NEW YORK -- Could the apparel industry have an Enron in waiting?
Accounting irregularities in the apparel trade have tended to be less sophisticated than the intricate web of global lending, leasing and laundering alleged to have been practiced by the bankrupt energy giant. but it's had its own peculiar brand of numerical improvisation.
"I don't know about today but the fashion world historically has been known for keeping the books fast and loose," said Michael Young, litigation partner at Willkie Farr & Gallagher and an expert on the issue of financial fraud.
Beyond the standard tricks of the trade, such as two sets of books and distorted valuations of inventory, the industry's publicly held firms have had their share of government investigations, criminal indictments, convictions and eye-catching earnings restatements:
Upscale retailer Barneys New York was under investigation by the Manhattan district attorney's office shortly after it filed its Chapter 11 petition in January 1996. The probe involved financial information that the company provided to investors in a private syndication four months prior to the bankruptcy filing. The financial statements used were later "adjusted" during the pro forma period before the company filed its official yearend results. The D.A. subpoenaed numerous Barneys executives, including those in the accounting department. No charges were ever filed and the company exited bankruptcy proceedings in 1999.
In a $130 million fraud scandal, the former Leslie Fay Co. in 1993 said that it discovered that false accounting entries turned profits into losses in 1991 and 1992, causing restatement of those periods and forcing the company into bankruptcy. Paul F. Polishan, former chief financial officer of Leslie Fay who was convicted in July 2000 of orchestrating the elaborate financial fraud, was sentenced to nine years imprisonment last month. Former controller Donald F. Kenia was sentenced in October 2001 to two years in prison, two years of supervised release and 500 hours of community service.
Maurice "Corky" Newman, former chief executive officer of swimwear manufacturer Sirena Apparel Group Inc., and Richard Gerhardt, former cfo, both pled guilty in April 2001 to securities fraud in a Los Angeles federal court. Accounting fraud was one of the counts against them in an October 2000 indictment for their role in the fraud. The two were charged with falsely inflating Sirena's third-quarter 1999 earnings by 30 percent and tampering with computer clocks in order to hold open the quarter long enough to meet analysts' expectations. The company, which entered bankruptcy in June 1999 and emerged in August 2000, has since sold its trademark to New York-based swimwear manufacturer A.H. Schreiber Co.Bankrupt Warnaco Group in August 2001 disclosed that it needed to take a $43 million charge to earnings in the third quarter in connection with the restatements of earnings for the past three years, "to correct certain errors" discovered in its recording of intercompany price policies, accounts payable and accrued liabilities. A Securities and Exchange Commission probe is ongoing. No criminal charges have been filed.
Richard Rubin, Donnkenny's former chairman and ceo, in September 2000 was sentenced to a three-year supervisory release program for committing securities fraud that overstated Donnkenny's sales figures by millions of dollars through journal vouchers that recorded numerous fictitious sales. Rubin was ordered to pay restitution of $111 million. According to charges filed by the U.S. attorney's office in Brooklyn, Rubin directed a scheme from 1994 through 1996 to inflate and misstate Donnkenny's financial results in reports filed with the SEC and in press releases issued to the company's shareholders as well as to the investing public.
Financial professionals contacted by WWD rate as unlikely the chances that an Enron-like debacle could occur in apparel, mostly because apparel firms tend to be smaller in scale and, therefore, not as complex. Even the larger apparel conglomerates and retailers, they said, probably wouldn't encounter anything similar to the magnitude of Enron because they tend not to have offshore partnerships, which were a key hiding platform for the bankrupt energy trading firm.
Gilbert Harrison, chairman of investment banking firm Financo Inc., observed that many of the people who head up the firms that form the backbone of the industry aren't "sophisticated enough" to perpetrate such a massive fraud. He, of course, was referring to how most firms are started by entrepreneurs with a creative bent for merchandising and selling, rather than concocting elaborate fiscal schemes.
