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|Case 4. 6 | |Instructional Notes | | | |Phar-Mor, Inc. : | |Accounting Fraud, Litigation, | |and Auditor Liability | | | |Mark S.
Beasley, Frank A. Buckless, | |Steven M. Glover, Douglas F. Prawitt | |( | INSTRUCTIONAL OBJECTIVES • To illustrate the degree of legal exposure professional accountants face. • To define auditors’ legal liability under common and statutory law. • To demonstrate that massive fraud typically involves collusion of a number of individuals in the management team.
Further, those involved in the fraud will go to extreme lengths to fool the auditors only to later attempt to use their independent auditors as scapegoats when material errors or irregularities are discovered. • To illustrate the potential independence problems that can arise when a client generates large audit and other service revenue. • To illustrate the importance of maintaining a healthy degree of professional skepticism during all audit engagements. • To illustrate the need for auditors to identify key red flags by conducting “smell tests” both on their client’s financial statements and top management’s personal integrity.
KEY FACTS •Phar-Mor had grown from 1 store in 1982 to 310 stores in 1992, with sales exceeding $3 billion. • The deep discount drug store retail business is extremely competitive. • Mickey Monus was found guilty in December 1995 of embezzling more than $10 million and sentenced to nearly 20 years in prison. • Nearly $1. 14 billion were invested in this privately-held company by Westinghouse Credit Corp. , Sears Roebuck & Co. , Edward J. de Bartolo, and Lazard Freres & Co. Corporate Partners Investment Fund, among others. • Monus was an original equity investor in the Colorado Rockies baseball franchise.
Although not discussed in the students’ case he was also the founder of the World Basketball League, a league for players 6′ 5” and under, and continued to financially (sometimes with Phar-Mor funds) to support franchises that were losing money until the WBL’s demise. It was noted later only a man who was supremely confident (or arrogant) would dare take on the NBA. • Monus and his CFO, Patrick Finn, manipulated income statement accounts, overstated inventory, and manipulated accounting rules in order to carry off this fraud for nearly six years. The total loss to investors and creditors reached over $1. 1 billion, making it one of the largest corporate frauds in U. S. history. • The fraud was facilitated by many factors, including lack of adequate MIS, poor internal controls, the CFO’s hands-off style, inadequate internal auditing, collusion among upper management, and the existence of related parties. • The fraud was discovered when a travel agent received a check from Phar-Mor for WBL expenses signed by Monus. She showed the check to her landlord, who happened to be a Phar-Mor investor.
The landlord then called David Shapira, CEO. • After the fraud was uncovered, Phar-Mor laid off more than 16,000 employees, closed 200 stores, and filed for bankruptcy. • Phar-Mor emerged from Chapter 11 in 1995, its common stock traded on NASDAQ, and it in 2001 it operated 139 stores in 24 states under the names Phar-Mor Rx Place, and Pharmhouse. However, on September 24, 2001, Phar-Mor filed again for Chapter 11 bankruptcy to restructure their operations in an effort to return to profitability. Phar-Mor’s securities have been delisted from the NASDAQ. In late 1995, Coopers & Lybrand, LLP settled with Phar-Mor as well an many investors and creditors banks who together were seeking in excess of $1 billion (the terms were not disclosed). Several investors and creditors did not settle at that time and in February 1996, a federal jury found Coopers guilty of having a “knowing or reckless disregard for material problems in the condition of Phar-Mor,” which is paramount to fraud. The student case indicates only that the auditors were found liable, it does not specify that the plaintiffs had to prove fraud to be successful.
PROFESSIONAL STANDARDS Relevant professional standards for this assignment include AU Section 230, “Due Professional Care in Performance of Work,” AU Section 316, “Consideration of Fraud in a Financial Statement Audit,” AU 319, “Consideration of Internal Control in a Financial Statement Audit. ” USE OF THE CASE This is a rich comprehensive case that can be used in an undergraduate or graduate auditing class. An important point to stress is that financial frauds that involve collusion of top management are very difficult to detect.
Some of the topics that can be addressed with this case are legal liability, auditor independence, analytical procedures, inventory valuation, and revenue recognition. When going over the case, consider showing all or part of the 57-minute PBS video called “How to Steel $500 million. ” The video is excellent and includes interviews with members of Phar-Mor’s management team and a Coopers & Lybrand representative. To order the video, call PBS Video at (800) 328-7271; to order transcripts of the video, call Strictly Business at (913) 649-6381.
Legal Liability. This case can be used in a legal liability module as it points to the large dollar amounts involved in lawsuits against professional accountants. It can also be used to effectively discuss the differences between statutory (e. g. , U. S. Federal Securities Acts of 1933 and 1934) and common law. Within common law, the case can facilitate discussions about the differences in liability to third parties between jurisdictions and countries. The attorney for Sears, Sarah Wolff, of Chicago’s Sachnoff & Weaver, said under U. S. ederal securities law and Pennsylvania State common law, a plaintiff alleging fraud must prove that the defendant made a misrepresentation or omission of a material fact, and that the plaintiff relied substantially on that misrepresentation or omission in making investment decisions. She added that scienter—which includes recklessness—is an element of both causes of action. However, while U. S. federal securities laws require that recklessness be proved by a preponderance of the evidence, Pennsylvania state common law requires proof by a clear and convincing standard, a higher hurdle.
