Opening

In the early 2000’s, Interpublic Group was a successful advertising firm with over $6 billion in annual revenue. Interpublic had dominated the ad industry for decades and had a stellar reputation. But the company’s public image was about to change.

In 2002, Interpublic was forced to restate its financials going all the way back to 1997. In 2002 alone, the company had overstated its profit by 496%.

Executives blamed the problem on poor internal controls, & said it was an honest mistake. But the SEC began an investigation, and the results were shocking. Had the company committed ANOTHER fraud, right after the first one?

I’m Michael McLaughlin, and this is Scheme.

Background

In 1930, two companies merged to form the largest advertising agency in the world: McCann-Erickson. In 1961, this company would carry out an innovative restructuring plan. It divided itself into several business units, which operated as part of a holding company called, “The Interpublic Group of Companies.” Today, most large advertising agencies follow this model.

Interpublic continued to grow over the years, mainly by acquiring other ad agencies. By 2008, Interpublic owned over 600 agencies in 130 countries. McCann-Erickson was its largest subsidiary, accounting for as much as 50% of Interpublic’s revenue.

Culture

Both Interpublic and McCann had a dark culture. They focused on hitting profit targets, by whatever means necessary.

Here’s how it worked. Each fall, McCann asked its agencies to submit profit targets. McCann would either accept or reject those profit targets. If McCann rejected an agency’s profit target, the agency had to come back with a more ambitious, higher profit target. But that’s not all. McCann would revise its budgets in the spring and summer, raising the profit targets even higher and calling them “stretch targets.”

But remember, McCann is part of Interpublic, so it had to submit its own profit targets. Interpublic would either accept them, or reject them and request a higher target. If you didn’t meet the targets, you could lose your bonus or be fired.

This constant pressure to meet targets created the perfect environment for fraud.

Intercompany transactions

To explain the fraud, we need to discuss something called intercompany transactions.

McCann owned hundreds of ad agencies, and these agencies often entered into transactions with each other. For example, one agency might provide services to another agency. This would result in revenue for one agency but an expense for the other agency. Since the agencies are all owned by the same company, a $100 increase in revenue and a $100 increase in expenses would cancel out, and have no effect on the company’s overall profit on a consolidated basis.

But here’s the catch: sometimes there were imbalances. One agency would record $100 of revenue, but the other agency would delay recognizing the $100 expense. This could occur for innocent reasons; there could be a delay in processing the invoice, or the agency might dispute the amount of money. For example, an agency might say the expense shouldn’t be $100 but rather $80. In such a case, the agency would only record an $80 expense; the other $20 would be categorized as accounts receivable because it hopes to have the $20 returned.

Once the dispute is resolved and it’s found that you really do owe $100 (not $80), McCann would write off the accounts receivable to acknowledge the full $100 expense. At least, that’s what was supposed to happen…

The fraud

In reality, McCann never wrote off the accounts receivable. The disputes weren’t being resolved and intercompany accounts weren’t being reconcile. They didn’t even have a system in place for doing a reconciliation. They literally just kept putting it off.

In 1998, a member of the finance team said in an email that disputed amounts had reached “an unacceptable level.” But then he said, “Hey, what’s a $28 million discrepancy between friends.” I’m not kidding. He literally wrote that in an email while committing a large-scale fraud.

Writing off the accounts would have prevented McCann from reaching its profit target. Executives knew about this for years, but most of them did nothing. The finance director for McCann’s Europe-Middle-East-Africa region resigned, so he must have had some type of conscience. In his resignation letter, he said that he had brought up the write offs to his boss, only to be told “not to discuss these matters further.”

With no finance director, the Europe-Middle-East-Africa region had its COO handle the finance duties. The COO had no training in accounting, but that was totally okay because he had a willingness to commit fraud. He then told the finance team: “the stretch goal is not a ‘goal’, it is a mandate and we are the people who make it by whatever means we can dream up!”

The fraud is discovered

So you’re probably wondering how the fraud was discovered.

