Brown-Torrington and Emmett, Orr & Peterson One Giant Down The Other To Fall?

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Brown-Torrington and Emmett, Orr & Peterson One Giant Down…the other

to fall?

Introduction

“I don’t think you understand. This could be the end of us,” said Noel Jameson, senior
partner of Emmett, Orr & Peterson LLP, to the president, Randy Mays. Mays
responded, “Not necessarily Noel. We canrecover.”

In early March 2004, Emmett, Orr & Peterson LLP (EOP), a leading U.S. auditing firm
was under question for not stepping in to prevent the accounting malpractice that had
led to the bankruptcy of Brown-Torrington, a Fortune 500 pharmaceutical company.
The events leading up to the collapse of Brown-Torrington shocked the investment
community as well as regulators who had heralded Brown-Torrington as a well-
respected and ethical leader in the pharmaceutical industry. The downfall was ignited
when Brown-Torrington management was found to have accounted for special purpose
enterprises (SPEs) off the balance sheet. These SPEs had a high level of debt, which
was not fully transparent to Brown-Torrington’s shareholders. After a series of top
management fled from Brown-Torrington, it became obvious that something had ran
amok. Within weeks, Brown-Torrington’s share price plummeted leaving shareholders
and pensioners with worthless stock and the company with a mountain ofdebt.

When the accounting issues at Brown-Torrington arose, the spot light was immediately
turned on the accounting firm EOP. On January 25th, 2004, EOP management admitted
to shredding important documents that contained details about Brown-Torrington’s
suspicious off-the-balance sheet transactions. EOP was now on
the precipice of disaster. Was it their responsibility for what had happened at Brown-
Torrington? Could they have prevented the malpractice? What should be done to
maintain their client base?

Pharmaceutical Industry

The pharmaceutical industry was one of the largest industries in the world with
estimated global sales of $300 billion USD per year. While the industry had
experienced strong growth throughout the 1990s, the rate of increase had slowed to
about five per cent per year in 2003. Even though there was tremendous opportunity
with an aging population in North America, Western Europe and Japan (the world’s
three largest markets), many pharmaceutical companies were struggling to allocate
research and development dollars and develop the next “blockbuster” drug.
Governments, health insurance companies and consumers had all put downward price
pressure on new drugs being released into the marketplace.

The process of introducing new drugs was an exhaustive process sometimes exceeding
ten years and costing up to $300 million USD per drug. In order to develop new drugs,
pharmaceuticals allocated up to 15 per cent of their sales in research and development.
Although this allocation was considerable, pharmaceutical companies were not
necessarily guaranteed that their developed drugs would hit the marketplace. This
process was frequently referred to as the “pipeline” which had three major phases: pre-
clinical, clinical testing and the drug approval and registration. The pre- clinical phase
took approximately four years and before moving into the clinical testing phase,
pharmaceuticals took out a 20-year, non-renewable patent. This meant that
pharmaceutical companies had to be mindful of the time in the preceding two stages.
The second stage of clinical testing involved a series of tests on humans. The phase
typically lasted five to six years. Finally, if the drug had made it through the other two
stages, it was ready for approval and registration. The governing body for
pharmaceuticals in the U.S. was the Food and Drug Administration (FDA), who
required that companies demonstrate the superiority of their product over existing
drugs. The approval process took approximately 18 months. Delays were costly to
pharmaceutical companies with some industry observers estimating that each daycost
$1 million USD in lost sales.

Once a drug’s patent expired, other pharmaceutical companies were permitted to


produce a “generic” version of the same drug, often at a 30 per cent price discount. This
was considered to be the last part of the drug’s life cycle from a profit perspective. Thus,
it was vital that the large pharmaceuticals continued developing their “pipeline” for
future blockbusters.

Ethical considerations in the Pharmaceutical Industry

The pharmaceutical industry was heavily regulated by the government. Governments


levied regulations on the testing, content, pricing and relationships that pharmaceuticals
had with the rest of the health care industry. A number of major ethical debates existed
within the bioscience industry. The first involved scientific and testing issues such as
genetically modifying foodstuffs, testing on animals, prematurely releasing a drug by
skipping testing phases and the treatment of human embryos and the humangenome.

The second central issue involved the actual business practices of companies
participating in the bioscience or pharmaceutical industry. Several scandals had come
to light in recent years such as insider trading at ImClone, misleading business
statements by Biopure, charges of fraudulent activity at AstraZeneca and Merck-
Medco and the questionable marketing practices of ‘fen-phen’, a diet drug produced by
Wyeth-Ayerst.

