The article “Dangerous Games,” by Jonathan Laing is here reproduced from Barron’s

(June 8, 1998). The article describes apparent earnings management devices used by Sunbeam Corp., with “Chainsaw Al” Dunlap as CEO, to “largely manufacture” its 1997 reported earnings of $109.4 million.

Dangerous Games Did “Chainsaw Al” Dunlap manufacture Sunbeam’s earnings last year?
Albert Dunlap likes to tell how confidants warned him in 1996 that taking the top job at the small-appliance maker Sunbeam Corp. would likely be his Vietnam. For a time, the 60-year-old West Point graduate seemingly proved the Cassandras wrong. As the poster boy of ‘Nineties-style corporate cost-cutting, he delivered exactly the huge body counts and punishing airstrikes that Wall Street loved. He dumped half of Sunbeam’s 12,000 employees by either laying them off or selling the operations where they worked. In all, he shuttered or sold about 80 of Sunbeam’s 114 plants, offices and warehouses.
Sunbeam’s sales and earnings responded, and so did its stock price, rising from $12.50 a share the day Dunlap took over in July 1996 to a high of $53 in early March of this year.
But last month Sunbeam suffered a reversal of fortune that was as sudden and traumatic for Dunlap as the Viet Cong’s Tet offensive was to U.S. forces in 1968. After several mild warnings of a possible revenue disappointment, Sunbeam shocked Wall Street by reporting a loss of $44.6 million for the first quarter on a sales decline of3.

6%.

In a trice, the Sunbeam cost-cutting story was dead, along with “Chainsaw Al” Dunlap’s image as the supreme maximizer of shareholder value. Now Sunbeam stock has fallen more than 50% from its peak, to a recent $22.

And just as suddenly, what was supposed to be an easy sprint, Dunlap's last hurrah as a corporate turnaround artist, has turned into a grinding marathon. Lying in tatters is his growth scenario for Sunbeam, based on supposedly sexy new offerings such as soft-ice cream makers, fancy grills, home water purifiers and air-filter appliances. Many of the new products have bombed in the marketplace or run into serious quality problems. Moreover, Sunbeam has run into all manner of production, quality and delivery problems. It recently announced the closing of two Mexican manufacturing facilities with some 2,800 workers, citing the facilities’ lamentable performance. Dozens of key executives, members of what Dunlap just months ago called his Dream Team, are bailing out. And now he faces another year or more of the wrenching restructuring that’s needed to meld Sunbeam with its recently announced acquisitions, including the camping-equipment maker Coleman Co., the smoke detector producer First Alert and Signature Brands USA, best known for its Mr.

Coffee line of appliances. These acquisitions will double the size of a company whose wheels are coming off. This may not be Vietnam, but it sure ain’t Kansas, Toto.

Sunbeam declined to discuss the company’s problems with Barron’s. In some ways, Dunlap seems to have morphed into a latter-day Colonel Kurtz of the movie Apocalypse Now, increasingly out of touch with the grim realities of Sunbeam’s situation and suspicious of friend and foe alike. For example, Wall Street is still buzzing over a confrontation that Dunlap had with PaineWebber analyst Andrew Shore at a Sunbeam meeting with the financial community in New York three weeks ago. Shore had the temerity to ask several questions that Dunlap deemed impertinent, and Dunlap snarled, “You son of a bitch.

If you want to come after me, I'll come after you twice as hard.”

Shore, the first major analyst to downgrade Sunbeam’s stock in April when word began to circulate of a possible first-quarter earnings debacle, is still upset over the incident.

