going to find $5 million. Cook did agree that what Saunders apparently had in mind was taking it out of the clearing account and putting it back by understating future revenues, indicating that this was the only way to interpret the request.

Hill also testified that Saunders at least quarterly made demands for additional revenue. When asked how Saunders expected him to find it, he answered, "I have no idea, frankly. I assume by adjusting the book." He indicated that Saunders constantly and legitimately raised the issue with him that he, Hill, could not with absolute certainty document the revenue within 1, 2, maybe even 5 percent. Hill understood that Saunders by these comments was trying to tell Hill to increase the revenues. However, Hill testified that the 1 to 2 percent elasticity inherent in the figures could not be used legitimately to manipulate revenues within that 1 to 2 percent range.

Saunders describes these conversations as merely reflecting his concern that all revenues which could legitimately be recorded that quarter be recorded and that the accounting people went out and made sure they picked up everything possible. While it is clear that the types of effort he described were taking place, the situations described by others appear to extend well beyond Saunders' appraisal of them. The operating people, who were under fire for performing poorly, were making their own revenue calculations and coming up with more favorable figures than those of the accounting people, thus fueling Saunders' desire for more income. Saunders admitted he recognized the bias in the operating department figures, indicating that that was the reason why he inevitably accepted without question the accounting figures. However, Hill describes one occasion in late 1969 which refutes this claim. The executive vice president for marketing gave Saunders a memorandum charging that the financial department figures were understating revenues by several million dollars:

Answer. Saunders confronted me with the memorandum and requested that I adjust to that level. We could not adjust to it. We had what we regarded as factual data. It went beyond the information available to the Vice-President of Marketing.

Question. Did he [Saunders] tell you that he was going to be the one to make that decision and not you?

Answer. That substance of words crept into the conversations but without result. Question. How did you withstand that pressure, then?

Answer. By simply not making the changes in the account.37

This situation is illustrative of the environment in which the accounting department was forced to function.38 Considering the nature and source of these pressures, it is not unreasonable to believe that such pressures had a significant impact on the recording of various items, encouraging the staff to push things as far as they felt they could hope to get away with.

Per diem charges 39 were another situation where full charges would not be known for some time and accruals were necessary. Bevan's diary describes two situations, one in mid-1967 and one in mid-1968, in which he claims that Saunders advocated deliberately understating per diem charges to increase income. In the second situation Bevan

37 Saunders and Cole recall the meeting, but deny it went as far as Hill indicates. Saunders offered the same incident as an example of how he always followed accounting department policies. These are the charges which one railroad must pay for using the cars of another railroad.

indicates that, when Hill told Saunders it was probably already underaccrued, Saunders said that did not matter, "[i]t had been underaccrued before and it was not necessary to become a 'Christian' all at once." While Hill did not recall the incidents, he indicated, however, that they would be characteristic of the situation. Notes which Cole took at the budget meeting described also appear to support Bevan's

comment.

Per diem costs were very high in 1967-69, a matter which concerned Saunders greatly. Operating people, in defense of their poor performance, would indicate that they thought per diem charges were being over-accrued by the accounting department and would come up with their own supporting figures. Cook testified that Saunders never directly told him to under-accrue the per diem account but it was suggested at budget committee meetings and Saunders was a party to the discussions. And Hill recalled that accounting personnel were being challenged at virtually every budget meeting that they were overproviding for per diem costs and being directed by Saunders to reevaluate the figures. Hill indicated that, indeed, they felt they were just barely at the correct level with a struggle to keep fully accrued. Cook characterized it as being a matter of Saunders believing his operating people (who were offering higher profits) rather than his accounting people.40 Hill and Cole indicated that Saunders had a tendency to want to wait on these unfavorable items, until "we have a better feel" (that is, when operating conditions improved).

THE MERGER RESERVE

Another subject of controversy and pressure involved the merger reserve. In line with his past proclivities to advocate accounting treatments which would avoid charges against current income, Saunders took the position that all types of costs which could be considered merger-related should be charged off against a reserve established for that purpose. Once again, while this would not result in any real savings, it would enable Penn Central to report higher earnings than if it was forced to treat these items as current expenses as they were incurred. In contrast to costs, merger savings would be allowed to flow through to increase reported earnings.

41

Before it could establish the reserve, Penn Central had to obtain. ICC approval. Saunders was told by his staff that an all-inclusive, broad proposal had no possible chance of getting the required approval and, accordingly, such a proposal was never submitted. Indeed, Cook told him that even a much narrower plan the company was preparing would probably be turned down by the ICC's Bureau of Accounts and would have to be taken up with the Commission. Indicative of Saunders' keen interest in income maximization was the fact that upon being informed of this and before the accounting people dis

40 Saunders testified he always accepted his accounting department's judgment without question and when the staff pointed out that there was testimony from others which contradicted this, he characterized these incidents as discussions where he sought to understand what was going on.