An on-going debate in the industry was the extent to which physician incentives should
be provided by pharmaceutical companies. A study conducted in 2002 by the Kaiser
Family Foundation discovered that 61 per cent of doctors received free meals, travel
and entrance to events in exchange for prescribing new drugs to their patients.
The industry had also been prone to pharmaceutical companies offering kickbacks to
doctors for using their drugs. In response to rising pressure, the Pharmaceutical
Research and Manufacturers of America (PhRMA) put forth a voluntary Code on
Interactions with Healthcare Professionals that stipulated appropriate expenses for the
purpose of marketing to physicians.

History of Brown-Torrington

Brown Pharma was founded in 1926 by Joseph Raymond Brown. Brown was a leading
academic and scientific researcher from Northwestern University. He was one of the
first pharmaceutical academics to form his own company and build a stand- alone
research staff. By the Second World War, the U.S. government became more involved
in drug research. Brown was credited as forging positive relationships with the U.S.
government, developing an anti-malarial drug in the 1940s and being on the forefront
of commercially viable penicillin in the 1950s.4 Brown’s undying dedication towards
pharmaceutical development was the cornerstone of his organization. He had instilled
strong academic principles, while pushing his company’s scientists towards drugs that
would be profitable. When he died in 1974, Brown had left behind a highly successful
scientific-driven enterprise.

Under new management the company flourished throughout the late 1970s and 1980s,
until it was investigated in 1986 by the U.S. government for its pricing practices. The
company had priced a number of new drugs by claiming incorrect categories that
allowed for higher prices. Industry observers felt that Brown Pharma had made a grave
error, which would cost them their company. However, the company paid out
compensation, decreased its prices and reduced its overhead by cutting back on its
oversized sales department. By the late 1980s, the company had returned to profitability
through the release of a “blockbuster” drug. By 1994, its problem was quite different –
it had plenty of cash but it had no other blockbuster drugs in the pipeline. It targeted
Torrington Stills for a takeover.
Torrington Stills had been founded by a group of pharmaceutical and agricultural
scientists in 1967. The company was quite different to Brown Pharma in that it had
fostered group activities in its development, marketing and sales approaches. The
company had become known as an alternative to the larger corporate pharmaceuticals.
By the early 1990s however, some industry observers felt that the company was part of
the mainstream. Although it was credited in recognizing new trends in drug
development and having a strong research arm, the company had had several problems
with late releases. Analysts questioned Torrington Stills’ ability to compete in the
industry, since industry players were constantly cutting out time in the development
process to bring new drugs to the market. By 1994, Torrington Stills was highly
leveraged and could not meet its loan payment requirements, making it ripe for a
takeover.

In November 1994, Brown Pharma purchased Torrington Stills and Brown- Torrington
was the new name given to the merged entity. The challenge of the merger was to
integrate Brown Pharma’s expertise in marketing, sales and production, while utilizing
the group development process at Torrington Stills. The integration process was long
and taxing. One senior manager from Brown Pharma who participated on the
integration team commented, “Just because they’re a bunch of long-lost hippy
scientists, does not mean that everything can be effectively done in a group. There’s no
accountability. They don’t seem to understand the dynamics in getting a product’s cost
down and getting it out into the market.” A member from the Torrington Stills team
recalled the integration process, “the Brown Pharma side was very demanding and a
little too quick. Contrary to popular belief, we’re very aware of the importance of
getting products out quickly. However, that should not come at the cost of developing
a quality drug. It may cost $1 million per day for every day, but that’s a lot better than
several million if the drug proves to beharmful!”

Brown-Torrington had overcome its integration challenges and by 1997, it was


considered to be one of the fastest growing companies in the pharmaceutical industry.
The company posted superb financial results from 1998 through to 2002, growing at a
compound annual growth rate of 21 per cent at a time when industry growth had slowed
to five per cent. In early 2001, an analyst report stated: “We feel that Brown-Torrington
is well positioned. They have some great blockbusters and have sorted out their pipeline
problem that plagued them a few years ago. The company has managed to innovate and
build production capabilities to take advantage of making generic drugs. We believe
that they will continue to outperform their earnings per share (EPS) estimates.”

