The Wall Street Journal Interactive Edition

In the early 1990s, executives at W.R. Grace & Co. became troubled about the performance of the company's National Medical Care Inc. unit. The problem: earnings were growing too fast.

Profit was increasing more than 30% a year, exceeding the unit's growth target. While most companies would be ecstatic, Grace executives worried the unit couldn't keep it up. So they quietly stashed the excess profit in an all-purpose reserve, which they later would tap in a way that masked real problems -- including slowing earnings.

The profit stockpile soon was discovered by Price Waterhouse auditors, who repeatedly told Grace that this was wrong, internal Price Waterhouse memos show. But instead of standing firm, the accountants gave the financial statements a clean bill of health.

How Grace allegedly cooked its books, to use layman's parlance, provides a rare glimpse at earnings "management," which can cover a range of practices and involve sums large and small. Though widely believed common, it is usually invisible, and only came to light in this instance because of a case filed by the U.S. Securities and Exchange Commission against Grace and a whistleblower suit filed by Grace's former inhouse audit chief, who claims he was fired after raising questions.

The SEC contends that the chemical company and six former executives fraudulently manipulated earnings. As part of a broad crackdown on accounting fraud, SEC staffers also are considering actions against the firm now called PricewaterhouseCoopers LLP and two of its partners, people involved in the case say. The SEC actions against Grace, filed late last year in federal court in Miami and before the commission in Washington, D.C., have already caused a stir because they are seen as an assault by the agency on the games companies play to tweak results to avoid missing Wall Street's quarterly earnings estimates. This "is not an isolated phenomenon," says SEC enforcement chief Richard Walker.

Internal company and audit-firm memos, as well as deposition excerpts, show a breakdown in controls at Grace and far larger distortions to earnings than previously disclosed. At least six Price Waterhouse auditors and Norman Eatough, Grace's former inhouse audit chief, questioned the propriety of Grace's accounting maneuvers. Mr. Eatough even took the bold step of complaining to the board's audit committee -- to no avail.

	What the Company Said: ... it is clear, barring unforeseen events, that the combination of NMC's operational forecasts and these reserves would permit achievement of a 24% annual growth rate objective for several years.
	What the Auditors Said: JFA and EFG both commented this was inappropriate accounting and that appropriate accounting called for the amounts to be taken to income as earned. (JFA and EFG are Price Waterhouse auditors.)

Some business people insist the SEC's initiative is much ado about very little, noting that companies have leeway to use accounting techniques to deliver consistent earnings, as long as any adjustments aren't "material." That's the fuzzy disclosure standard under securities laws, often defined by accountants as events that have more than a 5% or 10% impact on earnings.

"Any CFO anywhere has managed earnings in a way the SEC is now jumping up and down and calling fraud," maintains Wallace Timmeny, a lawyer for Brian J. Smith, Grace's chief financial officer until leaving the company in July 1995 and one of the executives named in the SEC case. Grace denies wrongdoing, and says Price Waterhouse blessed its financial statements as "accurate in all material respects." But if the SEC prevails, audit committees of corporate boards may have to grill managers more closely about how they met analysts' forecasts. A trial is expected next year.

The earnings reserve plan was allegedly conceived at Grace headquarters in Boca Raton, Fla., early in the decade, when profit at NMC -- which provided kidney-dialysis services -- was skyrocketing, in part because of a change in Medicare reimbursement rules.

Mr. Smith feared that NMC couldn't sustain its growth, he testified in a deposition in the SEC case. So, he testified, "We believed that it was prudent to reduce the growth rates."

To smooth out publicly stated profit and keep Wall Street happy, former Grace and NMC employees say in court papers and depositions, Mr. Smith ordered NMC to report only earnings that met the unit's growth target of 24% and squirrel away the rest. Mr. Smith's attorney denies his aim was to satisfy Wall Street and says he had real liabilities in mind. But in memos, NMC officials soon referred to the "Brian Smith Reserves" or the "profit reserve."

Former NMC Chief Executive Constantine "Gus" Hampers, who is named in the SEC case, says in an interview that he agreed on several conditions: He wanted -- and says he received -- Price Waterhouse's approval, as well as Grace's promise to tie incentive pay for NMC executives to the unit's real profit.

The outside auditors grew suspicious in mid-1991, when one noticed a mysterious surplus in an NMC reserve for "physicians' compensation."

Later that year, senior Price Waterhouse partner Eugene Gaughan learned that the surplus, including sums in another account, was projected to climb to $23 million by year end. When he asked Mr. Smith why the sums weren't reported as income, the finance chief responded that he wanted to keep NMC's growth "within targeted ranges of approximately 20-25%," according to a Price Waterhouse memo.

