Classic Case Studies in Accounting Fraud, Study notes of Accounting

Download Classic Case Studies in Accounting Fraud and more Study notes Accounting in PDF only on Docsity! “Classic Case Studies in Accounting Fraud” A thesis submitted to the Miami University Honors Program in partial fulfillment of the requirements for University Honors. by Justin Matthew Mock May 2004 Oxford, Ohio ABSTRACT “Classic Case Studies in Accounting Fraud” by Justin Matthew Mock Over the past several years, accounting fraud has dominated the headlines of mainstream news. While these recent cases all involve sums of money far in excess of any before, accounting fraud is certainly not a new phenomenon. Since the early days on Wall Street, fraud has consistently fooled the markets, investors, and auditors alike. In this thesis, an analysis of several cases of accounting fraud is conducted with background information, fraud logistics, and accounting and auditing violations all subject to study. This paper discusses specific cases of fraud and presents the issues that have been and must continue to be addressed as companies push the envelope of acceptable accounting standards. The discussion and findings demonstrate the ever-present potential for fraud in a variety of accounts, companies, industries, and time periods, while also having a powerful influence on an auditor’s work and preconceptions going forward. iii vi ACKNOWLEDGEMENTS “Classic Case Studies in Accounting Fraud” was completed under the direction of the Miami University Honors Program. The Honors Program provided financial support essential to the project’s research and successful completion. Additionally, the faculty and coursework of the Miami University Accountancy Department proved invaluable. Drs. Phil Cottell and Larry Rankin and Mr. Jeffrey Vorholt, all faculty members, collectively aided the research in a mentoring role, offering insight and advice from the project’s early stages to its completion. Also, the publications and resources of the Association of Certified Fraud Examiners were especially helpful. vii TABLE OF CONTENTS Pages Introduction 1 - 2 McKesson & Robbins 3 - 12 Allied Crude Vegetable Oil Refining 13 - 18 ZZZZ Best 19 - 27 Crazy Eddie 28 - 39 Phar-Mor 40 - 49 Foundation for New Era Philanthropy 50 - 56 Enron 57 - 68 Conclusion 69 - 71 Works Cited 72 - 73 viii 3 MCKESSON & ROBBINS “In the business world, the rearview mirror is always clearer than the windshield.” Warren Buffett Stock market fraud was once a perfectly respectable way to achieve wealth and much of America's industrial and financial colossus was built on such actions. In fact, “some of the greatest names in American history made their fortunes through shameless chicanery, including Vanderbilt, Morgan, Rockefeller, Stanford, Gould, and Kennedy” (Carlson). Regulation was limited and ethics were not even considered as “insiders benefited from price fixing, stock manipulation, and various schemes of questionable legality…Mergers, cutthroat competition, railroad rebates, and bribery were some of the techniques used by businesses” (Giroux) in these early days. Given this situation and the culture that it fostered, auditors faced a number of challenges in performing their work. A milestone case in fraudulent financial reporting occurred in the 1930s, soon after the Great Depression, at McKesson & Robbins (McKesson), a pharmaceutical giant. The case would drastically affect the auditing profession, which was completely blind to the fraudulent activity at McKesson. The fraud went on for over ten years and through forged invoices, purchase orders, shipping notices, contracts, debit and credit memos enabled the company to collectively overstate its inventory and sales by over $19 million, incredible amounts for the time. BACKGROUND With a lengthy rap sheet, Philip Musica had a colorful background in rising to his position as President at McKesson. Philip Musica was the oldest of four sons of Assunta Mauro Musica, born in 1884 in the Lower East Side area of Manhattan. Within this 4 district, the family grew up in the Mulberry Bend neighborhood, known for some of the toughest gangs in New York. At age 14, Philip followed his mother’s orders and dropped out of high school. By 1901, Philip’s father had managed to save enough from his barbershop to open A. Musica & Son, a small shop selling Italian pastas, sausages, and dried fruits. Under his self-educated mother’s guidance, Philip learned the business and began wholesaling. Philip made contacts and was able to import his own goods and then act as a distributor to other shops. Philip’s younger brothers, George and Robert, also entered the family business. New York detectives soon got word that Philip was bribing cheese inspectors, writing down the goods he received to skirt import tariffs. At the same time, he was keeping two sets of financial records. Following his mother’s recommendations, one set reflected the true inventory and one was according to the bribes. After the detectives moved in, Philip took the entire blame, clearing his father, mother, and brothers of criminal charges. At age 25, Philip was sentenced to one year in prison. At the Elmira Reformatory, he lied, telling the guards that he had a degree in accounting, and earned a position in the warden’s house. After serving just five months of his one-year sentence, President Taft mysteriously pardoned Philip Musica. After Philip was released, the family returned to father Musica’s barbershop business for their next series of exploits. With hair extensions extremely