In 2002, the company had posted record revenues of $18.7 billion USD and profits of
$4.6 billion. The company’s stock price had soared to $32.80 from the previous year’s
level at $23.56. Credit agencies rated the company’s debt instruments as triple A.
Financial success was not its only strong point – the company had been selected by the
popular press as one of the Top 100 best companies to work for in the U.S. Scientific
organizations, management consultants and business schools all studied the company’s
unique development process and how it had managed to leverage the expertise of its
merged companies and innovate successfully. The company’s CEO and Chairman
Aaron Wheelwright was credited with much of the firm’s vision and was handed several
awards for one of the best CEOs in theU.S.

The Auditing Industry

Auditing rose to prominence in the 1930s as companies looked to independent firms to


evaluate their public financial statements on an objective basis. The role of auditing
firms was to provide technical expertise and objectivity in interpreting generally
accepted accounting principles (GAAP). Accounting was not deemed to be an exact
science. GAAP provided a framework for companies to prepare their financial
statements and for auditing firms to ensure that the financial statements were reliable.
Exhibit 1 shows a list of GAAP definitions. The reach of auditors work was wide as
banks, creditors and investors all made decisions based on a particular company’s
financial statements. This objectivity and coherence to a set of principles was
particularly important to instill confidence in the general investing public who chose to
buy and sell shares on security markets. In fact, the growth of the worldwide stock
markets was often credited to auditing, which had worked to allay the fears of the
investing public by providing an objective view of financial performance.

The Securities Exchange Commission (SEC) was the governing body in the United
States responsible for the public trading of securities. SEC required that any company
engaged in public trading of stocks, bonds or any type of security, submit a set of
audited financial statements on an annual basis. SEC’s primary mission was to “protect
investors and maintain the integrity of the securities markets.” SEC held the belief that,
“all investors, whether large institutions or private individuals, should have access to
certain basic facts about an investment prior to buying it.” As part of this concept, SEC
disclosed all public documents on their website (www.sec.gov) for every publicly
traded company. Each year, SEC brought between 400 to 500 civil enforcement actions
against infractions like insider trading, accounting fraud and the release of misleading
and false information.

Major auditing firms had expanded into strategy consulting and information technology
consulting in the late 1970s and early 1980s in order to develop alternative revenue
streams. Auditing was becoming increasingly competitive, and as such, auditing firms
started lowering prices to compete. For many firms, consulting became more lucrative
and attractive since each situation required a custom solution, allowing the consultants
more flexibility in bill-out rates.
Emmett, Orr & Peterson (EOP) LLP

Godfrey Emmett, a Harvard professor and one of his students Richard Orr, a Harvard
MBA, founded Emmett & Orr as an auditing firm in 1927. Emmett and Orr saw great
opportunity with the burgeoning U.S. stock market and believed that corporations could
benefit from an objective third party opinion. In the early days, clients were
surprised at how Emmett and Orr, two men with an age difference of 20 years had
managed to equally operate the firm. In a public speech at Harvard, Emmett commented
on his younger partner, “Richard [Orr] and I are equals. We both make decisions. While
the circumstances of our initial acquaintance was through the teacher-student dynamic,
we have become business partners.” In another speech, Orr talked about Emmett,
“Some people find it strange that we could both be in charge of making decisions.
People, have often take me aside, tug on my coat and say, ‘no really, the big guy makes
the final call, right?’ For me, it’s been an ideal partnership…I bring hustle to the
organization and Godfrey brings calm.”

Both Emmett and Orr emphasized the importance of strict confidence with their clients.
At the same time, they never strayed from their role of giving an objective third party
opinion. They recruited young, aggressive and bright auditors and imparted a doctrine
of “be respectful, show integrity and be direct.” They sought individuals who had
technical acumen and people who could interpret financial information for management
decision-making. Orr had been quoted as saying, “we train our auditors to see the forest
beyond the trees. If they need to count the number of rings of a hundred year maple
tree, fine, but they need to be able to then rise above and tell the client why that’s
important.”

Emmett and Orr were extremely successful at building their organization and by the
1960s had become one of the United States’ pre-eminent accounting firms. In 1967,
Emmett passed away and the reins were turned over to Orr. Orr promoted a young rising
manager named Joshua Peterson through the ranks and Peterson eventually became a
senior partner in the late 1970s. Peterson convinced Orr to consider moving heavily
into management and information technology consulting. Peterson recalled in an
interview years later, “I saw that we were in there with top management of major
multinationals. We were already talking about confidential and future strategic
decisions. I felt that we could do a lot more than verify the numbers.”

