Assignment

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 JE's 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 $100's 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.

Questions

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

What should the external auditors have done in this situation?