Figures prepared for internal management purposes and including only 1968 and 1969, show the following:

The loss for the first quarter of 1970, calculated on the same basis, was over $100 million.

SUMMARY

It appears that the underlying factor which sent Penn Central into reorganization was the gigantic losses it had to absorb on railroad operations. These losses reflected problems more deepseated than simply those brought about by the merger. There is, of course, no way of knowing whether the PRR and Central would have ultimately survived if there had been no merger.25 It is clear, however, that in contrast to the expected benefits of the merger, it had instead the opposite effect, and that the immediate problems arising therefrom were a critical factor in the collapse of Penn Central in mid-1970.

5 Perlman indicated he felt that the Central had the financial capacity to survive, absent the merger. Bevan testified that the merger probably accelerated the downfall of the PRR, although he had reservations about the long term viability of the railroad at any rate.

81-936-72

I-B. INCOME MANAGEMENT

THE MAXIMIZATION POLICY

As suggested in the last section, by background and experience. Saunders was ill-prepared to handle the fundamental problems facing the Pennsylvania Railroad and later the Penn Central. Exhortations, without substance, proved inadequate. Saunders' reaction was to substitute improvement through accounting devices for the real improvements which were essential. His policy, he made clear to the other officers, was that, despite the vast array of problems facing the company, the earnings picture was to be presented in the best possible light. Basil Cole, a Penn Central vice president and special assistant to Saunders in the 1967-70 period, described the situation as follows: Relating that phrase [income maximization] to my experience working for Mr. Saunders, I think it means, it reflects, keeping the company on an even keel during times of adversity. He was not prepared to see the earnings of the company look any worse than they had to in days of declining business and increasing expenses, and when an opportunity occurred for producing income that would keep the earnings of Penn Central on as level as possible a basis, he tended to favor that course of action.

There was, of course, except possibly in 1965-66, nothing but periods of adversity for Penn Central, with the situation steadily deteriorating and no real prospect of a turnaround.

Perhaps management had hopes of some future improvement, but the shareholders and the public were entitled to be provided with the picture as it existed at the time, minus the impact of the temporary expedients being utilized to provide the illusion that the company was on an even keel when it was not.

Just as Saunders was not an operating man, his background was not in the financial area either. Therefore, while he established and encouraged the basic policy of maximizing the reported income, he had to rely on others for ideas, which he would then pursue. It became a group effort among the top echelons of management. As Cole suggested:

Everyone thought it was their job. Certainly in the real estate area

Sam Hellenbrand would have thought it was his job. Ted Warner certainly thought it was his job to do what could be done in the tax field.

Warner also, he added, took over responsibility for searching the company's multitude of subsidiaries for income opportunities for the parent. William Cook, who was comptroller of Pennsylvania Railroad and later Penn Central, explained that in recommending one of his employees, Charles Hill, for a raise, he noted that Hill was extremely creative and had added millions annually to the Pennsylvania Railroad's reported net income. This comment was made because it was recognized that it would have a special appeal to Saunders. Cook also indicated that many of the accounting devices. which might be used to increase earnings emanated from operating people who were not meeting the goals which Saunders had established.

for them, and would come up with these proposals as a defensive measure. Saunders would be receptive to any such suggestion.

Various classes of devices fell within the maximization program, all directed toward improving apparent earnings.26 In many instances they reflected the desperation of the circumstances facing Penn Central, and the importance attached to immediate earnings, since the benefits were clearly short term, with offsetting detriments of equal or greater scope in the future. One class of activity, sometimes referred to as "cannibalizing" the company's assets, involved the selling off of anything salable, both for earnings and for cash flow purposes. While this type of transaction hardly reflects a healthy situation, it does increase reported earnings, especially if the company limits the transactions to those which can be executed at a profit. Another practice involved the timing of certain items. Apparent improvements in reported earnings could be brought about by simply accelerating the recording of revenues in a particular quarter, while at the same time delaying the recording of expenses. This could be, and was, done legitimately in some cases where reportable transactions themselves were rushed through or delayed, but in many other instances such action simply reflected improper accounting practice. Another device employed by management was to stress the ordinary and recurring nature of various somewhat unusual income items, while seeking to label somewhat unusual expenses as nonrecurring.27 The purpose was, of course, to show the maximum possible basic or normal earning power.28 In all of these arrangements the imprint of what one witness described as Saunders' "preoccupation with the appearances of income" is clearly visible.