Peterson’s strategy worked – by the mid-1980s, Emmett, Orr and Peterson had captured
over 100 major contracts accounting for over $1 billion in consulting revenues. When
Orr retired at age 80 in 1982, Peterson ran the company until 1997. Peterson was
acknowledged for promoting the original founders vision of being direct and
maintaining “one face” to its customers, whether the activities were in consulting or
auditing. By the time Peterson retired, EOP was posting revenues of $6 billion, with
over half coming from consulting engagements. The presidential title was handed to
Timothy Bayliss, who had a vision of spinning off the consulting arm from the original
auditing firm. In 1999, Bayliss formed Emmet, Orr, Peterson and Bayliss Consulting
and maintained the EOP name for the accounting activities. The split was long and
arduous and insiders had divided into one of the two camps. Animosity grew within
the ranks and a once seamless “one face” organization had split into two disparate
companies with distinct corporate cultures. The consulting arm was seen as aggressive
and cutthroat whereas the accounting side had retained its conservatism.
Relationship between Brown-Torrington and EOP

The relationship between the two enterprises dated back to both founders. Joseph
Brown and Godfrey Emmett were contemporaries: both were born in the same month
in 1887 and both were former professors who had broken out from their academic
research to form companies. They first met in 1928 and the following year, Emmett had
convinced Brown to “let him audit their books.” Brown and Emmett were often
compared in the popular press and management journals. In the late 1950s, the two even
went on a road show, visiting five of the top U.S. universities talking about how
honesty, integrity and ethical practices could translate into profitable business. In one
speech, Brown commented, “Professor Emmett and I are peas out of the same pod. We
both are investigators and we both believe that directness is the only way to build a
successful enterprise.” In an interview before his death, Emmett talked about Brown,
“It’s people like Joseph Brown that have made America great. I feel fortunate to call
him a contemporary, client andfriend.”

Brown-Torrington was the longest standing client of EOP. Because the relationship was
of great historical importance, EOP’s management emphasized the importance of
“keeping Brown-Torrington happy.” A former EOP auditor commented, “from day one,
it was very clear. Don’t mess with Brown-Torrington. It was like they were a sacred
cow.” Another EOP employee saw it differently:

“I worked on the Brown-Torrington account for several years. They were an


outstanding organization. Yeah, sure, our management made it clear to us that
it was an important relationship. But, I never felt that anyone was saying, ‘do
what they want.’ I always felt comfortable telling Brown-Torrington
management that they should change something if I didn’t feel it was
appropriate.”

Brown-Torrington also used EOP as a training ground and recruitment pool. Several
Brown-Torrington finance, IT and general managers had at one time worked for EOP.
An employee that had worked at both companies commented, “it’s no secret that when
you’re out on audit at Brown-Torrington, you may also be evaluated for a job there.”

In 2002, EOP earned over $50 million from Brown-Torrington, which was weighted
evenly between consulting and auditing fees. EOP had a full-time staff of 25 individuals
working at the Brown-Torrington head office. Within that team, pressure was mounting
to confront Brown-Torrington on their treatment of off-the-balance sheet transactions
and the treatment of debt of special purpose enterprises (SPEs).

By the end of 2002, EOP had identified Brown-Torrington as a ‘maximum-risk’ client


due to their potential exposure to high debt. One internal memo from audit team lead,
Alejandra Seinra to EOP’s president Randy Mays in early 2002 read:

“We’ve been studying the SPEs of Brown-Torrington for sometime now. The
documentation is light in some areas and it looks as though they have over
$1.1 billion due in the next three years. But, all of their profits have been booked
to Brown-Torrington on the net present values of drugs that are still in the
pipeline. I personally feel that this is not a good idea. They’re exposed and
I think we need to convince them to show some of this exposure on their
corporate balance sheet, instead of having it hidden from public view.”

Accounting Practices at Brown-Torrington

In 1999, Brown-Torrington had established special purpose enterprises (SPEs), which


were intended to represent the development of each new “blockbuster” drug in the
pipeline. Brown-Torrington had also created other SPEs for other companies’
blockbuster drugs, with the plans that Brown-Torrington would be in a position to
produce generic drugs once their competitors’ patents expired.

