Summary of the Tyco International (Corporate Scandal)
Tyco International was a major producer of electrical components in over 100 different countries. They also designed and manufactured underwater telecommunications devices, fire protection systems, plastics and adhesives, electronic security equipment, specialized valves and a large market share of disposable medical products. In 1992, Tyco International announced Dennis Kozlowski as CEO. Two incidents were brought to Kozlowski during 2002 and 2003 along with Tyco’s CFO, Mark H. Swartz. The results were released in 2005, Kozlowski and Swartz were convicted of major larceny charges, bribery, securities fraud, and falsifying business records.
Kozlowski was the main person who manipulated and convinced other senior Tyco workers to participate and cover in exchange for financial benefits from their activities. The CEO and CFO began combining the assets and started using the company’s capital for personal expenses. Once Kozlowski had Tyco pay $30 million for his apartment and $14.7 million for an abstract painting, an example of commingling. All this was easier to manipulate as the company already had systems that would enable this kind of abuse of the assets of the company.
According to (Romero, 2017), not just stealing funds was the Tyco scandal. It was an evasion of firm policies for financial loopholes. (Romero, 2017) The fraud was carried out by the CEO and CFO who provided themselves with very low interest loans often disguised as incentives that were not approved by the board and never paid back. Some of these loans where part of Key Employee Loan a program that the company offered.
They were further accused of selling the shares of the company without consulting investors, which is a prerequisite under SEC regulations. When part of Tyco’s loan-forgiveness program, up to 40 loans were eventually “forgiven.” Something to note is that a lot of people didn’t think they were doing something wrong. Money was also paid out through the business systems to buy their silence about Kozlowski’s behavior in the organization. It resulted in further bribery in Tyco’s top branch of members making Kozlowski bolder as time went by. (U.S. Securities and Exchange Commission, 2002)
Tyco took advantage of the financial term “acquisition” to confuse investors and put in place accounting loopholes. Tyco pursued a special course of acquisitions to win the attention of market watchers with exceptional and impressive financial performance. While it focused solely on delivering outstanding results to prevent the low organic growth it actually had. It purchased several companies and kept on following the scheme for a couple of years to play a wicked trick to cover the slow organic growth by taking advantage of acquisition and disposal accounting procedures to inflate the CFFO.
Tyco’s trick centered on switching between two parts of the cash flow statement: the operating and the investment cash flows, particularly acquisition accounts. Rather than getting fooled and brought an outflow through the Tyco operating segment through the investing one.
It positively impacts the CFFO by showing strong quarterly numbers. By doing so, Tyco became a professional trick master by taking advantage of loopholes. This can, of course, be achieved in two ways when it buys another company: either by selling shares in return, which do not have cash outflow, or by paying out cash, which comes under accounting rules as an investment outflow.
Since Tyco actually owns the company, it profits from the purchased company’s new inflows, in that case, all the acquired revenue is reported as sales on Tyco’s financial statements and the same for all other accounts falling under one company. (Shcilit & Perler, 2010)
This influenced and highlighted CFFO’s strong performance by adding new revenue sources from new businesses to improve the operating segment. This can certainly be incredibly affective if in a few years you do this regularly. Between 1999 and 2002 (the timeframe of scandal), Tyco spent approximately $29 billion on buying and including under its wing businesses that acquired over 700 new companies (Shcilit & Perler, 2010). Tyco has produced the following CFFO during these years:
($ millions) 2002 2001 2000 1999
Cash flow from operations 5,696 6,926 5,275 3,550
Tyco used deceptive forms of accounting to massively inflate its earnings. During the time of controversy, the home security surveillance subsidiary of Tyco, ADT, was becoming a well-known popular company in the 1990s. It is necessary to have a higher number of contracts with new customers to increase the profits of a business. In a typical case, a company can do this through its sales department or through dealerships, which in that instance is considered an external network. Nevertheless, Tyco used both approaches, but heavily relied on the last.
The trick Tyco greatly benefited from was that it used several sales forces from suppliers as an outsourcing service; hence not using them as a payroll in the expenditure myth, but as they sell security contracts. In exchange, Tyco paid $800 for every new customer deal. The key problem was that Tyco distorted accounts by treating such sums of transactions as “acquisition of contracts.” Thus, the change from an expense to an investment outflow in the cash flow statement. Of course, it would overestimate the cash flow from operations (CFFO) by playing this card. It seemed, however, that Tyco enjoyed the game and manipulated this move by going into another shenanigan further.
Tyco invented a special bogus charge that would plug millions into its company. This created a charge naming it “dealer connection fee” which reflects a $200 payment charged by the dealer for each Tyco purchase in contract. In this scenario it benefits from its cash flow from an operating inflow of $200. Indeed, doing that would annoy the dealers defiantly as it will decline a contract’s net profit to $600 down from $800. But then again, Tyco already thought about that and just increased the sales fee from $800 to $1000 to the dealers. In this circumstance, everyone was satisfied except that Tyco would profit from the $200 fraudulent “dealer connection fee” which produced a total of $719 million in CFFO over those years as an operating inflow. (Shcilit & Perler, 2010)