I think we can take a break from the current topics of accounting profession, regulator, and board bashing for a week. It is also unlikely that the options exchanges will improve the way they do business by next week, so that can wait also. In the midst of the current mania about public accounting firms’ conflicts of interest and possible fraud, as well as questions about their real proper role, I think it might be interesting to describe a situation at a firm I was involved with before becoming a trader. My purpose is both to tell a good story (the truth being more entertaining than fiction) and to show that a lot of the conflicts and interplay between firms and auditors regarding bad news were there long before auditors became consultants as well as auditors.

           
In the late 1970’s I worked as a senior financial analyst for the passenger car division of Pullman Inc. I don’t know exactly what made me “senior” since there was no “juniors” beneath me, but that was my title. At the time Pullman was the oldest company listed on the New York Stock Exchange, and had a wide range of businesses, building passenger rail cars, freight cars, truck trailers, refineries, and large chimneys. About two years before I joined Pullman, in 1978, they had contracted with the U.S. government to design and build 284 double decked railcars for the new Amtrak rail system. Due to a lot of reasons, including literally hundreds of customer driven design changes, a strike at Pullman, a bad initial estimate, etc. the contact was seriously behind schedule when I arrived. The problem was in figuring how far behind, both in time and money, and when and how to tell the world.

           
The auditing firm used by Pullman was Arthur Young and Co., a firm with whom they had a long relationship. At the time Pullman was sticking to its story that even though there had been “some slippage” in the program, they had essentially only burned up the profit built into the original estimate. Auditors were paying particular attention to the latest estimates showing the contract still at break even, and were literally camped out at the plant. At one point I was assigned to organize a plant tour for a particularly attractive female auditor. Fortunately, she took my advice on dressing conservatively, as plant floors weren’t exactly politically correct in those days. I still remember her quizzing a succession of crusty old welders with questions like “Are you confident you can maintain 100% labor efficiency for the remainder of the contract?” She created quite a stir, maybe not the right kind, but there was no question she was trying her best to justify the numbers being thrown at her. 

           
At the audits completion, which in the days before computers literally meant trunks of work papers, senior officers of both Pullman and Arthur Young would get together to negotiate the official story. Then, as well as now, the auditing firm did not just run to the press with their version of a disagreement. There was a negotiation process. The Pullman financial people were able to sell their belief that some combination of back-end efficiency, possible increased money from the customer for design changes, etc. meant that no official loss declaration was warranted at the time. The auditors bought it, but I think they were pretty suspicious. As time went by the contract continued to slip, but the combination of denial and false hope caused the company’s “official” break-even story to persevere for quite a while. You would think that one or two of the board members would be suspicious when the entire amount of labor hours in the original estimate were used up before any cars were delivered.

           
Somewhere in this denial phase my boss asked me to take no more than two days to come up with an internal and independent estimate as to the state of the contract. Of course, no one was to know what I was working on and no one was to see the results before him. My only qualification for this assignment over anyone else was that I was the only finance person the plant guys trusted, so for two days my job was to pick other peoples brains and add up the results. The analysis was fairly straightforward, Pullman had a long history of labor hour studies and learning curve tables, so I was able to estimate the total labor hours to finish the job. From there it’s easy to figure the amount of hours per month to calculate the time slippage in terms of overhead. Add in a little material cost overrun estimate, and there you have it. As for the number, “Holy bleep!” My two-day assignment had come up with a loss estimate of $240 million - if nothing else changed, which in 1979 was serious money. Even though everyone close knew the contract was in serious trouble, this number was a shocker to all, including me. Due to the fact that the customer caused much of the slippage by continual design changes, and the possibility of them being forced to adjust the purchase price of the cars, Pullman management was not ready to admit to my worst case estimate. They did subsequently start to declare some losses, but in increments of $20 to $40 million. Even though no one disagreed with my logic, upper management was not willing to give up hope that things could be partially saved or renegotiated. Even though it was not my area, I too thought that Amtrak was a big part of the mess, and could be forced to monetarily share some blame.

           
As for the horrible results for the shareholders, there weren’t any. A company named Wheelabrator-Frye submitted a non-solicited cash bid for all the outstanding stock of Pullman at a substantial premium. When the smoke cleared they ended up paying $52 cash for a stock that had been trading under $30. Everyone was off the hook, Pullman executives had long buried stock options that were suddenly revived, Pullman’s CEO became the head of the Federal Reserve Bank of Chicago, board members and management who had ignored the signals from the passenger unit were heroes, and Arthur Young was in the clear. As you might have guessed, none of us close to the problem owned any stock. As for how the Wheelabrator people felt eventually about their hasty purchase I never heard.