By 2002, there were approximately 20 SPEs that had been created. Brown-Torrington
had been moving the research and development expenses from the parent company to
the SPEs as assets. Brown-Torrington had been financing that development through
private debt instruments, which became the SPEs liability. Brown-Torrington then
calculated the expected return in the form of Net Present Value9 of future free cash
flows from each blockbuster and generic drug and booked the profits immediately.
This practice was highly speculative as Brown-Torrington was not certain which drugs
would become blockbusters. Booking profits based on future earnings inflated
Brown-Torrington’s yearly profits from 1999 through to 2002. It was estimated that
the company had booked over $3 billion dollars in speculative revenues over the past
three years. Increased profits led to the company’s increase in share price as more
investors were attracted to Brown-Torrington’s performance.

When an EOP team member working at the Brown-Torrington head office requested
a bank document proving the assets of three SPEs in late 2001, a Brown-Torrington
executive submitted three separate letters from the same offshore bank with a
statement of the SPEs holdings. The EOP team member felt that there was no need to
investigate further. However, the Brown-Torrington executive had asked his teenage
daughter to make changes to one bank letter with Photoshop, altering the amount of
holdings and the SPE name. Out of an estimated $1.2 billion in assets, there was under
$25 million in actual cash holdings. On the liabilities side, all of the SPEs carried
substantial debt loads. The total exceeded $1.1 billion, which were payments due in
2004 and 2005. Exhibit 2 shows Brown Torrington’s financial statements and Exhibit
3 shows a sample of the exposure of three of the company’s SPEs.

Events leading to the fall of Brown-Torrington

The first correspondence doubting Brown-Torrington’s accounting treatment of SPEs


was within EOP and was sent to the senior partner Randy Mays by Alejandra Seinra
in February 2002. Around the same time, Maurice Levine a Brown-Torrington
finance manager and former auditor at EOP wrote an email to Alex Yury, Brown-
Torrington’s CFO, which read:
Net present value refers to a calculation that estimates the future free cash flows of a
particular project discounted at a rate reflective of market and business risk.
“Dear Alex, I would like to meet with you about some of our SPEs. I know we
have the management review coming up and I think it’s prudent to discuss
moving some of the debt back to the parent company. Is there a plan to transfer
more capital to the SPEs? Do we feel that the income from Code72 [a new
blockbuster drug] will offset this risk? I look forward to speaking with you about
this. Maurice.”

Yury responded with an email:

“Thanks Maurice. Aaron [Wheelwright, the CEO] and I are meeting tomorrow
on the SPEs and will be discussing that very topic. I have been keeping a close
eye on those SPEs to make sure that everything is in check. And, yes, to answer
your question --- Code72 is going to be our next ‘Titanic’
--- not the sinking ship of course, but rather the cinematic blockbuster! Regards,
Alex.”

After six months in August 2002, another finance manager Rajinder Lata wrote to
Brown-Torrington’s group of finance managers stating:

“Does anyone have the documents based on the asset holdings of the
followingSPEs: Jenby, Gano and Lewis? I’ve been scouring this finance
department and all I can come up with is a lot of debt for those holdings…”

Maurice Levine was the only to respond to the group email, “Hi Rajinder. I had spoken
about this with Alex a few months ago, and he’s looking after it. Regards, Maurice.”
In January 2003, a month after management bonuses were paid out, Alex Yury, Brown-
Torrington’s CFO resigned abruptly. One newspaper reported:

“There seems to be no apparent reason for the sudden departure of Brown-


Torrington’s CFO Alex Yury. Yury has put in fifteen successful years at the
company. CEO Aaron Wheelwright was asked to comment, ‘Alex has moved
on for personal reasons.’ The departure seems out of character for the company.
Yury was not available for comment.”

Yury’s departure left the finance department frozen. Yury had maintained frequent
informal communication with all of his managers and none of the managers were able
to contact him after he left the company. Within a month, RajinderLata received an
email from Brown-Torrington’s legal department asking to see some of the SPEs assets
holdings. This time, she decided to do a thorough investigation talking with every
member of the finance department and all of the EOP auditors. By March 2003, she
had found the three bank letters with asset holdings that had been given to EOP auditors
by a finance manager no longer with Brown-Torrington. She personally phoned the
offshore banks and learned that the assets did not exist. This prompted her to write an
email to Brown-Torrington’s CEO Aaron Wheelwright. Itread:

“Dear Aaron: I would like to meet with you about some of our SPEs and their
asset holdings. Along with the help of some EOP auditors, I have found
letters,whichIbelievetobeforged.Theystatewehaveassetsupto$1.2

10
billion. However, I have followed up with the banks and have learned that those
assets do not exist. You may know from having met with Alex before he left
that our SPEs owe over $1.1 billion in the next two years. I’m attaching all of
the documents for your review. Regards,Rajinder.”

