Abstract
Sigma Industries recently suffered a series of telling blows to its corporate empire including the resignation from the company and likely prosecution of founding family members. Lenders to the company are suffering from defaults on loans to the firm, and investors have seen the value of their holdings almost disappear. Follow the work of Jerry Kramer as he tries to unravel some of the causes for this breakdown, and how company policies allowed many of these transgressions to occur.
Background
With a strong background in accounting and finance as well as audit experience in public accounting, Jerry Kramer has high hopes of becoming a financial VP in the computer networking industry. He believes that networking firms will benefit from increased business spending as the country comes out of the recent recession and once again looks for increased productivity. Despite the recent slowdown in technology he reasons that more and more firms will be willing to spend heavily on bigger, more sophisticated wireless based systems as they seek new efficiencies in order to more successfully compete in their respective industries. Thus, he believes that his recent switch in employment to Sigma Industries will give him the opportunity to break into the management side of the business. He hopes that his current position as assistant controller will give him the opportunity to learn more about the overall scope of the business as he prepares for advanced responsibilities. Little did he know that working at Sigma would soon begin to resemble the former television soap opera Dallas , in which family members had greater concern for their own well-being than for that of others.
Sigma Industries is a networking computer and services firm with customers throughout the world that has grown in recent years through a series of acquisitions. Founded by George Collins in 1985, it continues its expansion into all areas of the industry including wireless networking and systems development consulting. The company's nine board of directors until recently included five of its founder's family with day to day operations also heavily managed by several family members. These members in addition to George Collins include his daughter and two sons: Diane Collins, the company's CFO, Michael Collins, the firm's executive president for operations, and Tom Collins, the firm's executive vice president for strategic planning. The company's vice president of finance and its assistant treasurer are also close associates of the Collins family. Recent events have uncovered business relationships with even more family members.
Jerry has been assisting the controller in providing the special independent committee of the board with new and sensitive information. His responsibilities have increased as the company seeks to provide this data so that new auditors can complete their work and sign off on the annual financial report. Dave Leno, the controller, is counting on Jerry and a few others to help restore the integrity of the company and to help get to the heart of certain items in question.
The Discussion
Sitting down to lunch after a morning round of golf, Jerry begins "Dave, my initial findings indicate we have a serious problem with some transactions, and the widespread use of company funds by some of our directors. Foremost among these are the large loans to founding family members guaranteed by the company. In one instance the use of those funds by family members to buy back corporate shares was unknown to the company's board. Other transactions include company guarantees for board members' personal asset acquisitions.
Dave frowns, "Those are serious accusations."
Jerry pauses to order a roast beef on rye and then continues quietly. "There are more. Other transactions also involved transfers of funds to partnerships that were partially owned by family members. This related party involvement was unknown by some board members at the time, and was not completely disclosed in company filings. Furthermore, activities between the firm and these partnerships helped conceal substantial corporate debt and sham transactions masking substantial risk to our lenders and stockholders."
Dave leans forward in his chair. "It is imperative we have all necessary backup for those transactions, and knowledge of exactly where funds went and for what purpose. I'm sure that "legal" will need a detailed accounting for all of those transactions."
As a result of these types of transactions and others related to internal control, legal and ethical business dealings, and improper accounting, Jerry and other members of the finance team have spent several weeks trying to better understand the complexities of certain transactions and entities, and how the company can comply with generally accepted accounting principles including their required disclosures. The entire governing structure of the company is now an issue and great care must be exercised if the company is to move forward.
As Jerry gathers information for the committee, he learns that several interest payments required by debt agreements have not been met. These defaults and other disclosures already released by the company have shaken the confidence of its lenders. As a result of this, the company is preparing for a Chapter 11 filing in order to keep it operating, and to provide time to satisfy all creditors.
Though Jerry is discouraged by these new revelations and the possibility of other discoveries of accounting improprieties, based on recent acquisitions he is not completely surprised at the debt default since the company has substantial debt. He believes it is the goal of satisfying analysts that has driven the corporate behavior that goes beyond some of the obvious personal benefits to officers.
Because the company's stock price has dropped over 90% during the past year there is seldom a day that portfolio managers, brokers, and the news media have not inquired about the firm's financial condition and steps the company is taking to meet its obligations. Unlike some other accounting scandals based primarily on fraudulent financial reporting, Sigma's problems seem multi-faceted including, but not limited to, deceptive accounting, conflicts of interest between the board and owners, and a lack of oversight by management and the board. During discussions with Tim Blake of finance, Jerry begins to wonder how some of these events were not discovered earlier and how those perpetuating these activities expected not to be caught.