Arnold Cohen of Mahoney Cohen, an accounting firm with many fashion industry clients, observed: "The bulk of our industry is privately owned, generally serviced by different practitioners than the big five accounting firms. The audience that the financial statements of these family-owned businesses are going to are financial institutions, the lenders such as banks and factors and credit firms. In many cases, information is disseminated on an almost-daily basis, often providing enough checks and balances between the parties."Although there may be some improprieties here and there, he said, they haven't been near the magnitude of an Enron. Cohen explained: "The bigger guys have more financial tools. This industry is more hand-to-mouth. The Enrons of this world operate in a different arena and deal with bigger bucks."
Emanuel Weintraub of Weintraub & Associates, consultant to apparel firms, touched on a more common fraudulent practice -- the inflation of inventory value. "It is not widespread and usually the bankers and accountants catch it. Enron had accounting issues, and the middle-market accounting firms who service the private and public mid-market fashion firms are very solid. They have to be extremely careful about the absolute integrity of the balance sheets and operating statements because they depend on lenders for their business. Often, it is the lenders who recommend the accounting firms and, in turn, lend to the fashion companies based on the integrity of the accounting firms and their reports."
A factor observed: "Every once in a while it crops up, whether it is intentional or sloppy reporting that gets out of hand. Maybe the inventory valuation is wrong or we didn't realize there was a prebilling of shipments. Even when it comes up, the improprieties are not the sort that has one looking at the accounting firms. It is still not as ugly as Arthur Andersen shredding documents."
Accounting mistakes sometimes can also be just that -- errors made through inexperience or happenstance.
Guess Inc. had to recast its earnings for the first three quarters of 2000 after overstating them in the first two periods and understating them in the third. The mistakes came when the denim firm classified certain costs -- related to real estate and computer systems -- as capital spending that should have been treated as expenses because it failed to record accurate inventory levels while it was relocating its distribution center.
Late in 2000, Guess' cfo resigned and Carlos Alberini was brought on as president and chief operating officer. He said at the time that the accounting mistakes were clearly unintentional and were due to a "lack of knowledge of some people." Co-chairman and co-ceo Maurice Marciano added: "I am confident that with Carlos on board and with all the steps we have taken to improve financial controls and procedures, we will avoid similar issues in the future."Dollar General Corp., a Goodlettsville, Tenn.-based off-pricer, undertook a sweeping review of its practices after it reduced earnings per share by 30 cents for the three-year period starting in 1998 because of accounting irregularities. The revelation first came to light a little more than a month after the firm named James Hagan its new cfo. The retailer said last month that it settled a class-action lawsuit that resulted in charges of $99 million.
William Blair & Co. equity analyst Mark Miller in a research note praised the accounting procedural changes that the company made after their internal review, specifically "more conservative accounting policies, particularly for accrual of [selling, general & administrative expenses] and treatment of certain operating leases as capital leases." Miller added that the hiring of Hagan as cfo was "an important first step -- as he was likely a catalyst for bringing the accounting irregularities to light."
Dollar General had three cfo's in as many years, and the tenures of two encompassed the period that was restated. Michelle Barishaw, a Fitch Ratings debt analyst, observed that one sign of possible accounting difficulties is "ongoing changes in the finance area or the ceo slot." This could be the reflection of executives seeing something they're not comfortable with, she said.
That said, there are no guarantees that the fashion and retail sector won't see a blowup at some point in time.
According to Harrison: "If a company really wants to devise a scheme to hide earnings, report different earnings or inflate earnings -- whether through offshore partnerships, minority-owned companies or any other methodology -- it'll find a way to do it."
That, of course, can make it difficult to ascertain for sure if the books are in order when considering an acquisition. "You just have to keep plugging when you do your due diligence, whether it's checking inventory turns, aging of inventory and so on. It takes a tremendous amount of work, and if there's a bit of uncertainty or an inconsistency, you just have to plug down as deep as you can to get the answers," Harrison said.
According to Willkie Farr's Young: "The kinds of accounting problems in the headlines today can happen almost anywhere. The frightening thing is that almost any company is vulnerable to the kinds of pressures, culture and issues that can cause an accounting land mine to explode."Young's firm defended accounting firm BDO Seidman, Leslie Fay's auditors at the time of the scandal: "Even with new rules and regulations, at the core of an accounting problem is a fundamental breakdown that no layers of rules and regulations can reach. The problem is the result of a culture that surrenders to accounting manipulations to make up for operating shortfalls. Culture is not something you can change from rules or regulations. The change has to come from within the company," he said.