“As far as I'm concerned, Al is the most overrated CEO in America,” he grouses. “He's nothing but a bully who speaks in sound bites and completely lacks substance. ”
Despite Sunbeam’s latest reversal of fortune, don’t expect Al Dunlap to be headed for the poorhouse any time soon. Though the swoon in Sunbeam shares has vaporized the value of the options held by most of the company’s executives and managers, Dunlap’s large option and stock grants are still worth about $70 million, down from a peak value of over $300 million when the stock was at its high. Moreover, in February Dunlap negotiated a new contract, doubling his annual base salary of $2 million. Under a rich benefits package, Sunbeam even foots the bill for Dunlap and his wife's first-class air fare from Florida, where Sunbeam is headquartered, to Philadelphia so that Dunlap can visit his personal dentist to keep his latest bridge comfy and pearly white. Limo charges and overnights at the Four Seasons hotel are included as well. All this from the self-styled champion of shareholder value.
We can’t say we are surprised by Sunbeam’s current woes. In a cover story last year entitled ”Careful, Al” Uune 16), we cast a skeptical eye on Dunlap’s growth objectives in the low-margin, cutthroat small-appliance industry. We also pointed out the yawning gap between Sunbeam’s performance claims and reality. We took special note of Sunbeam’s accounting gimmickry, which appeared to have transmogrified through accounting wizardry the company’s monster 1996 restructuring charge ($337 million before taxes)
into 1997's eye-popping sales and earnings rebound. But to no avail. Wall Street remained impressed by Sunbeam’s earnings, and the stock continued to rise from a price of $37 at the time of the story.
Sunbeam’s financials under Dunlap look like an exercise in high-energy physics, in which time and space seem to fuse and bend. They are a veritable cloud chamber. Income and costs move almost imperceptibly back and forth between the income statement and balance sheet like charged ions, whose vapor trail has long since dissipated by the end of any quarter, when results are reported. There are also some signs of other accounting shenanigans and puffery, including sales and related profits booked in periods before the goods were actually shipped or payment received. Booking sales and earnings in advance can comply with accounting regulations under certain strict circumstances.
“We had an amazing year,” Dunlap crowed in Sunbeam’s recently released 1997 annual report, taking an impromptu victory lap for the profit of $109.4 million, or $1.41 a share, on sales of $1.2 billion. Sunbeam had every incentive to try to shoot the lights out in 1997. Dunlap and crew were convinced they would be able to attract a buyer for the company just as they had done in the second year of their restructuring of Scott Paper in 1995, when Dunlap managed to fob Scott off on Kimberly Clark for $9 billion. They openly shopped Sunbeam around in the second half of last year, but the offer never came. The rising stock price made the company too expensive, and would-be buyers were also deterred by the nightmares Kimberly Clark experienced after buying Scott.
Yet, sad to say, the earnings from Sunbeam’s supposed breakthrough year appear to be largely manufactured. That, at least, is our conclusion after close perusal of the company’s recently released 10-K, with a little help from some people close to the company.
Start with the fact that in the 1996 restructuring, Sunbeam chose to write down to Zero some $90 million of its inventory for product lines being discontinued and other perfectly good items. Even if Sunbeam realized just 50 cents on the dollar by selling these goods in 1997 (in some cases, they reportedly did even better), that would account for about a third of last year’s net income of $109.4 million.
One has to go to the 1997 year-end balance sheet to detect more of mother’s little helpers. One notes a striking $23.2 million drop, from $40.4 million in 1996 to $17.2 million in 1997, in pre-paid expenses and other current assets. There’s no mystery here, according to a former Sunbeam financial type. The huge restructuring charge in 1996 made it a lost year anyway, so Sunbeam prepaid everything it could, ranging from advertising and packaging costs to insurance premiums and various inventory expenses. The result: Costs expensed for 1997 were reduced markedly, if unnaturally. This artifice alone probably yielded an additional $15 million or so in 1997 after-tax income.
Why did Sunbeam’s “Other Current Liabilities” mysteriously drop by $18.1 million and “Other Long-Term Liabilities” fall by $19 million in 1997? The answer is simple, according to folks close to the company. Various reserves for product warranties and other items that were set aside during Sunbeam’s giant 1996 restructuring were drained down in 1997, creating perhaps an additional $25 million or so in additional net income for the year.
On top of all that, as part of the 1996 restructuring charge, Sunbeam reduced the value of its property, plant, equipment and trademarks by $92 million. Though some of these charges applied to assets Sunbeam was selling off, the bulk of the charge related to ongoing operations. This allowed Sunbeam to lower its depreciation and amortization expense on the 1997 income statement by nearly $9 million. That would create about $6 million of additional after-tax income.
Oddly enough, the figure for net property, plant and equipment on Sunbeam’s balance sheet still rose during 1997, to $241 million from $220 million the year before. This is likely an indication that such costs as product development, new packaging and some advertising and marketing initiatives were capitalized or put straight on the balance sheet instead of being expensed in the year they were incurred, as was the previous practice.
In this manner, expense could have been shifted from 1997 into future years, when they can be burned off at a slower, more decorous pace afforded by multi-year depreciation schedules. Why else would Sunbeam’s advertising and promotion expense drop by some $15 million, from $71.5 million in 1996 to $56.4 million last year? Particularly when Sunbeam trotted out a splashy national television ad campaign in 1997 to boost consumer demand for its new products. This advertising shortfall alone contributed another $10 million to Sunbeam's 1997 profits.
The company also got a nice boost from a 61% drop in its allowance for doubtful accounts and cash discounts, from $23.4 million in 1996 to $8.4 million in 1997. And this decline occurred despite a 19% rise in Sunbeam’ sales last year. The milking of this bad debt reserve in 1997 likely puffed net income by an additional $10 million or so.
Then there's the mystery of why Sunbeam’s inventories exploded by some 40%, or $93 million, during 1997. Quite possibly, Sunbeam was playing games with its inventories to help the income statement. By running plants flat out and building inventories, a company can shift fixed overhead costs from the income statement to the balance sheet where they remain ensconced as part of the value of the inventory until such time as the inventory is sold. To be conservative, let's assume this inventory buildup might have helped Sunbeam’s profits to the tune of, say, $10 million.

