Under The Microscope

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As questions swirled around its accounting practices, Tyco International, an industrial and services conglomerate with $36 billion in annual revenues--and a beaten-down stock price--said last week it would split into four companies in a bid to "unlock tens of billions of dollars of shareholder value." The company's combative CEO, Dennis Kozlowski, predicted the breakup would add 50% to the stock price. Going him one better, Don MacDougall of J.P. Morgan Chase said the move would make the stock worth $80 to $90 a share-- double the current price. Haven't they heard? Post Enron, any hint of questionable accounting is the functional equivalent of finding asbestos in everything a company makes. So a day that dawned with promise for Kozlowski quickly turned to loss. By week's end Tyco shares were at $45, down 3% from the day before its breakup was announced--and down 24% since fresh accounting worries surfaced at the start of this year.

Kozlowski insists that "Tyco has better disclosure in its financial statements than anybody out there." Almost two years ago, the company emerged from an informal Securities and Exchange Commission inquiry with no action against it, and in an unusual step, the SEC has put out word that no new inquiry is under way at Tyco. But while there appears to be nothing illegal about Tyco's bookkeeping, jumpy investors are suddenly setting a higher standard. They want to see clearly how a company earns, spends and invests. And Tyco--despite its planned reorganization--remains a complex conglomerate, with headquarters in tax haven Bermuda. Many investors feel it still doesn't reveal enough. Says James Chanos, president of hedge fund Kynikos Associates: "Investors just have to exercise a fair amount of diligence when looking at companies that appear confusing."

In a financial world shaking from the Enron scandal, many investors are viewing with fresh skepticism the bookkeeping methods of a range of companies, including even blue chips that are widely admired and accused of nothing illegal. Some of the companies that investors point to are American Airlines, the insurer American International Group, Coca-Cola, Electronic Data Systems, General Electric, IBM, J.P. Morgan Chase and Xerox.

These marquee names say it all. Even companies once considered above suspicion are being subjected to increasing scrutiny. Under current accounting rules, management can essentially do whatever it pleases, says David Dreman of Dreman Asset Management, based in Jersey City, N.J. It can scatter explanations in impenetrable footnotes it is confident no one has the time or capacity to decipher. "There are enormous overstatements of earnings and understatements of expenses," he says.

Enron's unraveling can be traced to investors' first whiff of "off-balance-sheet" partnerships that hid billions of dollars of the company's liabilities. By the time Enron crashed, it was primarily a trading firm. It had relatively few hard assets to cushion its fall when business faltered and hidden debts came due. The risks aren't nearly so great at asset-rich companies like Tyco and GE. But, as with Enron, seasoned analysts have trouble determining whence, exactly, they derive their profits.

Since the Enron fiasco blew wide open, the influential Moody's Investors Service has requested additional information from some 4,000 companies that use accounting methods that Moody's believes make it harder to judge their creditworthiness. Companies are also deciding on their own that confusing books just aren't worth it. Last Wednesday, Bank of America went to great lengths to explain a $418 million gain in the fourth quarter from a subsidiary set up last year to deal with problem loans. The gain resulted from tax savings after bad loans were shifted to the subsidiary. Not wanting an Enron-like taint, the bank clearly spelled out to analysts the legal maneuver, and investors rewarded the extra disclosure by pushing the stock up 4% in a week.

K Mart, which filed for Chapter 11 bankruptcy protection last week, announced on Friday that it was looking into internal accounting issues. The company offered no details. But the accounting getting closest scrutiny in the wake of Enron generally falls into three categories:

REVENUE RECOGNITION The SEC says its No. 1 line of inquiry is into the ways that companies book their sales. The most glaring example of revenue fraud occurred at Sunbeam five years ago. (The company's infamous former CEO, "Chainsaw" Al Dunlap, just last month settled a shareholder suit stemming from his stint at the small-appliance maker.) Sunbeam recorded the sale of gas grills and other goods well before they left the warehouse. Many of the items never did get shipped. By offering retailers deep discounts to place orders months before they normally would and by booking those sales immediately, Dunlap was able to show escalating revenue and earnings. Eventually, though, the scheme collapsed as retailers couldn't sell enough appliances even at discount prices and had to cancel orders.

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