time during thepast three years were categorized as high risk, while those thatwere never above the sixth decile were put in the low-riskcategory.

While Criterion notes there are endless possibilities fordefining such categories, these particular classifications provedto be predictive. Companies that fell in Criterion's high-riskbucket represented about 21 percent of the universe of companies,but about 37 percent of all class actions--accounting andnon-accounting--and 41 percent of accounting class actions.

Low-risk companies, on the other hand, which accounted for 19percent of all companies, faced only 8.4 percent ofaccounting-related class actions and 8.8 percent of all classactions after exhibiting low-risk patterns.

Mr. Baron explained that subscribers to Criterion's research canalso go to Criterion's Web site, type in a company's stock tickersymbol, and not only view the decile history but also view a barchart showing which accrual items are high contributors toearnings. Clicking on a particular bar--say, receivables or othernon-current assets--will bring up an explanation of why a highpercentage might raise a red flag for companies in highdeciles.

This, in turn, can help the D&O underwriter dig deeper,understanding what questions need to be asked to make informeddecisions about extending coverage or pricing a risk.

"We picked up Krispy Kreme before it crashed because it showedthe category 'other non-current assets,'" Mr. Baron said,explaining that the doughnut franchiser had a disproportionatelyhigh amount of goodwill (an intangible asset) on its books.

Turning to receivables, he said a company that shows high growthin receivables may be boosting revenues by booking sales tocustomers with weak credit profiles--or just booking fictitioussales.

Such companies are going to be irresponsible in other areas."It's a matter of behavior," he suggested, adding that whilecompanies engaged in accounting trickery remain a small percentage,D&O carriers need a means of trying to pick them out of theuniverse of potential insureds.

Subscribers to the research on Criterion's Web site pay between$25,000 and $50,000 per year, depending on the number of users, Mr.Baron said. A new feature, useful to reinsurers, allows subscribersto input a portfolio of companies (for example, a primary insurer'sD&O book) to view the distribution of limits in high- andlow-risk categories, he said.

Infographic: (with art of pulling cash out of a magician's hat)

Flag: By TheNumbers

Head: Accounting Trickery

According to Criterion's latest research:

o There were nearly six times more accounting-related securitiesclass actions against companies in Criterion's highest accrualcategory (10th decile) than in the first accrual decile as of theclass start date.

o There were four times more non-accounting-related securitiesclass actions against companies in the 10th decile than in thefirst decile as of the class start date.

o High-risk companies--those which remained in the ninth or 10thdeciles for four consecutive quarters at some time during the pastthree years--represented 21 percent of the universe and faced 37percent of securities class actions.

o Low-risk companies--those that were never above the sixthdecile during the past three years--represented 19 percent of allcompanies but faced only 8.8 percent of securities classactions.

o The three-year period was selected because Criterion alsofound that roughly 90 percent of class actions are brought withinthree years of the date on which false information entered themarket (the class start date).

FYI

There's no correlation between industry groups and accrualdeciles, according to Neil Baron, chairman of the New York- basedCriterion research firm. In fact, industry classes from chemicaland drug producers to apparel makers--and even insurance agents andbrokers--have companies ranked in every decile from 1 through 10,NU found when granted access to Criterion's site.

Callout, if needed to fill jump:

Criterion's research supports the theory that management teamsthat behave irresponsibly when booking revenues or other accountingitems will also be irresponsible when pushing out products.