Well, Interpublic had a rough year in 2001. The advertising market was in a downturn, and Interpublic was having problems related to one of its acquisitions. Thus, Interpublic decided to take a large restructuring charge, which included the cost of layoffs and lease termination fees.

McCann’s Europe-Middle-East-Africa region spotted an opportunity. They could finally take the write offs that they’d been putting off for years by just lumping them in with the restructuring charge. The company was having a bad quarter, so executives weren’t going to hit their profit targets anyways; it was the perfect time to recognize the write offs. Interpublic’s CFO said it was like having “Christmas in July.”

But there was a problem. The company’s auditor, PWC, said it would be a violation of GAAP for the write offs to be included with the restructuring charge. PWC also said there had been a “fundamental breakdown of internal controls” at McCann. This came to the attention of Interpublic’s Audit Committee, which demanded that McCann’s CFO reconcile the accounts by September 30, 2002.

Then came the surprise; few people had realized how big the write offs really were. Interpublic would have to restate its financials going all the way back to 1997. The company issued a $181 million restatement, with $101 million relating to the intercompany transactions.

Another fraud

After all this, you’d think Interpublic would be eager to get a fresh start. They could put all the fraud behind them and focus on growing the company.

But no…Interpublic immediately became involved in another fraud

The SEC launched an investigation, the CEO resigned, and the company went through four CFOs over the next few years. It was a mess. PWC and teams of forensic accountants tried to piece together what happened. It turns out Interpublic had overstated its profits again, but this time the fraud was more complicated.

First, Interpublic recorded revenue for AVBs that should have been returned to clients. AVB stands for “Agency Volume Bonification.” AVBs are rebates that companies like Interpublic receive when they buy a large volume of advertising from a media company. Interpublic was supposed to pass these rebates on to their clients, but they failed to do so.

Second, Interpublic improperly recognized the profits of companies it acquired. If your fiscal year-end is December and you acquire a company in August, you can include the profits earned by the company from August to December in your consolidated income statement. But you can’t book profits that occurred prior to August, since you didn’t own the company then. That’s what Interpublic did; they booked the full year, recognizing profits that occurred before they even acquired the company.

Third, Interpublic had reduced expenses by capitalizing some of its earnouts as goodwill. Earnouts are a type of contingent consideration that are a part of acquisitions. The acquirer, in this case Interpublic, will agree to make an additional payment if the target company achieves certain financial goals after the acquisition. The SEC said that some of the earnouts were really a form of compensation and should have been expensed.

Interpublic’s response

Interpublic initially said these were all honest mistakes that occurred because of the company’s “extensive global presence.” But the firm later admitted it was fraud and fired several employees.

The firm found itself in the embarrassing position of having to restate its financials yet again. The restatement forced Interpublic to recognize an additional $420 million of expenses between 2000 and 2004. In 2002, for example, Interpublic had reported a profit of nearly $100 million when its true Net Income was just $16 million.

The constant scandals were taking a toll. Interpublic lost some of its biggest customers, including Bank of America and Lowe’s, and some of Interpublic’s senior managers decided to leave. They were tired of all the fraud and deception, and they wanted to work for an honest, values-based company like Enron. I’m just kidding; Enron had already imploded and gone bankrupt by then.

The outcome

After concluding its investigation, the SEC accused Interpublic, McCann, and two executives of fraud. They each settled with the SEC, neither admitting nor denying the fraud. McCann agreed to pay a $12 million fine, while the executives were fined a grand total of $75,000. Given that the company had to restate nearly a decade of financials, I’d say the company and its executives got off pretty easy.

Takeaways

So, how did all this happen? One reason is the lack of internal controls.

It’s absolutely inexcusable that a large, publicly-traded company like Interpublic didn’t have a formal policy for reconciling the intercompany transactions. They clearly knew they should do it, as they emailed each other about it each year. But it wasn’t explicitly stated who was responsible for carrying out the reconciliation, and clearly no one did. They just kept kicking the can down the road, and as the write offs grew larger, the incentive to ignore them grew stronger. No one wanted to do the right thing and take the write offs, because it would cause them to miss their profit targets… which leads to the second issue.