PRESSURES ON THE ACCOUNTING DEPARTMENT TO ALLOW THE REPORTING OF HIGHER INCOME

It is clear from the testimony of various witnesses, for example, Bevan, Cook, and Hill, that the accounting department was under pressure to do their part to assist management in reporting higher earnings. Hill, for example, testified as follows:

Question. I got the impression that you were under a mandate to compute earnings to the greatest extent possible, is that correct?

Answer. Unquestionably correct.

Question. That mandate came from Saunders directly?

Answer. From Saunders directly.

He later indicated that there was a continuing effort on the part of top management "to create the most favorable income at all times by the best favorable transactions".

The impact of such pressures was predictable. Wherever advantage could be taken either of some imprecision inherent in the figures or of some situation not specifically and precisely covered by the accounting literature, the effort was made to do so. In the former situation, where some imprecision was inherent in the figures, accounting department personnel appear to have pushed things as far as they

2 As will be discussed in a later section on disclosure, the actions described here were part of an overall pattern of masking railroad operating losses. 27 At times this was reflected in the financial statements themselves and at times in textual material contained in press releases and other information disseminated to the public.

Generally, the value of a stock, at least for long-term investment purposes, is dependent on its future earning power, and current basic earnings levels are the starting point for an assessment of future levels.

dared, although the staff has not attempted to measure the precise. impact. In the latter situation, where specific accounting precedents. were lacking, several examples will be given below in which technicalities of form were stressed and the substance of the transaction was ignored. In effect, concepts established under generally accepted accounting principles were stretched to justify the treatment desired to the point where their application under the circumstances of this case may have been misleading.

Since the bankruptcy, Penn Central's prebankruptcy accounting practices have been widely criticized. Saunders was obviously very much aware of this and came in to testify with his defense prepared. Again and again in his testimony he referred to "generally accepted accounting principles." The almost incredible number of times he used this phrase suggests that this had been his all-consuming standard while he was running Penn Central, yet Cook suggested that it did not seem to him that Saunders was overly concerned with such principles. Cook stated that "if the accountants would go along with overstating it [reported income], that would not bother him [Saunders] particularly either".

Initially, Saunders in his testimony sought to create the impression that he was not an accountant and would almost blindly and without question accept anything accounting personnel proposed. Obviously, he was not qualified to discuss what was and was not acceptable under generally accepted accounting principles. However, while neither the Penn Central accounting staff nor the accounting profession can escape responsibility for their contributions to the events involved in this situation, it is clear that Saunders was not playing the passive role he sought to project. Indeed, by the conclusion of his testimony, Saunders was characterizing Cook as "overly cautious and highly straitlaced".29 Cole testified that:

I think he [Saunders] felt many times that they [the accounting department] were unimaginative and wanted to slavishly follow through on a project for the sheer joy of making the entries.

Considering the extent to which the accounting department was willing to go to satisfy Saunders' recognized desires for the maximum possible reported income, the foregoing comments seem ironic. However, as indicated earlier, there was a barrage of suggestions from a variety of sources, and the accounting officers did resist certain of these. Both Cook and Hill indicated that Saunders sought to make his influence felt, and, even though they might ultimately prevail, they were constantly being called upon to defend their actions to him. Cook added that in these matters it was always helpful to have some outside support, for example, from the ICC accounting regulations or professional accounting literature in fending off these demands. As illustrated in subsequent sections, at times even this was not sufficient to convince Saunders, who then sought to apply his keen persuasive powers on representatives of these outside sources. And all this effort was being exerted to salvage the apparent earnings of a failing company.

He added that, while he did not mind this in an accounting officer, he did not feel that Cook's word was gospel or that he could not be questioned.