Lastly, there are more than superficial indications that Sunbeam jammed as many sales as it could in 1997 to pump both the top and bottom lines. The revenue games began innocently enough early last year. Sales were apparently delayed in late 1996, a lost year anyway, and rammed into 1997. Likewise, The Wall Street Journal reported several instances of “inventory stuffing” during 1997, in which Sunbeam either sent more goods than had been ordered by customers or shipped goods even after an order had been cancelled. But these are comparatively venial sins that companies engage in all the time to make a quarter's results look better. Besides, Sunbeam gave the plausible excuse at the time that glitches in a computer system consolidation in the first quarter had them flying blind for a time.
But as 1997 dragged on and the pressure to perform for Wall Street intensified, Sunbeam began to take greater and greater liberties with sales terms to puff current results. The latest 10-K, for example, discloses that in the fourth quarter of last year Sunbeam recorded some $50 million in sales of cooking grills under an “early buy” program that allowed retailers to delay payment for the items as long as six months. Moreover, some $35 million of these “early buys” were categorized “bill and hold” sales and never even left Sunbeam’s warehouses.
Sunbeam engaged in bill-and-hold transactions in other product lines, too, according to a number of people in the appliance industry. In the second quarter, for example, Sunbeam booked a sale and “shipped” some $10 million of blankets to a warehouse it had rented in Mississippi near its Hattiesburg distribution center. They were held there for some weeks for Wal-Mart. The company also pumped millions of dollars of goods into several national small-appliance distributors on such easy payment terms as to call into question whether a sale ever took place. Some with knowledge of Sunbeam’s business practices say the appliance maker in some instances transferred title for the goods to distributors but then agreed to not only delay payment but actually pay the distributors what amounted to a storage charge for taking the goods. These sources also said that in some cases distributors also had the right to return the items to Sunbeam without suffering any loss.
How much did various types of questionable sales add to 1997's net income? No outsider can know for sure. But we can make an educated guess based on the fact that Sunbeam’s receivables, or unpaid customer accounts, jumped by 38%, or $82 million, in 1997. Taking into account Sunbeam’s profit margins, it seems that questionable sales could have boosted 1997 net income by as much as $8 million.
We by no means are privy to all Sunbeam’s techniques for harvesting current earnings from past restructuring charges and future sales. Deconstructing Al Dunlap is a daunting task. But to save our gentle readers the effort, our total estimate of artificial profit boosters in 1997 came to around $120 million compared with the $109.4 million profit the company actually reported. Thus, one is left to wonder whether Sunbeam made anything at all from its actual operations, despite Dunlap’s claim to have realized some $225 million in cost savings as a result of his restructuring prowess.
Our dour view of Sunbeam’s current financial health is only confirmed by the company’s consolidated statement of cash flow in the latest 10-K. These numbers, of course, are harder to finesse because they track the actual cash that flowed in and out of the company during 1997. And the statement doesn’t paint a pretty picture. Despite 1997's eye-catching $109.4 million net profit, Sunbeam still suffered negative cash flow from operations of $8.2 million, after taking into account the explosion in Sunbeam‘s inventory and accounts receivable during the year. And that operating cash flow deficit would have been an even larger $67.2 million if not for the sale of $59 million in receivables in the last week of 1997. After capital expenditures of $58.3 million is thrown into the equation, Sunbeam’s free cash flow deficit amounts to more than $125 million.
Sunbeam’s first-quarter earnings debacle is yet another sign of a company that's in anything but the pink of health. Despite management assertions into April that Sunbeam's first-quarter sales would finish comfortably ahead of those for the first quarter of 1997, they ended up declining 4%. Even more shocking to Dunlap’s fans was the $44.6 million loss in the March quarter compared with a profit in the year earlier period of $6.9 million. Sure, $36.8 million of that first-quarter loss was the result of nonrecurring charges, mostly a handsome new pay package Dunlap managed to negotiate in February. But the operating loss Sunbeam suffered of $7.8 million was a clear sign of its true earnings power once the tank from the 1996 restructuring charge had run dry.
Dunlap trotted out a whole raft of excuses for the company’s lamentable first quarter performance. He cited dumb deals his former No. 3 executive had made with major retailers before Chainsaw fired him in April, the effect of bad weather on grill sales caused by El Nino, and so forth.
Whatever the case, the first-quarter disaster wasn’t the result of any lack of effort on Sunbeam’s part to pump up the results. The company recorded $29 million of additional “buy now, pay later” grill sales. In fact, the company is now holding so many grills, in various warehouses around its Neosho, Missouri, grill plant that it has had to lease warehouse space in nearby Oklahoma. Who knows how many of these grills will ever make it to the selling floor?
Sunbeam also extended its quarter by three days, from March 28 to March31.

