Sunbeam Corporation Accounting Fraud and Audit Failure

Introduction and Corporate History

This paper examines Sunbeam Corporation's fraudulent accounting during fiscal years 1996, 1997, and early 1998. It also reviews the historic audit failure that occurred and discusses the factors that contributed to the scandal and the ways in which it might have been prevented.

Sunbeam, the consumer brand name that would become well known among generations of Americans, had its beginnings in 1893 when founders John K. Stewart and Thomas J. Clark began manufacturing and selling a commercial horse-clipping machine in Chicago. In 1897 the company was incorporated as the Chicago Flexible Shaft Company. When the company began manufacturing an electric iron named "The Princess" — its first electric appliance — the product's introduction marked the beginning of the Electrical Appliance Division of today's Jarden Corporation (Jarden, 2011).

In the early years, the company's products, ranging from toasters to irons to mixers, were so successful that the company changed its name to the Sunbeam Corporation in 1946. In 1980 Sunbeam acquired the Oster Company, which produced consumer items including barber and beauty care products. Allegheny International purchased Sunbeam in 1981, at a time when Sunbeam had sales of well over one billion dollars and was already the best-known brand of small electrical appliances in the country (Funding Universe, n.d.).

Allegheny International fell victim to a series of management problems, culminating in the company filing for reorganization under Chapter 11 in 1988. The court-approved reorganization resulted in Japonica Partners' purchase of the Sunbeam-Oster Company. Within two years the company yielded a billion dollars in sales revenues, enabling it to make the Fortune 500 list. By the mid-1990s the company's revenues had grown to $5.5 billion in global sales of consumer products, with manufacturing facilities around the world (Funding Universe, n.d.).

However, by July 1996 the company's shares were trading at a low of $12.50 and revenues had declined drastically. To turn the company around, Sunbeam's board of directors brought in Albert J. Dunlap, known in the business press as "Chainsaw Al" and "Rambo in Pinstripes." Within seven months of joining Sunbeam, Dunlap divested divisions, cutting the number of factories from 26 to 8 and warehouses from 61 to 18. He also eliminated 6,000 positions — half the company's workforce. Dunlap installed his hand-picked team of executives, including Executive VP and Principal Financial Officer Russell Kersh, who had been Dunlap's right-hand man for 14 years. In 1996 Sunbeam reported $26 million in savings from the cuts, with only a marginal decline in revenues, from $1 billion to $982 million (Sadka, 2010).

Sunbeam revenues increased dramatically in 1997, with sales rising 22% over 1996. Earnings per share increased to $1.41, compared with a $2.37 loss in 1996. In its 1997 Annual Report, the company attributed cost savings to its restructuring while crediting its revenue growth to: a global sales increase across all five product categories; the introduction of new appliances, including redesigned blenders, mixers, and toasters, along with increased distribution through national retailers; and, most significantly, an increase in sales of outdoor cooking grills, which had previously reported three straight years of declines.

The annual report credited the stepped-up grill sales to "increased merchandising and advertising programs" and an entirely new line of grills and accessories for the 1998 season. These products began to ship in the fourth quarter of 1997 under the company's new early-buy marketing program, which included significant discounts along with credit extended into the second quarter of 1998. Sunbeam claimed that the early-buy program leveled out seasonal dips and peaks. Meanwhile, Sunbeam competitors and market analysts wondered how the company could survive such aggressive selling with such low prices and flexible payment terms (Sadka, 2010).

Investors anticipated further exceptional positive results at the end of the company's first quarter of 1998, sending the stock price climbing to a high of $52 in March. Investors also anticipated that the company would seek a buyer; instead, Sunbeam acquired three companies — Coleman (camping products), First Alert (home safety and security), and Signature Brands (maker of Mr. Coffee coffeemakers) — transforming Sunbeam into a $2.6 billion company (Sadka, 2010). Some analysts began to suspect that these acquisitions were intended to disguise losses through the use of write-offs.

Fraudulent Accounting Schemes

Wall Street was shocked by Sunbeam's announcement on April 3, 1998 that the company would report a loss, coming in at 5% below the previous year's revenues of $253 million. Initially Sunbeam blamed the loss on costs incurred with the three acquisitions and attributed the revenue deficiency to lower-than-expected orders for barbecue grills — the very product it had credited with producing exceptional results for 1997. Dunlap then made a show of firing Executive VP of Consumer Products Don Uzzi along with other top executives. Sunbeam followed that up with an announcement that it would cut 40% of its workforce — approximately 6,400 jobs — and close 8 of its 24 plants.

