Jim Beck Valve Division Controller

Tyco Valves did about $1.0 Billion in annual sales (Tyco did consolidated sales of $40 Billion). We had Mfg plants worldwide and sold through a series of distribution centers in the US. I was aware of other dealings but not first hand.

The trouble at Tyco at started before all the SOX stuff so controls were very loose to nonexistent.

When I was controller of the Industrial Valve division there was no requirement to reconcile accounts or to have JEs approved. Support for a JE was up to the individual controller so support was inconsistent. Operational control was centered with the division president and division CFO (my direct report). They were profit oriented with 25% operating profit (OP) growth required year over year, no exceptions. Making your OP profit number ensured 100% bonus + stock. 125% of OP profit goal got you 200% bonus and more stock. And it went up from there. Not make your OP profit number got you fired.

I never talked to an internal auditor when I was there (1.5 yrs). The internal auditors were not allowed to talk to the board and reported directly to the CEO.

As far as the CEO, CFO and others, they ran Tyco as their own personal company. The CEO was greedy and dumb. He was raking in $100s of millions from Tyco in salaries, bonuses, stock and shady forgiven loans. The thing that started his downfall was something minor. He bought some art in Europe for his New York apartment which Tyco bought and renovated for him. Rather than pay New York personal property tax he created a phony set of delivery documents showing the art was delivered to Vermont when it actually was shipped direct to New York. New York caught him and it was yet another reason to peel back the layers of his criminal activity. Yet another piece of evidence into the mind set of top management

In addition PWC earned 10x the fees from acquisition consulting than they did in auditing. Management continued to remind them that these consulting fees were at risk if they got too critical during their audit. I think Tyco was primarily responsible for this provision in SOX that auditors not engage in consulting services for audit clients.

Questions

How would you rate the control environment at Tyco at this time?

How should the external auditor have responded?

Here is what happened in our division: I will give you 3 actual situations I was involved in (which led me to quit)

Tyco Scenario 1 Goodwill and Liabilities

Tyco was an acquisition machine, all the divisions were encouraged to buy up companies and Tyco averaged an acquisition a week. This also came at the time when the Goodwill amortization rules started changing. It was no longer required to amortize goodwill you just had to do the analysis every year that the goodwill on the books was going to generate sufficient cash flow to justify the asset. In our case we were buying up distribution centers in Canada, US and Mexico. When doing the analysis on the acquisition we would go overboard with setting up contingent liabilities for any and everything (a huge GAAP violation) , i.e. setting up a legal liability for defense of the right to sell our brand in that territory, it was set at 10x the amount any reasonable person would set it at, of course we had Tyco lawyers help with the estimate and a complicit PWC passing on it. This of course goes to goodwill. After one year when fair value was established you are left with a big goodwill balance and a bunch of liabilities that you will never pay. Now you have this big pool of liability balance to reverse into Operating profit whenever you need it. I would get a call every quarter telling me how much of a particular liability to reverse to meet the OP expectations. Always a phone call, nothing in writing. (I always documented the call anyway). It was an easy way to manage profitability. You could always make some assumption that would keep you from having to make the corresponding reduction to the intangible asset. Almost fool proof. BUT here is what happened. This was nothing but a Ponzi scheme. Operating profit achieved this way generates no cash. You need to keep making acquisitions to keep the accounting entries coming. Tyco started running out of cash to make acquisitions. When that happened the liabilities were no longer there to manage OP profit. Investors started looking behind the curtain and the house of cards started collapsing.

Tyco Scenario 2 Goodwill and Inventory

Since we had manufacturing facilities, stuff happens with finished inventory. Defects, production overruns, order cancellations etc. You are always left with a bunch of excess, obsolete and defective inventory. Tyco would never make a provision for this (GAAP rule broken). Here is what we would do. Tyco used to sell to independent 3rd party distributors and did not sell direct to the end user. They changed this philosophy about the time I was hired and began buying up all of their distributors. So here is what happened, after you have agreed to a deal to buy a distributor (which used to be your customer) but before the deal is closed, you instruct them to place a purchase order for your distressed inventory at prime prices (they agree to this since it is usually a deal based on a firm price plus a change in working capital. The distributor never pays for the inventory but puts it into inventory at a prime value. On the closing day the old owners get the agreed upon price + the increase in working capital (which includes this inventory). The day after the deal closes Tyco makes the determination the inventory is worthless and makes the adjustment to goodwill. The factory just got rid of a bunch of obsolete inventory without taking a reserve hit. The number ends up in goodwill forever.

Tyco Scenario 3 Standard Costing and Discontinued Operations

Tyco was on a standard cost system. Every day when I looked at the inventory receipt transactions for the previous day, I would look for large unfavorable purchase price variances. This was my indication that we had a new commodity and that it was missing a standard cost. I would work with the engineers and we would develop the cost and enter it into the system and reverse the unfavorable variance.

At my last year end close the President of the division found out about this. He instructed me to find all inventory that was missing a standard cost, create one and take a positive hit( again managing OP). I told him I review this daily and there was nothing there. He got somebody (not me) to run a report for him and he found a block of inventory with no standard cost and told me to make an entry and write it up. As I investigated, all of the inventory was for a discontinued operation for which a reserve was taken and all the financials reported this as a discontinued operation. His argument was we sold bits and pieces of this inventory as spare parts. I informed him that was not sufficient justification for writing up an asset on a previously reported discontinued operation. He told me to do it or he would find somebody who would. Then I quit.

Questions

What internal controls could have been in-place to prevent this from happening?

Could the external auditors have done anything in this situation?

Standard Costing Example

Inventory on books for standard cost of $50. Actual cost to produce is $100. When produced, the entry looks like this:

Debit Inventory 50

Debit Price Variance 50 (This reduces profit on income statement)

Credit Accounts Payable (or Cash) 100