Along with Maurice Levine and one of Brown-Torrington’s lawyer John D’Amico,
RajinderLata met with Brown-Torrington’s CEO, Aaron Wheelwright in April 2003.
Lata recalled the meeting:

“Aaron seemed really open to listening to us. But, here we were telling him that
we had some major debt to repay, and I couldn’t believe how calm he was. He
thanked us for bringing it to his attention and said that he would look into it.
But, the problem is, we didn’t see any action until much later.”

Legal counsel, D’Amico commented, “Aaron was really hard to read that day. I walked
out of the meeting wondering if he had understood the severity of what we were all
saying.”

By the second quarter of 2003, Brown-Torrington had missed all of its sales targets and
was at risk for delivering the new blockbuster Code72 drug. The investment community
responded and Brown-Torrington’s share price slid from over $30 to
$15.20. An analyst commented, “Brown-Torrington’s sales predictions were too high
for the first half of 2003. It’s unlikely they’ll be able to make up the remainder of the
year, and if they falter for even a moment on the release of Code72, then there stock
will be severely bruised.”

In late July 2003, Wheelwright resigned from Brown-Torrington as CEO. He had tried
to leave graciously by saying in a public statement, “Brown-Torrington has had some
recent short-term blips. But, Code72 is on the verge of happening, and I leave the
company in an extremely good position to exceed second half and full-year 2004
results.”

However, a newspaper reporter did not believe Wheelwright’s parting line. Through an
odd connection the reporter quoted a teenager who said, “yeah, my friend is a whiz at
Photoshop. I think her dad even got her to change bank letters for his company once.
No one knew the difference.” The reporter went on to say:

“It turns out the company is actually Brown-Torrington, the pharmaceutical


giant, who has recently lost its top two senior managers to suspicious
circumstances. Why? Perhaps there’s something to their sudden departures.
Who’s been playing in Photoshop? What are they hiding?”

Immediately after reading the newspaper, Randy Mays at EOP ordered that all
documents pertaining to Brown-Torrington’s SPEs be shred. Most of the EOP
employees had not seen the article, as it took a few weeks to be spread through the
popular press.

By September 2003, the news of Wheelwright and Yury’s departure in connection to a


potential fraud at Brown-Torrington was everywhere. Brown-Torrington’s finance
managers, Rajinder Lata and MauriceLevinalsoresigned. Lata commented in an
Interview, “when both of key management resigns without warning or reason, it
certainly does not give you a lot of confidence in the company.” Levine said, “I kept on
thinking of Yury’s reference to the Titantic. And, I thought, I’m on a sinking ship! I
had to get out.”

When interrogated in September 2003, Brown-Torrington’s former CEO Wheelwright


stated, “look, you’ve got to ask that question to Emmett, Orr and Peterson. They had
blessed all of our number and all our practices. They were well aware what was going
on.”

EOP’s president Randy Mays claimed at first that he was unaware that forged bank
documents existed. By January 2004, he confirmed that he had commissioned EOP’s
staff to shred documents relating to Brown-Torrington’s SPEs. Mays had put one of his
top performers Noel Jameson on the task of “sorting out Brown-Torrington.”

But, by February 2004, it was too late. Managers at both EOP and Brown-Torrington
were struggling to sort out the problem and had realized that repaying the debt on the
SPEs was going to be impossible. They made the decision to transfer the debt to the
parent company and reverse some of the profits that they had posted in the last three
years. This left them insolvent and with no other choice to file for bankruptcy. Credit
agencies downgraded the company from triple A to C, the lowest grade of a company’s
debt. The company had completely collapsed, leaving over 23,000 employees, a
number of pensioners and investors with nothing. Competitors bought the patents and
development of Code72 and other products in the pipeline. The proceeds did not even
cover 5 per cent of the secured debt.

As the Securities Exchange Commission (SEC) moved in to investigate the accounting


malpractice at Brown-Torrington, the blame was moving towards EOP. Why had they
shred the documents? Why didn’t Mays act sooner when he received the email from his
audit team lead Alejandra Seinra? Why didn’t EOP speak up?

Conclusion

In March 2004, both Mays and Jameson at EOP were spending everyday trying to re-
position their company. Since admitting to the shredding of documents, they had been
charged with an obstruction of justice and lost a quarter of their client base.

As both individuals sat in the Boston office of Emmett, Orr and Peterson, they
wondered what could be done to save the company. Jameson said to Mays, “Randy, we
have a criminal charge against for obstruction of justice. How in the world can we claim
to be a responsible accounting firm?”