1 Saunders also took the position that the reserve should be established by a direct charge to retained earnings. While it was ultimately handled as an extraordinary charge in the 1967 income statement, it would appear that as a practical matter this change is of little significance.

cussed the matter with the ICC staff, Saunders himself took Cook down to discuss the matter privately with William Tucker, Chairman of the ICC.42 No one was present from the Bureau of Accounts, although Tucker did eventually call in another Commissioner, John Bush, who had an accounting background. After some discussion it was decided to handle it through a normal presentation to the Bureau of Accounts. A meeting was held later with Mathew Paolo, Director of the Bureau, although the Pennsylvania Railroad did not inform him of their earlier meeting with the ICC chairman. After getting a staff denial on most of the request, the company then appealed through regular channels. When Cook came down for the appeal proceeding, Tucker, who was not one of the three Commissioners hearing the appeal, asked Cook to stop by afterwards and tell him how it went. Cook indicated to him that he thought it was favorably received. He got the impression that Tucker also was sympathetic to the road's position. Shortly afterwards, Pennsylvania Railroad was notified it had received virtually full approval of their request at the Commission level.

43

Upon approval, a $275 million pool had been created against which currently incurred expenses could be charged. The temptations for misuse this would present to a profit starved company were recognized by both the ICC staff and by Peat, Marwick, Mitchell & Co. (Penn Central's auditors) at the time the account was established. It was agreed it would have to be closely audited."

As anticipated, almost immediately after the merger Saunders began to make suggestions that the use of the reserves be expanded. Saunders denies a statement in Bevan's diary of April 22, 1968 that Saunders

42 Saunders did not specifically recall the incident, but agreed that it happened. His explanation of why Penn Central started at the top, so to speak, is as follows: "A. This was something new for the Commission mainly as to whether there is any possibility of getting this done and they submitted papers to the Bureau of Accounts and if they don't go along, you have got a right to appeal it, that is what they said.

"Q. Why didn't you do that in the first place, why didn't you go right to the Bureau of Accounts?

"A. We wanted to find out if we had any chance of getting this thing.

"Q. Couldn't he have told you that, couldn't Mr. Paolo have told you that?

"A. Told us what?

"Q. Whether you had a chance of getting it through or not?

"A. It's just like a court proceeding, you can submit something to the Federal judge or court of first jurisdiction if you don't like their decision.

"Q. You don't start with the Supreme Court and ask them their views before you go down to the trial court, do you?

"A. Well

"Q. That is what you did, isn't it?

"A. No, this is not a court.

"Q. You used the analogy.

"A. But you've got a right to appeal.

"Q. But you don't go to the Chief Justice first.

"A. Well, it's not uncommon to discuss matters of this sort with the Commissioners. "Q. You did it on a number of occasions, didn't you?

"A. Well, on certain occasions, yes."

43 The reserve had been established at a level which proved to be far in excess of the amount of charges authorized under the agreement permitting its establishment. While this is contrary to the pattern exhibited with the reserves discussed earlier, it should be noted that these earlier charges would have been against ordinary income, while the one-shot establishment of the merger reserve was treated as an extraordinary item.

Peat. Marwick, for example, in an internal memorandum dated January, 1968 noted:

"It seems to us that the critical points will be reached in determining the actual amounts to be charged against the reserve, since the establishment of the reserves has been based on rather broad estimates at best. Charley Hill recognizes that he will be under pressure to use up whatever reserve is created and, knowing him, I am sure he will find a way to rationalize many borderline expenditures."

Another memorandum during this period contained a number of guidelines and concluded:

"While the foregoing admittedly are rather stringent, they would serve as the basis for restrained discussion and would bring about the necessary reorientation in thinking to prevent the reserve from being used as an earnings stabilizer in future years.'

had been told at a budget meeting that Penn Central "could not hope to get away with" charging extra people against the account because it would be closely audited, and that he had tried to insist that all that Peat, Marwick and the ICC could do (if they learned of it) was to criticize the company, which did not bother him. Bevan was sufficiently concerned about the implications of this and other similar suggestions that in spite of the fact he no longer had accounting responsibility he discussed the matter with Edward Hanley, one of Penn Central's directors, in the summer of 1968. Hanley then met with Walter Hanson, senior partner of Peat, Marwick, in New York. Hanson assured him the account would be watched closely.

When the substance of Bevan's diary entry of April 22 was presented to Hill and to Cole they objected to the use of the term "get away with" but recalled that Saunders had on occasion made comments of similar import. Hill recounted that over the postmerger period, as earnings worsened, Saunders increasingly focused attention on what Hill described as an "expanded use concept" of the merger reserve, indicating a feeling that "in a general sense, the merger reserve ought to be a means of sheltering any unusual costs growing out of the merger." Hill further indicated that Saunders apparently looked upon the reserve as simply a bookkeeping device, and "at one time or another would have solicited a charge to the fullest extent of the reserve provision without regard to the nature of the agreement [with the ICC]." Saunders was clearly attempting to return to his original concept which he had been told could not generate ICC approval. In addition, Hill also stated that Saunders was constantly concerned that maximum use was not being made of the merger reserve and that he "was insistent in his own mind that we were not charging adequately to the reserve" so that Hill was constantly having to check the reserve to make sure that some legitimate cost was not getting by.

