The State of New York versus Ernst and Young

The New York Times reported this week that NY Attorney General Andrew Cuomo sued Ernst and Young on Tuesday, accusing the accounting firm of helping its client, Lehman Brothers, to "engage in a massive accounting fraud" by misleading investors regarding the financial health of the investment bank.
 
It seems that Ernst and Young approved a controversial accounting maneuver known inside Lehman Bros. as "Repo 105", which involved the "surreptitious removal of tens of billions of dollars of securities [debt] from Lehman's balance sheet to create a false impression of Lehman's liquidity, thereby defauding the investing public". The NY Times reported that this tactic temporarily removed as much as $50 billion from Lehman's balance sheet to give the appearance that Lehman had reduced its debt levels. 

Cuomo referred to the practice as a "House of Cards business model, designed to hide billions in liabilities before Lehman collapsed." The shock waves were felt with great pain around the world.  

The "repo" transactions, variations of which are employed ubiquitously on Wall Street, occur when an investment bank raises cash by selling assets, then buying them back a few days later. These transactions would typically occur just before the close of the books at the end of financial quarters.
 
Ernst and Young argue, of course, that such transactions are allowed under GAAP (Generally Accepted Accounting Principles). I am not an Accountant, and as such cannot express an opinion one way or the other. But this certainly fails to pass my ethical "sniff test": is management interfering in the normal patterns of business in an extraordinary way in an attempt to distort reality and otherwise mislead stakeholders?   

There is an analagous practice which occurs frequently in the Canadian retail, wholesale, and manufacturing supply chains. From the point of views of the industrial customer, this is called "forward buying." It works something like this:

As a manufacturer or wholesaler approaches its fiscal period end (month, quarter, or year), management realizes that it is about to fall short of its sales targets. It creates incentives for its customers to buy product in quantities that the customer would not normally need. These incentives are frequently expressed as reduced cost prices or discounts from contracted prices, if the customer will buy quantities prescribed by the seller. The customer, let's assume that in this case it is a retailer, performs a quick analysis of the "deal" (comparing the reduced prices to the related inventory carrying costs, for example) and arrives at a decision to buy or not buy the incremental quantities. 

Incentives need not necessarily come in the form of reduced prices. Occasionally, they can come in the form of an "exchange of favours" by individuals in senior management, extended payment terms, and a variety of other arrangements. 

As a professional inventory manager, I have always argued strenuously against this technique. Not only does it open the seller/customer relationship to unethical practices, but the true costs of such transactions are frequently overlooked. From the seller's perspective, I call it "mortgaging the future" to relieve current pain.  

It often takes a long time for conditions to develop which lead to offering such deals, but once the firm is on the merry-go-round it is very difficult to get off. It is like a heroine addict who receives great pleasure and results from the first hit, then spends a lifetime trying to replicate that first feeling.

Pretend that Wholesaler ABC has enjoyed 50 years of relatively stable growth, with sales averaging +5% growth annually. Senior management at ABC sign on to a +5% budgeted sales increase for 2010. Shipments in 2009 were 100,000 cases of widgets. ABC must therefore ship 105,000 cases in 2010 to meet their sales target. The average price of a case is $1,000, so annual sales in 2009 were about $100,000,000. 

Significant unexpected changes happen in the marketplace in 2010. Such changes might include the entry of new competitors, a softening of the macroeconomy, a change in consumer tastes, or government legislation. Whatever the negative issue, sales for ABC start to trend downward, at a rate of 95% of the prior year's volume. Management at ABC either ignore the slide, or dismiss it as a temporary "blip", or are completely unaware of it due to flaws in their sales analysis system.     

On Dec.  1, 2010, the sales trends hit management at ABC like a shovel in the face. Not only are sales down relative to last year, they will never make budget! In fact, the gap between actual and budgeted sales looks like it will be 10%! (5% vs.LY + 5% growth). After 11 months, they realize that their shipments will be about 95,000 cases, versus a target of 105,000 cases and the shortfall is therefore about 10,000 cases ($10,000,000).

Management panics. It's "Let's Make a Deal" time at ABC. They approach their top two customers, Customer 123 and Customer 456. If each of these two customers buy an extra 6,250 cases, to be shipped before December 31, 2010, ABC will extend a 20% cost discount on the incremental purchase. (6,250 x 2 x $800 per case = $10,000,000 = sales shortfall).

On Dec. 15, 2010, both 123 and 456 agree. The incremental purchases represent about 3 months' worth of stock at each of Customer 123 and Customer 456. Ultimately, ABC achieves their 2010 sales target.

What are the costs of this deal to ABC?

One might answer, correctly, that ABC has lost potential gross margin dollars of 12,500 x $200 / case = $2,500,000. Incidentally, ABC had  to ship 12,500 cases, and not just the "gap" of 10,000 cases, because the selling price has been reduced to $800 per case rather than the contracted $1,000 per case. So, 12,500 x $800 is enough extra volume to make up the shortfall in dollars. 

But, there are other costs to ABC. Since they are shipping an extra 12,500 cases, which is about 4 weeks of normal stock, in the last two weeks of December, they are cramming 6 weeks of work into 2 weeks. This means extreme pressure on operations.
- overtime might have to be paid to warehouse workers
- inbound product (e.g. subcomponents or raw materials) might have to be expedited. ABC have to incur air freight and premium routing costs in order to ensure backorders are not accumulated?.
- standard manufacturing or assembly maintenance procedures might be foregone, as lines are dedicated to increased production or assembly.
- standard Health & Safety considerations might be overlooked in the month-end rush. Might there be a higher risk of accident, injury or burn-out?
- this is Christmas Break time, and the extra work could effect employee morale.
- integrity of inventory record accuracy and inventory control measures might be compromised in the rush to finish paperwork.

At the end of the day, is ABC any farther ahead? In many cases, the answer to this is "no." Their Big Customers, 123 and 456, have simply "bought forward" 3 months' of supply. They now have surplus. They will simply shut down their purchasing for 3 months, until the surplus is reduced to normal levels. At the end of the First Quarter, therefore, Supplier ABC is in even worse shape than they were in December! The gap between actual sales and budgeted sales widens further. 

Besides, ABC has now misled their investors, by overstating their sales potential, and the financial health of their company.

Unless ABC is willing to tackle the underlying causes of the 2010 sales erosion (competition, style, or legislation) ABC's financial condition will continue to worsen. 

Customers become perturbed as well! Customers 123 and 456 now have surplus. Their careful management of inventories for the past 11 months has now been eradicated. Their warehouses are strained to find homes for the extra inventory. They are exposed to shelf-life issues, increased risk if shrink, and increased risk already associated with forecast accuracy.
 
I have see situations where Customers 123 and 456 end up returning the surplus stock! What a disaster for everyone!

There are too many reasons not to jump on merry-go-rounds of this nature. Do the right thing: address the underlying problems and take your lumps when you have to do so. But do not matrgage the future with schemes such as these.