Mays responded:

“Look, Noel, I stand behind my decision to shred those documents. If they were being
forged by Brown-Torrington employees, the documents could simply not be trusted.
And, I fully intend to prove this in a court of law. What I need is for you to get me all
the facts and at the same time get on as many planes as you can to personally visit
our client base. We cannot afford to lose any more.

Exhibit 1 Definitions of GAAP

The Business Entity Concept - The business entity concept provides that the
accounting for a business or organization be kept separate from the personal affairs
of its owner, or from any other business or organization. This means that the owner
of a business should not place any personal assets on the business balance sheet.
The balance sheet of the business must reflect the financial position ofthe business
alone. Also, when transactions of the business are recorded, any personal
expenditures of the owner are charged to the owner and are not allowed to affect
the operating results of thebusiness.

Continuing Concern Concept - The continuing concern concept assumes that a


business will continue to operate, unless it is known that such is not the case. The
values of the assets belonging to a business that is alive and well are
straightforward. For example, a supply of envelopes with the company's name
printed on them would be valued at their cost. This would not be the case if the
company were going out of business. In that case, the envelopes would be difficult
to sell because the company's name is on them. When a company is going out of
business, the values of the assets usually suffer because they have to be sold under
unfavorable circumstances. The values of such assets often cannot be determined
until they are actually sold.

The Principle of Conservatism - The principle of conservatism provides that


accounting for a business should be fair and reasonable. Accountants are required
in their work to make evaluations and estimates, to deliver opinions, and to select
procedures. They should do so in a way that neither overstates nor understates the
affairs of the business or the results of operation.

The Objectivity Principle - The objectivity principle states that accounting will
be recorded on the basis of objective evidence. Objective evidence means that
different people looking at the evidencewill arrive at the same values for the
transaction. Simply put, this means that accounting entries will be based on fact
and not on personal opinion orfeelings.

The source document for a transaction is almost always the best objective evidence
available. The source document shows the amount agreed to by the buyer and the
seller, who are usually independent and unrelated to each other.

The Time Period Concept - The time period concept provides that accounting take
place over specific time periods known as fiscal periods. These fiscal periods are
of equal length, and are used when measuring the financial progress of a business.

The Revenue Recognition Convention - The revenue recognition convention


provides that revenue be taken into the accounts (recognized) at the time the
transaction is completed. Usually, this just means recording revenue when the bill
for it is sent to the customer. If it is a cash transaction, the revenue is recorded when
the sale is completed and the cash received.
It is not always quite so simple. Think of the building of a large project such as a
dam. It takes a construction company a number of years to complete such a project.
The company does not wait until the project is entirely completed before it sends
its bill. Periodically, it bills for the amount of work completed and receives
payments as the work progresses. Revenue is taken into the accounts on this
periodic basis.

It is important to take revenue into the accounts properly. If this is not done, the
earnings statements of the company will be incorrect and the readers of the
financial statement misinformed.

The Matching Principle - The matching principle is an extension of the revenue


recognition convention. The matching principle sates that each expense item related
to revenue earned must be recorded in the same accounting period as the revenue
it helped to earn. If this is not done, the financial statements will not measure the
results of operations fairly.

The Cost Principle - The cost principle states that the accounting for purchases
must be at their cost price. This is the figure that appears on the source document
for the transaction in almost all cases. There is no place for guesswork or wishful
thinking when accounting for purchases.

The value recorded in the accounts for an asset is not changed untillater if the
market value of theasset changes. It would take an entirely new transaction based
on new objective evidence to change the original value of anasset.

There are times when the above type of objective evidence is not available. For
example, a building could be received as a gift. In such a case, the transaction would
be recorded at fair market value which must be determined by some independent
means.

The Consistency Principle - The consistency principle requires accountants to


apply the same methods and procedures from period to period. When they change
a method from one period to another they must explain the change clearly on the
financial statements. The readers of financial statements have the right to assume
that consistency has been applied if there is no statement to thecontrary.

The consistency principle prevents people from changing methods for the sole
purpose of manipulating figures on the financial statements.

The Materiality Principle - The materiality principle requires accountants to use


generally accepted accounting principles except when to do so would be expensive
or difficult, and where it makes no real difference if the rules are ignored. If a rule
is temporarily ignored, the net income of the company must not be significantly
affected, nor should the reader's ability to judge the financial statements be
impaired.