Nonetheless, the cuts did nothing to counter the news of a first-quarter loss of $44.6 million, a drop in sales of 3.6%, and lowered expectations for the remainder of the year. Sunbeam's domestic sales, which made up 75% of the company's revenue, were down 15%, clearly the result of the barbecue grill strategy. Dunlap offered a variety of excuses, blaming a marketing executive for the early-buy fiasco and the weather for discouraging shoppers from grill purchases. He categorically denied that the company had stuffed its channels to pump sales, claiming it was simply a failed marketing strategy (Sadka, 2010).

Intentional or not, Sunbeam had indeed employed channel stuffing — a practice wherein a company ships inventory ahead of schedule in order to fill its distribution channels with far more product than is needed. A company does this by offering promotions that are nearly impossible for the retailer to resist, then booking the shipments as sales. The Securities and Exchange Commission (SEC) permits companies to book sales for the amount of product shipped, less a reasonable estimate for expected returns. At the same time, the SEC prohibits a company from recognizing revenue until the number of returns is known, a requirement that may not be met for many months. Sunbeam failed to wait for the returns before recognizing revenue (Sadka, 2010).

Not only did Sunbeam pump its channels with grills, it also employed a "bill and hold" scheme intended to reassure retailers who may have been uncomfortable holding additional inventory for such an extended period. Sunbeam allowed its customers to use the company's own warehouses to store grills that customers had bought but had not yet paid for. Once again, the SEC permits "bill and hold" practices when specific requirements are met. One such requirement is that the buyer — rather than the seller — must request the arrangement, which was not the case with Sunbeam (Sadka, 2010).

Due to these losses and accounting irregularities, furious investors and analysts called for Dunlap's ouster, which occurred in July 1998 after only two years at the company's helm. Following its own investigation, the SEC announced in May 2001 that at least $62 million of Sunbeam's reported $189 million in income for 1997 did not comply with accounting rules. The SEC charged Dunlap and four former officers, as well as Arthur Andersen partner Philip Harlow, with knowingly allowing Sunbeam's accounting irregularities. The charges included cookie jar accounting — a misleading practice that takes generous reserves set aside from profitable years and uses them in unprofitable years to smooth out earnings. Dunlap initially expressed outrage at the findings, but by 2002 had agreed to pay a fine of $500,000 and accepted the SEC's decision to bar him from ever serving again as an officer or director of a publicly traded company. In February 2001 Sunbeam filed for bankruptcy protection (Sadka, 2010).

Nature of Material Misstatement

Sunbeam's manipulation of its financial reporting presented inaccurate financial statement information intended to influence the company's value and stock price. SEC Staff Accounting Bulletin (SAB) 99 sets guidelines for use in determining materiality. The bulletin notes that relying exclusively on particular quantitative benchmarks — such as a 5% threshold for misstatements — is "inappropriate." The fact that a misstatement falls below the 5% threshold does not mean it can be classified as immaterial (SEC, 1999). In every instance, Sunbeam's accounting practices manipulated financial reports such that misstated amounts far exceeded 5%.

Auditors have traditionally used a rule of thumb holding that a 5 to 10% impact on a company's financial statements is the threshold for determining whether an accounting discrepancy is material. SAB 99 clarifies other qualitative factors which may cause even numerically small misstatements to reach the level of materiality. While it can be argued that the guidelines listed in SAB 99, which was written after the Sunbeam scandal, should not be applied retroactively, it was the SEC's position that SAB 99 did not change existing standards (SEC, 1999).

SAB 99 provides references to earlier provisions already in effect under which Sunbeam's conduct was unlawful. The bulletin points out that firms must comply with Sections 13(b)(2)–(7) of the Securities Exchange Act of 1934, which requires SEC-registered companies to "make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets" (SEC, 1999). The standard for determining "reasonable detail" and "reasonable assurance" is that they would "satisfy prudent officials in the conduct of their own affairs" (SEC, 1999). The degree of manipulation that Sunbeam executives and auditors exercised in reporting the company's financial transactions far exceeded what most people would consider prudent or reasonable.

Conclusion

The SEC's enforcement role in the Sunbeam case could have been far more forceful. Most SEC actions end in negotiated settlements (Bloomberg, 2001), and those settlements apparently impose few stiff penalties. This practice needs to change. The SEC also needs to eliminate revolving-door hiring policies that allow companies to recruit SEC regulators and auditor personnel — a dynamic tantamount to putting the fox in charge of the henhouse.

None of Sunbeam's fraudulent accounting would have been possible without the collusion of its auditor. The entire scheme depended on Sunbeam securing unqualified audit opinions to enable the sale of the company at a grossly inflated price. These kinds of financial crimes would occur with far less frequency if the SEC and other regulatory agencies chose to prosecute perpetrators aggressively and ensure that they were appropriately sentenced to prison time and required to make restitution to their victims. Instead, the SEC handed out what amounted to slaps on the wrist to all the perpetrators, thus providing no real deterrent to what continues to be a white-collar crime wave in the financial community.

References

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