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

2. 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 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.

Questions 1. What internal controls could have been in-place to prevent this from happening?

2. What should the external auditors have done in this situation?