With recent events pointing further to an SEC inquiry, Jerry is gathering his findings for an upcoming meeting with Tim. Unfortunately, he is realizing that great effort went into the design of these deceptive activities and the term "forensic accounting" is more appropriate for his current job. Nevertheless, Jerry is pleased that his background enables him to seek out the back-up and underlying information to answer the questions now being posed.
"Tim, I have been trying to locate some of the legal documentation for loan guarantees to the Collins family. Do you have any of those papers?"
Tim grimaces, "Yes I do. I think the extent of those additional guarantees will surprise you. By my calculations there are about $900 million of co-borrowings by entities affiliated with the Collins family as of March 31, 2002 for which Sigma is jointly and severally liable. That amount is substantially higher than the previously reported amount since it now includes an additional $305 million of co-borrowing by entities affiliated with the Collins family for which Sigma is jointly and severally liable."
At this point Jerry is not surprised. "I just discovered that beginning at least as early as the year 2000, Sigma entered into agreements with our two main manufacturers of Ethernet switches to raise the price paid by the company by $15, and to separately receive the same amount from the vendors as marketing support in exchange for such payments. The company provided no such support for those payments. The payments for the switches were treated as capital expenses while the marketing support payments to the company were treated as a reduction of operating expenses. The proper accounting for that arrangement would reduce profit by approximately $12 million in 2001 and $9 million in 2000."
Tim is astounded. "What prompted the vendors to do this?"
Jerry replies, "Promises of increased future business appear to be the answer to that question. If that weren't enough, some customers for which we provided services on their networks paid the company with financial instruments whose value has been impaired. The previous quarterly statement included those payments as revenues. As a result of those impairments revenues should be reduced by an amount of $13 million for 2001 and $7 million for 2000."
Tim decides to question further even though he looks apprehensive. "How could these agreements have been approved?"
Jerry confidently asserts, "It seems pretty clear that a concerted effort was made to manage earnings via sham or overvalued transactions." Jerry looked at Tim attempting to read his reaction to the troubling revelations and then adds, "Also, in previous periods we capitalized certain labor expenses involving repair and service center arrangements. Those amounts should have been expensed rather than capitalized which would have resulted in a reduction to reported profit for both 2000 and 2001 of approximately $4 million."
Tim, now more somber, scrutinizes Jerry carefully as he says, "My research shows that transactions between the company and various Collins entities and other parties, had the effect of increasing the company's profits. Those transactions included management fee charges to the company by Collins entities and expenses transferred to a joint venture controlled by the Collins family. Because those amounts cannot be substantiated we should not include the fee income for both 2001 and 2000, which would result in a reduction to profit of approximately $7 million and $6 million, respectively."
Jerry calmly responds, "There seems to be a trend here."
Tim seems more relaxed as he continues. "As soon as we finish our determination of the dollar amounts in question, we will have to review all of these transactions from a control standpoint."
Jerry had done his homework. "In previous years the company recognized revenue ratably over expected periods of service including the free service period offered during the initial months of new or enhanced service arrangements. We are now going to postpone this revenue recognition until customer payments begin. This change will reduce revenue by approximately $3 million in 2001 and $4 million for 2000."
Visually disturbed by the proposed restatement Tim seemed almost ineffectual when he spoke. "We will also have to reflect that Sigma, through the Collins family, committed $300,000 of company funds for a partnership interest in a resort club. This expenditure appears to be primarily for the family's personal use rather than business purposes."
Jerry and Tim, as well as Dave Leno, will be meeting shortly to discuss the above findings and how they expect the committee and board members to react to those developments. They have already agreed among themselves that the cash management system and related controls were abused by Collins family members and that new and stronger controls are imperative. They also believe a stronger more independent board with an active audit committee would have helped to uncover many of the problems earlier. The three are distressed by the previous auditors' accusations that Sigma employees withheld important information from them, as well as Sigma's audit committee. The committee contends the auditors should have discovered some of those items and brought them to their attention. While it will take even more time to unravel all elements of Sigma's problems, there is little doubt that many factors contributed to the downfall of the company. The three co-workers wonder if the company can be saved in view of future litigation likely to result from all of these activities.