This allowed the company to book an extra $20 million in sales both from ongoing Sunbeam operations and two days of sales from Coleman (its acquisition closed on March 30). But to no avail. Sunbeam still fell $9 million short of last year’s sales of $253.5 million.

Reports are rife that Sunbeam tried to strong-arm suppliers into “recutting” their invoices for various goods and services so that Sunbeam would officially owe less money.

The proviso was that the suppliers would be allowed to add back the amount forgone, plus interest, in invoices submitted after the first quarter had ended. A Sunbeam financial official denies the “recutting” charge and characterizes the activity by the company’s procurement department as the normal give-and-take that goes on between suppliers and companies seeking rebates.

But that’s not the understanding held by an official at one China-based supplier.

When contacted by Barron’s, this official readily acknowledged that he had sent Sunbeam a check for $500,000, or 5% of the business he does annually with the company, in late March. “The only reason | sent them a check rather than a new invoice is that we had no invoices outstanding at the time we received the call,” he explained. “We figure our contribution dropped right down to the bottom line if Sunbeam actually booked it. | don’t know what happened, though.”

For the next few quarters, expect the recent acquisition of Coleman, First Alert and Mr. Coffee to restore a measure of calm to Sunbeam’s financial performance. The giant restructuring charges that Sunbeam is taking to integrate the new units, at $390 million before taxes, will give the company plenty of fodder with which to play earnings games.

The company is even forecasting earnings of $1 a share this year and $2 next year before extraordinary items, naturally.
But Dunlap’s days at Sunbeam may be numbered. The already-ailing company now has to struggle under $2 billion of additional debt and a negative tangible net worth of $800 million. And his enemies, including disenchanted shareholders, angry securities analysts, and bitter former employees, are growing in number and circling ever closer to the company's headquarters in Delray Beach. Of course, Dunlap could always escape by using the building's flat roof to chopper out, should it come to that. One can only hope he’ll remember to take the American flag with him.
Source: Reprinted by permission of Barron’s, at 1998 Dow Jones and Company, Inc. All rights reserved worldwide.
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Required

a. Jonathan Laing notes that Sunbeam’s prepaid expenses declined from $40.4 million at December 31, 1996, to $17.2 million at December 31, 1997, a reduction of $23.2 million.
He points out that 1996 was a “lost year anyway” (because of a 1996 restructuring charge of $337 million), so Sunbeam “prepaid everything it could.” Laing then states that this “artifice alone probably yielded” $15 million in 1997 after-tax income.
Do you agree with Laing’s analysis of the effect of the decline in prepaid expenses during 1997 on 1997 net income? Explain why or why not.

b. Laing reports that 1997 operating cash flow was —$8.2 million. Since net income was reported as $109.4 million, net income-increasing accruals must have totalled $117.6 million. Use the information in the article to itemize the impacts on net income of the various earnings management devices described. How close does your itemized list come to $117.6 million? In arriving at your itemized total, take your answer to part a into account. Do you agree with Laing’s statement that 1997 earnings “appear to be largely manufactured” ? Explain why or why not.

c. On the last page, the article refers to Sunbeam’s acquisition of Coleman, First Alert, and Mr. Coffee, indicating that Sunbeam is taking restructuring charges of $390 million to integrate these firms into its operations. Explain how this will “give the company plenty of fodder with which to play earnings games.“

d. Use the “iron law” of accruals reversal to help explain why there was a substantial first quarter 1998 loss.