The jury concluded that under either standard, Coopers had been reckless. Ms. Wolff added that the case could prove to be the model for getting a jury to find that a respected accounting firm behaved “recklessly. ” Other legal liability issues that can be addressed include the trend to “socialize losses” by holding external auditors liable for losses incurred by investors and creditors. Coopers & Lybrand’s attorney, Robert J. Sisk, chairman of New York’s Hughes Hubbard & Reed, said: The jury [rightly] saw that a corporate fraud had been committed, but it mistakenly blamed the outside auditor for not uncovering something no one but the perpetrators could have known about. ” He added, “It’s a first . . . that effectively turns outside auditors into insurers against crooked management. ” The verdict is significant because Coopers claimed the investors did not rely on the audited financial statements—and that Coopers never expected investors to rely on those reports—in making investment decisions, Wolff observed.
A clean opinion by an independent outside auditor, however, is relied upon by investors like Sears because it contains information about the company’s history, an “extremely important” factor in investment decisions, Wolff said. Cases such as the Phar-Mor and Waste Management frauds, as well as the savings and loan debacles in the U. S. have put independent auditors under considerable pressure to do more than certify that a company’s books meet accepted accounting principles.
Major accounting firms, as well as major law firms and other professional consultants, frequently are targets of people with grievances against their clients, in part because the professional firms may have more money to pay claims than the primary miscreants. In February 1997 the American Institute of Certified Public Accountants (AICPA) issued SAS 82, “Consideration of Fraud in a Financial Statement Audit,” outlining new guidelines to help auditors spot fraud and determine how they should treat the information. We want auditors to focus more on suspicious situations and carry a healthy skepticism with them when they do their job,” Richard Miller, the AICPA’s general counsel, told the Wall Street Journal. [1] At the writing of this edition, the AICPA has a project underway to further revise AU 316, “Consideration of Fraud in a Financial Statement Audit” to improve the guidance relative to auditor’s responsibilities to detect fraud. Auditor Independence. This case can also be used to discuss auditor independence. Auditor independence has received significant attention in the U. S.
Walter Schuetze, then Chief Accountant to the Securities and Exchange Commission (SEC), wrote a pointed commentary, “A Mountain or a Molehill? “[2] Several other SEC speeches and commentaries followed until November 2000 when the SEC adopted new rules governing the auditor’s independence. The amendments modernize the Commission’s rules for determining whether an auditor is independent in light of investments by auditors or their family members in audit clients, employment relationships between auditors or their family members and audit clients, and the scope of services provided by audit firms to their audit clients.
The amendments also identify certain non-audit services that, if provided by an auditor to public company audit clients, impair the auditor’s independence. Finally, the new rules identify non-audit services that might impair an auditor’s independence. For all annual proxy statements filed after February 5, 2001, a public company is required to disclose information related to the non-audit services provided by the auditor during the most recent fiscal year. In 2003 Title II of the Sarbanes-Oxley Act required additional independence restrictions but left the final determinations and ruling regarding restrictions to the SEC and the PCAOB.
For example in July 2005 the PCAOB issued Release No. 2005-014, “Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees. ” In 2001 the AICPA revised their ethics rulings and interpretations related to auditor independence to conform, for the most part, with the new SEC rules. Screening New and Existing Clients. This case provides an excellent opportunity to discuss the reasons why auditors should evaluate potential clients for any client specific risks before accepting a new engagement.
The same principle of evaluation can also be applied to existing clients. An excellent reference for evaluating clients is an article by Mark Murray published in the Journal of Accountancy. [3] One of the screening steps suggested in this article is to check all potential client’s references to determine such things as “reputation,” “cooperativeness,” “management quality,” and “personality. ” Mickey Monus spent most of his life in Youngstown, Ohio. This is also where he located the main office for Phar-Mor.
As a result of spending the majority of his personal and professional life in the same town, he was well known in the area and many people could comment on his reputation in both his personal and professional activities. After discussing the questions assigned to students, the instructor can focus on the information about Mickey Monus that is contained in Exhibit 1 at the end of these teaching notes. Have students assume the identity of the auditors and ask them how this information might influence their thoughts about a new or existing client.
The information about Pat Finn contained in Exhibit 2 can also provide a good opportunity to discuss the integrity of existing management. Pat Finn was a trained auditor who spent time working for Arthur Anderson before becoming the CEO at Phar-Mor. The comments in Exhibit 2, most from Pat Finn himself, give insight into his personality and his feelings about operations at Phar-Mor. Throughout the entire case materials, there is no evidence to suggest Pat Finn intended to become involved in a fraud of the magnitude that developed at Phar-Mor.