That's "inappropriate accounting," the memo says Mr. Gaughan told Mr. Smith. The reason: Accounting rules clearly state companies can only set aside profits in reserve for liabilities that can be foreseen and quantified; they can't use reserves as rainy-day funds. Later, during their year-end audit, the accountants proposed reversing the reserves.

But Grace, a client since 1906, refused. Executives said they wanted a "cushion for unforeseen future events," the accountants' records show.

Price Waterhouse then did what auditors often do when disagreements arise: They applied their materiality standard to see if management's position could be justified. After crunching the numbers, they concluded the reserves would be material only if NMC were a stand-alone company. It wasn't. So they rendered a clean opinion. A Price Waterhouse spokeswoman says such an opinion "doesn't mean that the financial statements are free from error or that the auditor agrees with everything" in them.

By the end of 1992, the reserves had bulged to about $55 million. Around then, Price Waterhouse's Mr. Gaughan saw an NMC memo that described using reserves to fix reported profit growth, but basing executives' incentive pay on "actual results."

To Mr. Gaughan, that suggested Grace was trying "to manage the earnings," he testified. "I had not heard a reasonable explanation as to why [the reserves] were on NMC's books," he said. So he and a partner took their concerns to J.P. Bolduc, who had recently been named Grace's chief executive.

The stockpiling is "wrong. You have got to stop doing it," Thomas Scanlon, a Price Waterhouse partner, testified that he told Messrs. Bolduc and Smith. At the auditors' urging, the executives agreed to systematically eliminate the reserves by slipping the money into profits. The understanding, Mr. Gaughan said, was that the reserves "shouldn't be available for use at will."

But Mr. Smith said in his deposition: "Knowing that we had those reserves and we were going to release them anyway ... we may have used those reserves to pick up that penny or two pennies" in per-share earnings. Messrs. Gaughan and Scanlon declined to comment.

Mr. Eatough, Grace's inhouse audit chief, meanwhile, was growing concerned. In a May 1993 letter to Mr. Smith, he said he wanted to see the board's audit committee.

Mr. Eatough laid out what he called "deliberate deferral of reporting of income." But, fearing his job was in jeopardy, he stopped short of calling it fraud, he testified in a deposition in his whistleblower suit. The committee pledged to investigate.

Four weeks later, the committee dismissed his concerns. In a report, the committee's lawyer said he had discussed the reserves with Mr. Gaughan and that Price Waterhouse didn't consider them material.

Mr. Eatough was fired in June 1994. He claimed in his lawsuit filed in federal court in West Palm Beach, Fla., that he was dismissed partly for complaining about the reserves. Grace said he was fired for poor performance, but settled last year on terms that weren't disclosed.

Even before Mr. Eatough left, Grace had begun to funnel millions from reserves into profits.

In the 1994 first quarter, for example, it shifted $5.4 million, bumping up operating earnings from continuing operations by 12%, according to figures Mr. Bolduc gave the SEC. At the time, Grace boasted in a news release about its ability to "sustain solid earnings growth."

In the second quarter, Grace moved $8.9 million, reducing its operating loss. The company again touted "strong, sustainable earnings growth." Mr. Bolduc's lawyer, Gerald Walpin, says Price Waterhouse found no material distortions in the quarters. Price Waterhouse says it did only "limited work" during the quarters.

In some quarters, Grace built the reserves back up. In late 1994, NMC's chief financial officer sent Mr. Smith a fax suggesting that "smoothing can be accomplished in 95 and 96 if large corporate reserves are established in Q1 and let out during the remaining quarters."

The plan backfired, though, when NMC needed a bigger jolt. A German acquisition had soured, adding to regulatory woes. Grace executives told the accountants they wanted to shift an eye-popping $35 million into 1995 operating income, a Price Waterhouse memo shows.

Mr. Scanlon balked. That would be a "problem," the memo says he told the executives. PricewaterhouseCoopers is now arguing that it shouldn't face an SEC action, in part because it prevented this more brazen maneuver, a person involved in the case says.

Moving such a large sum wouldn't have been a problem if Grace had designated the reserves for those purposes. Mr. Bolduc brushes off the distinction, saying in court papers that Grace was reserving for the very kinds of problems that cropped up.

Tension grew as Grace began considering a sale of NMC, with the auditors refusing to give the unit itself a clean opinion unless Grace reversed the reserves and restated the unit's earnings. Grace eventually did so, but gave only a vague explanation. NMC was spun off and is now part of German company Fresenius Medical Care AG.

None of the executives named by the SEC remains at Grace. PricewaterhouseCoopers continues to handle Grace's audits and other work and last year collected $11.3 million. Grace still insists the firm blessed its numbers "without reservation."

Money & Investing

SEC's Case Against Grace
Claims Profit 'Management'

Money & Investing

SEC's Case Against Grace Claims Profit 'Management'

SEC's Case Against Grace
Claims Profit 'Management'