popular in 1910, mother Musica was able to raise $1 million in capital for the US Hair Company from Italian businessmen. Within 18 months, US Hair was trading on the New York Curb 5 Exchange with market capitalization exceeding $2 million. Hair assets were recorded at $600,000 and offices were located around the world in London, Berlin, St. Petersburg, and Hong Kong. After two years, US Hair was a $3 million corporation and Philip was living lavishly, indulging in the luxuries of New York City. This fraud was exposed when a sudden sell off of US Hair stock prompted an investigation. Regulators halted the shipment of nine US Hair cases of product and discovered nothing but newspaper inside. US Hair was exposed as a shell company used to launder money through the family’s international offices. Philip and the entire Musica family managed to escape before being arrested. While mother Musica fled to Naples, Philip, his brothers George and Robert, sisters Louise and Lucy Grace, and father jumped from train to train on their way to Mobile, Alabama. A private investigator ultimately tracked them to New Orleans where they were arrested on board a ship bound for Panama. After the arrest on the ship, Philip and his family were found to be in possession of thousands of dollars in cash, insurance certificates, and expensive jewelry. Philip again claimed sole responsibility and cut a deal to become a prison informant, ratting out fellow prisoners at The Tombs. After his release, Philip Musica was able to create a new life, living under the alias Bill Johnson. Remarkably, he served as an investigator in the New York Attorney General’s office. While aware of Philip’s background, Deputy US Attorney General Alfred Becker was able to dismiss the criminal activity in his past and was convinced that Philip had repented on his many misdeeds. Although not very ethical, Musica was 8 FRAUD LOGISTICS Clearly, Musica/Johnson/Costa/Coster was a perpetual fraudster, continually returning to a life of crime. Many of his businesses took on illegal activities and the financial reporting of these businesses did as well. Musica and his two brothers went to great lengths to hide the fraud. They produced “every last piece of documentation – from raw materials and processing through packaging, shipping, and selling – which would be generated by a typical American business of the time” (Wells Frankensteins 120-121). Occasionally, they would even pay bills late, just as a completely legitimate business would. Through the Canadian subsidiary, phony sales documents were created and inventory at this business alone was overstated by millions. Warehouses were purchased, yet sat empty as the company merely used the address as evidence of its facility. An investigation later determined that the fraud resulted in at least $9 million of fictitious inventory counts and over $10 million in sales from fictitious customers. While Coster guided McKesson through the Great Depression, he also maintained several bulletproof aliases, shielding himself from a string of corrupt businesses and allowing himself to draw several McKesson paychecks. Nevertheless, Coster had been personally invited to run for the US presidency with the Republican Party against FDR. Coster declined the nomination citing personal commitments. WHERE WERE THE AUDITORS? Paralleling the recent accounting scandals, a February 1939 article on the McKesson fraud in the Journal of Accountancy read: 9 Like a torrent of cold water the wave of publicity raised by the…case has shocked the accounting profession into breathlessness. Accustomed to relative obscurity in the public prints, accountants have been startled to find their procedures, their principles, and their professional standards the subject of sensational and generally unsympathetic headlines. Until early in the 20th century, use of the balance sheet was paramount. Although the concept of earnings power began to emerge in the years after World War I, the income statement was still largely neglected because it was easily open to abuse, as no accounting standard existed to govern its creation. As a result, the benefits of the income statement to determine profitability, value for investment, and credit worthiness were all ignored. Additionally, insider trading was both common and legal; corrupt activity was frequent and acceptable. The McKesson fraud came following the collapse of the stock market in 1929, which spurred the Great Depression. The “Great Depression demonstrated problems with capital markets, business practices, and…considerable deficiencies in accounting standards. Many aspects of current accounting practices started with the flood of business regulations from the Roosevelt administration” (Giroux). Before the Great Depression, regulations existed…federal laws, state Blue Sky Laws on securities regulation, and so on. Companies issued prospectuses that typically (contained) audited financial statements and attorney review. However, these were not very effective. Lawyers, auditors, and brokers worked for the companies, not the potential investors. State laws were ineffective for regulating interstate commerce. The federal laws were still inadequate (Giroux). In response to a fraud involving Ivan Kreuger, the Swedish Match King, political support led to the passage of the US securities acts in 1933 and 1934, which required companies to publish audited financial statements before going public. These landmark 10 securities laws established antifraud and liability regulations that increased the legal responsibilities