The comments suggest Finn had some remorse and guilt about fraud and was drawn into scheme by Monus’ dominant personality. Exhibit 2 provides an opportunity to discuss the fact that participants in management and employee frauds often have a personality that provides no visible clues of danger to auditors. The auditors must be willing to perform their own screening evaluations of management for both new and existing clients. Auditor’s potential response to improve ability to detect fraud or avoid associating with high-risk client.
The case can also be used to discuss firm’s response to cases such as Phar-Mor. Firms should follow quality control guidelines as set forth in the professional standards. These include correct hiring, development, supervision and advancement practices, peer and quality reviews, partner rotation, consultation on difficult matters with other partners, and appropriate attention to auditor independence. The response of Coopers & Lybrand to audit and litigation risk is useful in answering how firms can reduce the likelihood of being associated with management fraud and resulting litigation.
In an address to the American Accounting Association in August 1996, Vin O’Reilly, a leading partner with C&L spoke about some of Coopers new methods of assessing and managing audit and litigation risk. These methods have been carried over to the merged firm PricewaterhouseCoopers (PwC). Mr. O’Reilly indicated that: The Firm has a firm-wide department of risk management. All new clients with risk factors must be approved by this department prior to acceptance, preferably prior to the proposal.
One major advantage of using this approval system is that the client acceptance decision is more objective. In the late 1980s, 25 percent of the clients the Firm accepted had experienced problems with the previous auditor. By the mid 1990s, that percentage was down to four percent. Partners are continuously reminded they are not alone. Difficult matters should be discussed with other partners at the local and national levels. Each year the Firm identifies the 200 highest risk continuing clients.
These engagements go through intense scrutiny as the firm challenges whether the client should be retained. The Firm has “fired” several high-risk clients in the last few years. Partners are taught that it is cause for celebration when they lose a “bad” client. The Firm’s engagement planning process specifically identifies factors that might indicate incentive, or the existence of management fraud. Based on a study of auditor litigation, the Firm has found that 85 percent of lawsuits against auditors are initiated when the client company fails.
Therefore, the Firm runs prospective and continuing clients through viability screens including sophisticated quantitative failure prediction models. In addition to the quantitative measures, the Firm considers several qualitative factors such as industry risk, company risk, management risk, corporate governance, oversight risk, etc. The Firm studies the personality factors of the client and the engagement team to ensure a proper match. The Firm has found that most audit failures have resulted because partner objectivity is compromised.
With this in mind, they conducted studies of partners who have been highly successful as well as those who have had problems with former audits to begin to understand the warning signs. They now monitor more closely partner traits and situations that may compromise objectivity. When necessary, the Firm provides objectivity counseling to the auditors. For example, an audit team may need counseling before an audit of a high-risk client that has aggressive and domineering management. The Firm demands better documentation of audit decisions.
They have found they can defend decisions that are written in the working papers easier than they can defend auditors’ recollections stated years after the fact. CURRENT INFORMATION ABOUT PHAR-MOR New management of Phar-Mor faced the task of restructuring its accounting records and strengthening the control systems. New management developed and implemented a strict internal control regimen designed specifically to avoid a situation in which a member of management could override controls and avoid detection.
In Phar-Mor’s 1997 10-K management indicated that they “(i) implemented three major information system improvements, each of which supports the accurate reporting of inventory and facilitates stricter accounting controls: point-of-sale scanning equipment, a pharmacy software system and a Distribution Control System warehousing system (these systems provide greater merchandising data, facilitate pharmacy processing and track and coordinate inventory purchasing and warehouse volume), (ii) undertook a review of various existing systems which included an operations and control nhancement project on the accounts payable system and a vendor correspondence and relations review and (iii) enhanced an internal audit department that assembled extensive protocols to follow in conducting audits of internal controls. ” The 10-K also indicated that “in order to further enhance the control process, new management regularly generates numerous internal reports which are distributed to a wide variety of senior, middle and lower level management on a daily, weekly and monthly basis. In addition, operational and financial planning meetings are now attended by members of all levels of management. In September of 2001, Phar-Mor operated 139 stores in 24 states under the names of Phar-Mor, Rx Place, and Pharmhouse. However, on September 24, 2001, Phar-Mor and certain of its affiliates filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code to restructure their operations in an effort to return to profitability. Management determined that the reorganization was necessary to address operational and liquidity difficulties resulting from factors such as the slowing economy, increased competition from larger retail chains, the reduction of credit terms by vendors and the service of high-cost debt.
Phar-Mor’s securities were delisted from the NASDAQ. Phar-Mor was not able to recover from these problems and liquidated the last of its assets in 2002. QUESTIONS AND SUGGESTED SOLUTIONS 1. Some of the members of Phar-Mor’s financial management team were former auditors for Coopers & Lybrand. (a) Why would a company want to hire a member of its external audit team? (b) If the client has hired former auditors, would this affect the independence of the existing external auditors? (c) How did the Sarbanes-Oxley Act of 2002 and related rulings by the PCAOB, SEC or AICPA affect a public company’s ability to hire members of its external audit team? d) Is it appropriate for auditors to trust executives of a client? (a)A company may desire to hire a member of its audit teams for a number of reasons: (i) the auditor is familiar with the company, (ii) the auditors are typically highly competent and have experience with a number of financial matters, and (iii) management has had the opportunity to work closely with the auditor and probably has developed a strong relationship. b) When former auditors become clients, there is the possibility that independence can be threatened in both fact and in appearance.