The Full Disclosure Principle - The full disclosure principle states that any and
all information that affects the full understanding of a company's financial
statements must be include with the financial statements. Some items may not
affect the ledger accounts directly. These would be included in the form of
accompanying notes. Examples of such items are outstanding lawsuits, tax
disputes, and company takeovers.

Exhibit 2

Brown-Torrington’s Financials
in millions USD $

2000 2001 2002 2003


Profit & Loss
Sales 11341.7 14582.0 18,700.0 9812.9
COGS 5,807.0 7,261.8 8,839.5 6,839.6
Gross Margin 5,534.7 7,320.2 9,860.5 2,973.3
Gross Margin % 48.8% 50.2% 52.7% 30.3%

SG&A 1894.1 2362.3 2917.2 2217.7


Depreciation & Amortization 340.3 466.6 654.5 637.8
Operating Profit 3300.4 4491.3 6288.8 117.8
Operating Margin % 29.1% 30.8% 33.6% 1.2%

Nonoperating Income 168.0 234.0 456.0 23.0


Nonoperating Expenses 178.9 148.9 247.9 984.2
Income before Taxes 3289.5 4576.4 6496.9 -843.4
Income Taxes 954.0 1327.1 1884.1 -244.6
Net Income after Taxes 2335.6 3249.2 4612.8 -598.8
Net Income as % of Sales 20.6% 22.3% 24.7% -6.1%

Stock Price 18.94 23.56 32.80 4.67


Diluted EPS from Net Income 2.07 2.84 3.64 -0.57
Shares Outstanding 1127.9 1145.9 1267.3 1045.6

Balance Sheet
Assets
Current Assets 10573.4 11956.4 8242.9 1093.2
Net Fixed Assets 12348.1 14219.8 14632.1 5389.2
Total Assets 22921.5 26176.2 22875 6482.4

Liabilities
Current Liabilities 12314.9 12876.2 11273.9 11273.9
Long-term Debt 452.9 698.3 1294.78 2423.3
Other noncurrent Liabilities 1345.7 1678.9 1678.9
Total Liabilities 12767.8 14920.2 14247.58 15376.1

Shareholders' Equity
Preferred Stock Equity 345.9 245.6 246.6
Common Stock Equity 10153.7 10910.1 8381.82 -9140.3
Total Equity 10153.7 11256 8627.42 -8893.7
Total Liabilities and Equity 22921.5 26176.2 22875 6482.4

Net Operating Cash Flow 2837.5 3784.2 4902 -1233.2


Net Investing Cash Flow -2149.3 -3717.2 -2865.4 -109
Net Financing Cash Flow -1115.8 -1636.4 -2345 -4578.4
Net Change in Cash -427.6 -1569.4 -308.4 -5920.6
Exhibit 3

Special Purpose Enterprises (SPEs) – Brown-Torrington

in millions USD $

YEAR 2002
Jenby Gano Lewis Total

Profit & Loss


Sales 109.8 28.9 19.3 158.0
COGS 95.7 23.4 13.9 133.1
Gross Margin 14.1 5.5 5.4 24.9
Gross Margin % 12.8% 19.0% 28.0% 15.8%

SG&A 5.5 0.6 1.5 7.612


Depreciation & Amortization 3.3 0.9 0.7 4.8943
Operating Profit 5.3 4.0 3.2 12.4431
Operating Margin % 4.8% 13.8% 16.5% 7.9%

Nonoperating Income
Nonoperating Expenses 123.4 479.4 417.9 1020.7
Income before Taxes -118.1 -475.4 -414.7 -1008.3
Income Taxes -34.3 -137.9 -120.3 -292.4
Net Income after Taxes -83.9 -337.5 -294.4 -715.9
Net Income as % of Sales -76.4% -1168.0% -1525.6% -453.1%

Balance Sheet
Assets
Current Assets 239.1 123.9 789.2 1152.2
Net Fixed Assets 1.3 2.6 1.8 5.7
Total Assets 240.4 126.5 791 1157.9

Liabilities
Current Liabilities
Long-term Debt 290.3 285.3 529.8 1105.4
Other noncurrent Liabilities 0
Total Liabilities 290.3 285.3 529.8 1105.4

Shareholders' Equity
Preferred Stock Equity
Common Stock Equity -49.9 -158.8 261.2 52.5
Total Equity -49.9 -158.8 261.2 52.5
Total Liabilities and Equity 240.4 126.5 791 1157.9

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