There was a serious problem with Interpublic’s culture. Giving someone an unrealistic target and telling them they’ll be fired if they don’t achieve it is a recipe for unethical behavior. As the COO said, their job was to make the numbers “by whatever means we can dream up!” This was a culture of fraud.

But I think Interpublic’s auditor, PWC, also deserves some of the blame. They made statements about Interpublic’s weak internal controls for years, but continued to sign off on the audits.

Aftermath

If you’re wondering what happened to Interpublic, it’s still around. It’s one of the Big Five advertising firms and had 54,300 employees at the end of 2019, when it reported a $674 million profit on $8.6 billion of net revenue. The company has had to change with the times; digital advertising is now a major focus.

To help its clients show more relevant ads, Interpublic has invested in consumer data. In 2018, it acquired Acxiom’s consumer data division for $2.3 billion. There are serious privacy concerns for firms when it comes to consumer data, particularly after Facebook’s data scandal with Cambridge Analytica. Hopefully Interpublic will show more integrity with people’s data than it did with its own financial statements. If not, you might see the company in the news again.

References

Interpublic’s 10-K for FY 2019
https://www.sec.gov/ix?doc=/Archives/edgar/data/51644/000005164420000013/ipg12311910k.htm
Interpublic’s 10-K for FY 2009
https://www.sec.gov/Archives/edgar/data/51644/000119312510041804/d10k.htm#tx47674_22
10/21/20 Morningstar
http://analysisreport.morningstar.com/stock/research/c-report?&t=XNYS:IPG&region=usa&culture=zh-CN&productcode=QS&cur=&urlCookie=8056723522&e=eyJhbGciOiJSU0EtT0FFUCIsImVuYyI6IkExMjhHQ00ifQ.jRbbMI400Bb9ZooVDzRwlWTjZLVQK8Wuoe4MTNuK_HRhEGWQC7iTj6RNX_QkUhRaIakTpCwLhioYtggMawqPo_MQQU9oqP5dJxQh_4aQBR9MdISHGljBgRaItM-6xRSIfSxa5GgnDmcwLALZe1tkPz0YI5rXlvXPDOflJOXHEuY.yO-n-CczhDqdbPMI.MPLk1bS9rMP369DrL5Q-RcyIIBeMhHp5svZmp0VIsOjaG0J9Sjk53Uq9PrFqk883utblUw2UqRXSn0ORFuXLSfQcS7fD1y1Y9a7VlubYNWqVfoBlbRZNxjaGidgk62ToWSvSkVztsyLfwQMbaBp1_G3ITrQ-Ud0GTNbK7oCzTZ7IMHwcvonZRt5gnVFRcSpe1EFT7Z3oZt3GtfwoNrI-mq8faPGpqForBnxtrDo.1-3ri8thKyjDFOjF2CIn2Q
7/2/18:  Wall Street Journal
https://www.wsj.com/articles/ipg-in-advanced-talks-to-acquire-acxiom-division-for-over-2-2-billion-1530561951
6/28/18:  Wall Street Journal
https://www.wsj.com/articles/ad-giants-expected-to-bid-over-1-5-billion-for-acxioms-customer-data-business-1530201685
5/1/08:  CFO.com
https://www.cfo.com/accounting-tax/2008/05/interpublic-settles-sec-fraud-charges/
5/2/08:  New York Times
https://www.nytimes.com/2008/05/02/business/media/02adco.html
5/1/08:  SEC litigation release
https://www.sec.gov/litigation/litreleases/2008/lr20547.htm
5/1/08:  SEC press release
https://www.sec.gov/news/press/2008/2008-71.htm
5/1/08:  SEC complaint:  LaGreca
https://www.sec.gov/litigation/complaints/2008/comp20547-lagreca.pdf
5/1/08:  SEC complaint:  Interpublic
https://www.sec.gov/litigation/complaints/2008/comp20547-ipg.pdf
9/16/05:  New York Times
https://www.nytimes.com/2005/09/16/business/media/interpublic-group-retraces-its-accounting-missteps.html