Current auditors may be close personal friends with the former auditor as a result of working on the same team for years. Further, the current auditors likely consider the former auditor to be a person of competence and high integrity. As a result, the current auditors may overrely on the representation of their former colleague. Finally, because the former auditor will be intimately familiar with the audit approach, the potential for successfully hiding an accounting fraud or mismanagement of funds may increase. ) Section 206 of the Sarbanes-Oxley Act of 2002 states that the CEO, CFO, Chief Accounting Officer or person in an equivalent position cannot have been employed by the external audit firm during a one year “cooling off” period preceding the audit. The SEC rules extend this position to prohibit the employment of such persons “in an accounting or financial reporting oversight role. ” Also PCAOB Rule 3600T, “Interim Independence Standards,” adopt the independence standards as described in the AICPA Code of Professional of Conduct. d)No, auditors should maintain healthy professional skepticism. AU Section 230, “Due Professional Care in the Performance of Work,” indicates that professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Section 230 also indicates that, “The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest” (paragraph . 9). Therefore, an audit team must objectively evaluate observed conditions and audit evidence, and follow up any potentially negative indicators to determine whether or not financial statements are free of material misstatement. 2. (a) What factors in the auditor-client relationship can put the client in a more powerful position than the auditor? (b) What measures has and/or could the profession take to reduce the potential consequences of this power imbalance? (a) The following factors can lead to a power imbalance between the client and the auditor: . Clients, typically financial management, select the auditor, determine the compensation, and have the authority to terminate the auditor. 10. To conduct an effective audit, the auditor must maintain a good working relationship with the client. In fact, the auditor must have the client’s assistance, and the auditor is often in a position where the auditor must rely on the client to provide needed information. 11. Many disputes between auditor and clients involve professional judgment.
Because of the subjective nature of the professional standards, the client can pressure the auditors to accept aggressive stances. b) To reduce the power imbalance between the client and the auditor, the profession requires the following: 12. SAS 84 in the U. S. requires communication between the predecessor and successor auditors. 13. All firms listed on the New York Stock Exchange are required to have audit committees made up of outside directors (neither the AICPA nor the SEC require audit committees. ) 14. In the U. S. the Securities and Exchange Commission requires an 8-K disclosure when there is a change in auditors. The disclosure describes important circumstances surrounding auditor changes, and the auditors are required to report any disagreements they may have with the client’s purported reason for switching. 15. SAS 50 in the U. S. imposes significant responsibilities on prospective auditors who are contacted by a client that may be involved in “opinion shopping” behavior. 16. Students commonly come up with several other alternatives.
Alternatives like, “have the government or SEC hire and pay the auditors,” “prohibit the audit firm from selling other services to audit clients,” “change partner compensation models away from rewarding selling of new services,” are common. 3. (a) Assuming you were an equity investor, would you pursue legal action against the auditor? Assuming the answer is yes, what would be the basis of your claim? (b) Define negligence as it is used in legal cases involving independent auditors. (c) What is the primary difference between negligence and fraud; between fraud and recklessness? a)Not surprisingly, the investors and creditors did sue Coopers & Lybrand. In late 1995, Coopers & Lybrand settled with Phar-Mor, Corporate Partners, and a number of banks who together were seeking in excess of $1 billion. The terms were not disclosed. Several creditors/investors did not settle and their cases went to trial. The plaintiffs brought claims under both Pennsylvania common law and the Securities Exchange Act of 1934 (even though Phar-Mor was a private company their securities and debt issues were covered under this Act).
However, these third party creditors/investors were not considered primary beneficiaries (see question 4), which meant that in order to be successful under both common law and the Securities Exchange Act of 1934 these plaintiffs had to prove the auditors were guilty of more than mere ordinary negligence (defined below). On February 14, 1996, a federal jury found Coopers & Lybrand, LLP guilty of fraud under both state and federal law because they had a “knowing or reckless disregard for material problems in the condition of Phar-Mor. Coopers faced over $176 million in claimed damages to the creditors/investors under federal securities and state common law fraud charges (the accounting firm was expected to have professional liability insurance to cover most damages awarded). Plaintiff attorneys explained to the jury that they understood Coopers did not have a responsibility to detect the management fraud. However, they asserted Coopers absolutely had the obligation to perform a GAAS audit. The plaintiffs’ case against Coopers basically was that Coopers was grossly negligent in their performance of the audit.
Plaintiffs argued that a GAAS audit would have easily uncovered the fraud in a number of audit areas. Attorneys representing the creditors believed Coopers’ credibility with the jury was hurt by the firm’s apparent conflict of interest. In particular, attorneys were critical of the actions of Gregory Finerty, the Coopers & Lybrand partner who oversaw audits of Phar-Mor. They note that while Coopers & Lybrand was raising red flags concerning Phar-Mor’s accounting practices, it was encouraging its auditors to sell additional services to the retailer.