Hill claims that no charges except those permitted under the conditions established by the ICC were made against the merger reserve, to the best knowledge of the accounting department. However, there were two situations where Penn Central returned to the ICC for expansion of authority. In one of these instances again, Saunders was directly involved, seeking to make his influence felt to obtain desired goals. This case involved a group of mail and baggage handlers and a $4.7 million charge. Initial indications were that both Peat, Marwick and the ICC staff were opposed to permitting this charge against the reserve. After meeting with Saunders, Hanson (of Peat, Marwick) apparently changed his mind, agreeing to abide by the ICC decision. And again Penn Central went directly to the ICC_chairman. Hill, who had taken over from Cook as comptroller, and Tucker, who had left his position as chairman of the ICC to become a Penn Central vice president, met with Mrs. Virginia Mae Brown, the then current chairman. Once again, Penn Central succeeded in obtaining the

decision it wanted at the Commission level.45 However, the SEC staff believes that $4.7 million charge did not come within the original "merger reserve" criteria and should have been reflected as a period expense during the year ended December 31, 1968. (See further discussion at page 67.)

OTHER DEVICES TO INCREASE RAILROAD EARNINGS

Management's attempts to improve railway earnings through exhortation were described previously, as was the unfortunate practice of skimping on maintenance to save current expenses (and cash). The suggestions for increasing revenues through use of the suspense account and for reducing expenses through delays in the booking of per diem charges, inventory losses, increases in reserves for damages, personal injuries and the like, has been noted, as has the plan to charge current costs against a reserve instead of against current operations. All of these actions were directed toward increasing reported earnings.

The last section was devoted principally to those situations where the accounting department was under pressure to do things which it was resisting. However, it agreed to and sometimes initiated schemes involved in other parts of the earnings management program.

Under railroad accounting, certain facilities are not depreciated but their costs (less scrap value) are charged to ordinary income when abandoned. It was up to Saunders to determine when a facility was considered abandoned, which gave him effective discretion to control expenses of this nature. He took advantage of this situation. In September 1969 Saunders issued instructions that, while he had approved the preliminary forms necessary for retirement of certain properties, none were to be made effective "until accounting authority is received which will avoid these losses from being charged to ordinary operations." Plans were underway for a Master Abandonment Program whereby at some point in the future, ICC authority would be sought to establish a reserve against which both past and future writeoffs could be made. In the meantime, the abandonments would pile up."

46

45 Another example of Saunders' keen interest in keeping every somewhat unusual expense item out of the calculation of ordinary income and his willingness to take steps personally to bring it about is a 1964 situation involving certain damage to equipment caused by heavy snowstorms that winter. Saunders wanted to charge it directly to retained earnings. He put a great deal of pressure on the accounting department, and when they resisted, he insisted that they take the matter to the ICC for approval. The Bureau of Accounts turned them down. Saunders then met with Walter Hanson of Peat, Marwick to seek his support, but Hanson, after some research, indicated that he was unable to do so. Saunders wrote back to Hanson stating his basic position:

"I am convinced that the business community benefits from financial reporting practices which are consistent in principle and which meet broad tests of acceptability. At the same time, it is highly important that investors and financial people obtain a correct picture of the effectiveness of management in conducting corporate affairs. It seems to me that the short-term disturbance to earnings produced by such events as the January snowstorm leads to misjudgment in evaluating our direction. The accounting profession and the business world would do well to look to a better solution to the problem of reporting period income." This statement reflects the clearly "even keel" attitude.

A few months later, Saunders was still complaining about the situation asking Bevan "What are we doing to get the Commission to adopt a more realistic attitude in this regard?" Bevan in a reply memorandum stated:

"Practically every well-known accounting firm in the country is strongly in favor of putting, with very few exceptions, all charges through the current Income Account. We believe that as time goes on their influence in this respect on the ICC's position will be such that it will become increasingly difficult to get permission to charge various items to Retained Income. Furthermore, each year a greater percentage of the railroads of the country are having their books audited by C.P.A. 's who, in turn, will insist on this approach with the various railroads involved. Under the circumstances those roads that wish to handle numerous items through Retained Income are going to find themselves very much in the minority and very much in an almost untenable position.

"These are the facts of life as we see the situation at the present time."

Cook testified that the PRR did obtain permission to charge these storm-related costs over the full 1964 year and that it was his impression that this was because of Saunders' intervention, but this matter is unclear.

46 One witness testified that from his trips around the system shortly after merger, it appeared that PRR had a lot of unused track, which it was apparently not taking out of service because it did not want to incur the service costs.