Richard D. Hastings, credit economist at Cyber Business Credit, said: "Generally, I think that the retail sector is extremely vulnerable to significant accounting irregularities. There isn't a whole lot of safeguards in the audits. This is because, frequently, the ones looking at the books are fresh out of college, while the executives -- the controllers, chief financial officers and managers -- are light years ahead. They know how to create things that the auditors don't always know how to understand."
Ladenburg, Thalmann & Co. equity analyst Eric Beder said a retail Enron was "conceivable, but is not highly probable." He noted that retailing is "a much simpler business, with relatively small transactions adding up." The lack of complexities usually don't lend itself to off-balance sheet financing vehicles, he noted. However, firms with multiple divisions, such as a retailer that also manufactures its apparel or has a proprietary credit card, may have more wiggle room in their books than just a straight retail concept, the analyst added.
So what are the internal precautions that can be implemented to halt potential abuses in financial reporting?
Stanley B. Frieze, managing partner at the Carl Marks Consulting Group specializing in restructuring, said: "If a company is run properly, there is certain information that the ceo needs to know everyday, such as what orders were booked the day before and what orders were shipped. Information from accounts payable, accounts receivable and availability under the bank lines should also be known. It is usually the cfo who prepares the information, and the ceo shouldn't relieve the people preparing the information from responsibility."
Alan Melamed, a credit analyst at Alan M. Melamed Associates, said that his participation on the board of C.R. Anthony & Co. after it came out of Chapter 11 and before its acquisition by Stage Stores taught him how important a role corporate governance is in preventing financial improprieties."I represented unsecured creditors, both the noteholders and the bondholders. As a board, we were extremely inquisitive. I focused on the operating side of the business, while others focused on the financial side. When something happened that we didn't understand, we would keep the auditors and the financial and accounting professionals in the boardroom for hours. It taught me that there is real value in going through that exercise. Because we understood the financial picture and operating strategies, we were able to properly evaluate whether or not to sell the company to Stage, and whether or not we received a good offer," Melamed said.
In 1999, then SEC chairman Arthur Levitt sought new rules governing membership in a company's board of directors, as well as those on the internal audit committee. Those rules require independence and some familiarity with financial operations. According to Young, those rules aren't nearly enough to curtail other firms from engaging in accounting high jinks.
In the aftermath of Enron, legislators are grappling with what needs to be done to protect the investing public. Fitch Ratings' Barishaw noted of Enron's accounting disintegration: "If you'd asked some of the accounting firms, they probably would have said this couldn't happen, but it did."
"Some greater disclosure requirements are likely so that investors have more information from reading the public documents," she said, "More disclosures are always going to be beneficial to the investor."
Whatever form those changes take, to be sure, will affect public apparel firms and retailers alike.
Sen. Christopher Dodd (D., Conn.), chairman of the Securities and Investment Subcommittee, and Sen. Jon Corzine (D., N.J.), a subcommittee member and former co-chairman of Goldman Sachs, last month said they will introduce legislation to address problems in the accounting industry. The proposal, among other features, doubles the size of the SEC audit staff to enable them to improve oversight of public accounting and ban any accounting firm from providing a public audit for a company whose controller or cfo had worked at the same accounting firm in the previous two years. Along with Sen. Barbara Boxer (D., Calif.), Corzine in December introduced legislation aimed at protecting employees' retirement savings.Excepting a change in disclosure practices, all that Wall Street analysts and investors can do is ask more probing questions and read the annual reports more closely than before, Barishaw said, adding that investors need to be on the lookout for large variances in revenues, expenses and valuations of assets. Also, what is recorded as special charges has a degree of subjectivity and could obscure impropriety even though regulations have been tightened in recent years.
However, if an individual is determined to cook the books, it won't matter what laws are enacted. "There is nothing that will be different tomorrow from what it was yesterday," said Cohen. "We certainly haven't determined that we have to do anything differently in auditing our clients' books."
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