As stated in the case, Monus was the source of significant new business for Finerty. Because of his relationship with Monus, plaintiff attorneys argued Finerty could not maintain the professional skepticism necessary to perform an independent audit. When the verdict was handed out, Coopers & Lybrand’s chairman Nicholas G. Moore stated that the Phar-Mor fight is far from over. Moore said, “We believe the jury has erred and may have believed that an audit is intended to discover fraud.
This is a dangerous message to send to those who seek to recoup business losses on the backs of innocent and well-meaning professional advisors. “[4] Coopers pointed out that the fraud was carried out by the top management via a sophisticated conspiracy wrought with lies, forgery, and cover-up aimed at fooling the external auditors. Coopers & Lybrand maintains it followed generally accepted auditing standards, which the firm claims have never been interpreted to require auditors to be trained detectives specializing in uncovering the collusive fraud of senior management. b)Ordinary Negligence: The absence of reasonable care that can be expected of a person in a set of circumstances. When negligence of an auditor is being evaluated, it is in terms of what other competent auditors would have done in the same situation. (c)Fraud occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive. The primary difference between fraud and negligence or recklessness is the intent to deceive. Recklessness or constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm.
It can also mean the lack of even slight care, tantamount to reckless behavior, that can be expected of a competent auditor. While, U. S. common law and U. S. statutory law, do suggest intent is necessary, the courts will find defendants guilty of fraud if the plaintiffs can prove recklessness, which is exactly what happened in the Phar-Mor trial. 4. Coopers & Lybrand was sued under both federal statutory and state common law. The judge ruled that under Pennsylvania law the plaintiffs were not primary beneficiaries. Pennsylvania follows the legal precedent inherent in the Ultramares Case. a) In jurisdictions following the Ultramares doctrine, under what conditions can auditors be held liable under common law to third parties who are not primary beneficiaries? (b) How do jurisdictions that follow the legal precedent inherent in the Rusch Factors case differ from jurisdictions following Ultramares? (a)In jurisdictions that follow the Ultramares Doctrine, only primary beneficiaries can successfully sue for ordinary negligence. However, even third parties who do not have privity of contract or who are not primary beneficiaries can successfully sue for gross negligence, recklessness, and fraud.
In fact, the creditors in the Phar-Mor case were not considered primary beneficiaries and therefore faced the more difficult burden of proof of knowing recklessness or fraud. In fact, while U. S. federal securities laws require that recklessness be proved by a preponderance of the evidence, Pennsylvania state common law requires proof by a clear and convincing standard, a higher hurdle. (b)Jurisdictions that follow the Rusch Factors case (or the Restatement of Torts) have broadened the Ultramares doctrine to allow recovery by third parties who are considered foreseen users.
Generally, a foreseen user is a member of a limited class of users who the auditor is aware will rely on the financial statements. For example, a bank with loans outstanding to a client at the balance sheet date is a foreseen user. 5. Coopers was also sued under the Securities Exchange Act of 1934. The burden of proof is not the same under the Securities Acts of 1933 and 1934. Identify the important differences and discuss the primary objective behind the differences in the laws (1933 and 1934) as they relate to auditor liability?
The burden of proof is very different for cases brought under the 1933 and 1934 Securities Acts. For cases brought under the 1933 Securities Act, the plaintiff must prove only that the audited financial statements contained a material misrepresentation or omission and that the plaintiff suffered a loss. However, the auditor faces an unusual burden of proof. The auditor must demonstrate as a defense that (1) an adequate audit was conducted in the circumstances, or (2) that all or a portion of the plaintiff’s loss was caused by factors other than the misleading financial statements.
The 1933 Security Act is the only common or statutory law where the burden of proof is on the defendant. For actions brought under the 1934 Securities Exchange Act, the plaintiff must prove reliance on financial statements that were materially misstated that thereby resulted in a loss. Furthermore, the plaintiff must prove the auditor acted knowingly or with recklessness. 1933 exposes the auditor to more litigation risk than 1934 Act. The primary objective behind the differences is to protect the purchasers of new securities.
Often on an original issue the only information publicly available is the prospectus whereas with an existing issue there are many sources of information (Internet, previous financial statements, analysts reports, industry publications, etc. ). Even though neither Phar-Mor’s management, the plaintiffs’ attorneys, nor anyone else associated with the case ever alleged the auditors knowingly participated in the Phar-Mor fraud, a jury found Coopers liable under a fraud claim. The crux of this fraud charge, as unfolded in the trial, was the plaintiffs’ allegation that Coopers made representations recklessly ithout regard to whether they were true or false, which legally enabled plaintiffs to sue the auditors for fraud. 6. A December 1992 Wall Street Journal article, “Inventory Chicanery Tempts More Firms, Fools More Auditors,” cited the rise in inventory fraud as one of the biggest single reasons for the proliferation of accounting scandals. (a) Name two other high profile cases where a company has committed fraud by misstating inventory. (b) What makes the intentional misstatement of inventory difficult to detect?
How was Phar-Mor successful in fooling Coopers & Lybrand for several years with overstated inventory? (c) To help prevent or detect the overstatement of inventory, what are some audit procedures that could be effectively employed? (a)A classic case that has influenced auditing standards in several countries was the discovery of a major fraud in the McKesson & Robbins Company in the U. S. in the 1937 financial statements. Other high profile inventory frauds have taken place at Leslie Fay Company, Inc. (1990-1992), and Comptronix Corporation (1992). b)Reasons why auditors have failed to detect the overstatement of inventory in the past include the following:[5] 17. Auditors who showed up at plants were fresh out of college; there was little continuity of assigned staff. 18. Partners or managers rarely attended audit team observance of inventory counts. 19. Auditors were fooled because they checked only small samples of management’s tallies. 20. Auditors permitted company officials to follow them and record where they made test counts, making it easy for officials to falsify counts for inventory not being tested. 21.
Auditors who did identify a situation indicating possible fraud—such as a barrel filled with floor sweepings whose contents management had valued at thousands of dollars—would then force the company to subtract the amount from inventory, but neglect to recognize the possibility of intentional and pervasive fraud. 22. Auditors gave a client advance notice of specific locations where they would observe the inventory count. As a result, the client refrained from making adjustments at locations where it knew the inventories would be observed, and instead made fraudulent adjustments at other locations.
Regarding Phar-Mor’s ability to fool Coopers, Generally Accepted Auditing Standards (GAAS) do not require the auditor of a retail chain to physically examine the inventory in every store. In fact, in 1989, Coopers & Lybrand physically examined inventory counts in only four stores out of 129. In 1991, only five of the 200 Phar-Mor stores’ inventories were examined. (One explanation for this seemingly low number of stores checked by Coopers is that the audit firm wanted to limit its cost since it had won the Phar-Mor account with a very low bid. 6] Another explanation is that Coopers was able to rely on the physical observation of an independent inventory control firm. ) It appears one reason Phar-Mor was successful in hiding the inventory fraud from the auditors is they were able to obtain a listing of the sample of stores selected by the auditors for physical observation well in advance. With this information, Phar-Mor was able to insure that the stores sampled by the auditors were “clean. ” To rectify this, Coopers & Lybrand could have made additional surprise visits for physical observations to several locations at random times of the year, not only at year end.
With these increased test counts coupled with price testing of these items, Coopers would have had a higher probability of identifying the overstatement. Also, the auditors could have contacted major suppliers to investigate the relationship between the supplier and Phar-Mor and to verify shipments. (c)Some observation procedures that can be followed to help prevent or detect the overstatement of inventory include:[7] 23. The audit team assigned to observe inventories should be led by capable, experienced personnel who are familiar with the client and its operations.
When less experienced personnel participate, they should be adequately supervised and encouraged to bring anything out of the ordinary to the attention of the partner, manager, or other auditor in charge at that location. 24. If not all locations will be visited, or if counts are made cyclically, the auditors should be certain the locations and cycles do not follow an easily predictable pattern and then advise the client as late as possible about locations or cycles to be observed. 25.
Be skeptical of large or unusual test count differences or of client personnel taking notes or displaying particular interest in audit procedures or test counts. If there are more than occasional differences, ensure that they are not systematic, or worse, systemic. 26. Be alert for inventory that appears not to have been used for some time or that is stored in unusual locations or fashions. If not already so identified, such conditions may indicate damage, obsolescence, or excess quantities. 27. Ensure that intercompany and interplant movement is kept to an absolute minimum.
Establish control of the inventory before the audit team leaves—satisfy that any items added to it after the count is completed are proper and reasonable. 28. Coopers may have been able to identify a higher degree of risk that inventory was misstated with extensive use of analytical procedures. For example, by artificially inflating ending inventory, the inventory turnover ratio would have indicated a slow down. It is also possible that analytical audit procedures would have identified the increase to inventory balances on a per store basis (at least for the stores not visited by the auditors).
The increase in inventory should have increased the inherent risk associated with inventory, which would require more audit testwork. Evidence presented in the trial indicated that the auditors were aware of the large “spikes” discussed in the case. • Surprise visits by auditors to various retail locations would likely have raised questions about empty shelf space. Accounts payable confirmation with some of Phar-Mor’s largest vendors would have identified the large overdue balances. Auditors could have informally or formally interviewed operations management and store personnel to identify any unusual situations. If the auditors had identified that vendors were not being paid and therefore withholding shipments, they may have discerned (1) the severe cash shortage Phar-Mor was having as well as (2) the overvaluation of inventory by employing an analytical procedure of same-store inventory levels. Then, understanding that actual physical inventory at the stores was lower than previous years, the inventory accounting records should have also shown a lower ending balance. 7. (a)The auditors considered Phar-Mor to be an inherently “high risk” client.
List several factors at Phar-Mor that would have contributed to a high inherent risk assessment. (b) Should auditors have equal responsibility to detect errors and irregularities? (c) Which conditions, attitudes, and motivations at Phar-Mor that created an environment conducive for fraud could have been identified as red flags by the external auditors? (a)Some of the factors that would have contributed to a high inherent risk assessment include the following: 29. Phar-Mor was competing in a highly competitive industry (too good to be true). 30.
Phar-Mor was rapidly expanding the number of stores; however, the accounting system was not keeping pace. 31. Management was highly motivated to meet budgets and maintain growth. 32. Previous audits had identified misstatements and system weaknesses. 33. Phar-Mor was extensively involved with a number of related parties. 34. Judgment was required for many of the accounting transactions (e. g. , Tamco, inventory valuation, exclusivity payments). 35. Inventory was a significant account. Physical observation occurred at times other than year-end, and valuation was based on cost complement. b)It is obviously more difficult to uncover irregularities because of their intentional nature. Professional auditing standards around the globe recognize that the function of the auditor is not to prevent and detect all irregularities. However, an audit is considered to have the responsibility to act as a deterrent. Professional standards do require auditors to plan and perform an audit with professional skepticism and standards require that an audit be designed and conducted to provide a reasonable assurance of detecting material misstatements (ISA 240, U. S.
SAS 53, U. K. SAS 110, Australia AUP 16). Interestingly, while international standards and standards of many other countries have explicitly described auditors’ responsibility for assessing the risk of fraud, the U. S. standards did not use the word “fraud” until SAS 82 which was issued in February 1997. SAS 82 requires auditors to document their assessment of the risk of fraud; and, when the risk is high, SAS 82 requires auditors to tailor the audit plan to address the risk. The U. S. standards are now similar to standards in Australia, the U. K. and Canada.
At the writing of this edition, the AICPA has a project underway to further revise AU 316, “Consideration of Fraud in a Financial Statement Audit” to improve the guidance relative to auditor’s responsibilities to detect fraud. (c)Some of the conditions and attitudes at Phar-Mor that made it conducive to the commission of fraud include the following:[8] Items preceded by a pointing finger appear to have been identifiable “red flags” to the auditors: ?Key executive involved in significant speculation (Monus’ investment in the now defunct World Basketball League). Key executive involved in excessive or habitual gambling.
Key executive exhibits greed as evidenced by overwhelming desire for self-enrichment and fame. ?Key executive is a “wheeler dealer” who enjoys feeling of power, influence, social status, and excitement associated with financial transactions involving large sums of money. Key executives had low moral character and lacked personal code of honesty. ?Significant related-party transactions exist. An attitude that success is more important than ethics. ?Rapid expansion of company. ?Heavy competition experienced. ?Inadequate internal control system, and/or failure to enforce existing internal controls.
Assets subject to misappropriation (money to WBL and Monus). ?Inexperienced management. ?Inventory increases on paper, with empty shelf space. ?Key executive have close association with suppliers. Too much trust placed in key employees (Shapira’s hands-off style). Liberal accounting practices (exclusivity fees booked up front). Some of the (c) motivations at Phar-Mor that made it conducive to the commission of fraud include the following. And, (d) those preceded by a pointing finger appear to have been identifiable “red flags” to the auditors: Inadequate profits relative to past performance and budgets. ?Rapid growth of company. Management job threatened by poor performance. ?Strong emphasis on earnings growth. Management believes there is a need to gloss over “temporarily bad situations” in order to maintain management position and prestige. Exhibit 1 Additional Information on Mickey Monus[9] The descriptions below were applied to Monus from people in the Youngstown area, or people who knew him professionally. All of this information would have potentially been available to auditors, or possible business associates, who did a little checking in Monus’ background. Reputation in Community • Brash exterior with an inspiring ability to create jobs and make money. Often found on the front lines at public celebrations, inviting people to believe in whatever enterprise he pushed. • “The Monus family has done more good for this valley than any harm to this valley. ” (Radio Talk Show Caller) • To the folks back home, Mickey Monus had become a legend who breathed new life into their old town. • Monus, the local boy made good, would occasionally stop by Kim’s Cafe to serve as guest bartender. • “He became almost like a cult figure. He was bigger than life. He could do no wrong. He had the Midas touch. However you want to say it, he was a very, very important person for the psyche of the Youngstown area. (Anthony Cafaro, Phar-Mor Investor) Business Philosophy • “There’s no stopping us now to being a national retailer and to having a store in every major market across the country. ” (Mickey Monus) • Monus committed Phar-Mor to underselling Wal-Mart. • “Power buying” was Monus’s catch phrase. • Monus would squeeze up-front payments from vendors in return for not selling their competitors’ products. • “There’s a lot of people who lose a lot of money in minor league sports, so yeah, it was a challenge because he was going to, again, do something that nobody had done.
He was going to be a success where others had failed. ” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League) • Monus had this attitude: “If we’re going to create a new basketball league from scratch and we’re going to make money on it when no one else has, well, hey, we’re the people who started Phar-Mor. We can do these kinds of things. ” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League) Personal traits and Lifestyle Observations • Monus’s salary and bonus was half a million dollars and he lived accordingly. He loved West Palm Beach.
He lived in a big house where he had spent large amounts ($500,000) to add rooms. His second marriage took place at the Ritz-Carlton Hotel, pool side where his second wife wore gold, an 18-carat gold mesh gown donated for the wedding day by a vendor. • “He had the ability to motivate all of his- everyone who worked with him to have that same type of fire and that same type of dedication towards Phar-Mor. ” (Pat Finn) • Monus had a gambling spirit—”Mickey’s personality is he’s in essence a gambler. If he loses a bet, he’s going to double up on the bet, and hope- hopefully, the next time he can recover his funds. (Pat Finn) • Monus loved the high life, loved to be where the action was. “It would be 3:00 o’clock in the afternoon and he’d say, ‘Let’s go to Vegas and we’re going now. Just take your wallet and let’s go. ‘ And we would fly into Las Vegas and there would be a limo from Caesar’s Palace that would meet the plane on the tarmac and we would get taken to Caesar’s Palace and there would be a suite for Mickey, 24 hours a day, seven days a week. It did not matter when we came there. There was always a suite. ” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League) • “Life was a game.
Life was just this ride you’re on. You know, you’re working hard and you’ve got all this money, you know, coming through your hands. Whether you own it or not, you know, that’s for someone else to decide, but you have the power, the ability to do anything. The gambling was insane. I mean, my coaches would come back and say, ‘Yeah, Mickey game me $4,000 to gamble with last night and I lost it all. ‘” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League) Exhibit 2 Additional Information on Pat Finn[10] “Pat Finn always had an aggressive approach to accounting and call it aggressive or call it creative, that’s the way it was done ever since I remember. ” (John Anderson, former Accounting Manager) • “You could see yourself going after problems, challenging yourself, solving problems. In accounting, you know, you worked through a problem. There was a right answer and a wrong answer. Things were, things were black and white. And that’s probably part of my personality. Things are black and white. Things are either right or wrong. ” (Pat Finn) • “You knew you were doing something wrong, but you never understood how wrong.
I think he- he (Monus) helped me believe that, you know, starting it for him was being a team ballplayer. Give him time and he’ll fix the problem. ” (Pat Finn) • “My energy, and people who worked for me, was going to cover up a situation and it really wasn’t going towards making Phar-Mor a better company and that really hurt. And I think we all longed for the day that we could just kiss this good-bye and just dedicate ourselves to making the company better. ” (Pat Finn) • I felt like I was almost in quicksand. I kept sinking deeper and deeper and deeper. But I always had a belief that we could fix it.
I never wanted to tell myself that we couldn’t fix it because it we couldn’t fix it, there was nothing but bad. ” (Pat Finn) • “It’s okay to be loyal. It’s okay to, as I did, try to build a company, to nurture something from the beginning. But never, never lose sight of yourself. Never compromise yourself for that. It’s not worth it. No matter how much of a team ballplayer you think you are, you’re just destroying yourself and destroying things that are important to you. ” (Pat Finn) ———————– Copyright © 2006 by Pearson Education, Inc. , Upper Saddle River, NJ 07458. 1]Berton, Lee, “Auditors Face Stiffer Rules for Finding, Reporting Fraud at Client Companies,” The Wall Street Journal, February 5, 1996. [2]Schuetze, Walter P. , “A Mountain or a Molehill? ” Accounting Horizons, Vol. 8 No. 1, 1994, pp. 69-75. [3]Murray, Mark F. , “When a Client is a Liability,” Journal of Accountancy, September 1992, pp. 54-58. h? °±?? µII S T V byzS?? §? © [4]”Jury Finds C Liable,” Public Accounting Report, February 29, 1996, p. 1. [5]Groveman, Howard, “How Auditors Can Detect Financial Statement Misstatement,” Journal of Accountancy, October 1995, pp. 83-86. [6]”How To Steal $500 Million,” Frontline, Video No. 304, aired on PBS, November 8, 1994. [7]Groveman, Howard, “How Auditors Can Detect Financial Statement Misstatement,” Journal of Accountancy, October 1995, pp. 83-86. [8]The items in the suggested solutions section listed as indicators are consistent with previous literature on fraud detection. Two examples of this literature are: Romney, Albrecht, and Cherrington, “Auditors and the Detection of Fraud,” The Journal of Accountancy, May 1980; and Calderon and Green, “Internal Fraud Leaves Its Mark: Here’s How To Spot, Trace, and Prevent It,” The National Public Accountant, August 1994. 9]Many of the facts in Exhibit 1 were obtained from the PBS video called “How to Steel $500 million. ” As noted earlier in the instructor’s notes, the video is excellent. To order the video, call PBS Video at (800) 328-7271; to order transcripts of the video, call Strictly Business at (913) 649-6381. [10]Many of the facts in Exhibit 2 were obtained from the PBS video called “How to Steel $500 million. “