of accountants, who now became liable to the public. Following the direction of the securities laws to create regulation, the Committee on Accounting Procedure (CAP) was a part-time committee of the American Institute of Certified Public Accountants (AICPA) that circulated Accounting Research Bulletins (ARBs). Subsequent to the McKesson fraud, CAP coined the term “generally accepted accounting principles” (GAAP) and the Securities and Exchange Commission (SEC) formally delegated authority to create accounting standards to the private sector. Accordingly, CAP began to issue the aforementioned ARBs, which determined GAAP from 1939 until 1959. While CAP is now nonexistent, its work and the ARBs are lasting, with many of the bulletins becoming a part of GAAP. Currently, generally accepted accounting principles are those accounting principles that have substantial authoritative support. Substantial authoritative support is a question of fact and a matter of judgment. The power to establish GAAP actually rests with the Securities and Exchange Commission; however, except for rare instances, it has essentially allowed the accounting profession itself to establish GAAP and self-regulate (Brunner 3). The auditing firm Price Waterhouse & Company inspected the McKesson books in fiscal 1937, yet did not verify the existence or amount of physical inventory and did not question the existence of numerous new customers over the previous fiscal year. As a result of the auditing firm’s limited work, ample opportunity to commit the fraud was present. However, on behalf of the auditors, it must be stated that, at the time of the case, they were required to neither count nor observe physical inventory. Thus, while perhaps satisficing, the auditors were compliant with the standards at the time. 13 ALLIED CRUDE VEGETABLE OIL REFINING “In the modern world of business, it is useless to be a creative original thinker unless you can also sell what you create.” David M. Ogilvy While regulators and the public demanded government regulation early on, “historically, the corporate tendency has been to react to fraud after the fact than to be proactive in its prevention. In most cases, blame is directed at accountants and auditors” (Davia). This reactive attitude certainly has and continues to promulgate the opportunities for fraud. Nearly three decades and many frauds after McKesson went bankrupt, another large-scale inventory fraud would impact the financial markets. The Salad Oil King, who executed this fraud, finally got caught in November of 1963, and was led from his home in the Bronx, New York to face criminal charges in nearby Newark, New Jersey. The actions of Anthony “Tough Tino” DeAngelis, a 5’5” 240 pound brilliant salesman, and extensive phantom inventory throughout the company fueled this fraud, affectionately known as the Salad Oil Swindle. The fraud nearly bankrupted two large brokerage houses, while adding to the growing fortune of Warren Buffett. BACKGROUND Anthony DeAngelis, a former New Jersey meatpacker, ran Allied Crude Vegetable Oil Refining (Allied), a major player in the commodities markets of the 1950s and 1960s. DeAngelis was well known for his ability to orchestrate terrifically intricate deals. However, before Allied, “he had previously run a solvent business into bankruptcy, had attempted to cheat the government on several occasions while carrying out government contracts…and had been expelled from two New York banks on the 14 suspicion that he was running check kiting schemes” (Wells Occupational Fraud 415). Between 1940 and 1952, he was forced to pay $100,000 at least three times for inferior products and short deliveries. Despite his spotty background, both lenders and investors willingly accepted his word throughout his salad oil shenanigans. Allied specialized in soybean, cottonseed, and edible oil. The business was designed to take advantage of the US Government’s Food for Peace program, which subsidized the export of certain US crop surpluses. However, due to Tino’s criminal background, he was not an approved exporter. The company regularly delivered legitimate shipments of vegetable oil to large vats in a warehouse in New Jersey. For each shipment, warehouse receipts were issued, indicating the amount of oil that had been stored and essentially fueling the company’s accounting records. DeAngelis received certificates of authenticity from a prominent banking subsidiary of American Express, with executives vouching for the validity of the salad oil. Tino would then issue the American Express certificates of authenticity to his investors and lenders. Several large banks and brokerages relied on these certificates to secure their loans to Allied. Investors were eager to cash in on the fortune that the Salad Oil King was making and didn’t question their investments, instead relying on the faith of DeAngelis and American Express. By late 1963, Allied was holding warehouse receipts indicating and legally verifying the existence of $60 million worth of salad oil. Allied used the warehouse receipts, evidence of its inventory, as collateral for $175 million in loans, which 15 DeAngelis then used to speculate on vegetable oil futures in the volatile and risky commodities market. Tino offered such low prices that exporters bought the oils from Allied and then exported the Allied oils that they had just purchased. In fact, although Tino was not an authorized exporter, he accounted for 85% of the country’s edible oil exports. Some of the countries that then accepted the goods soon complained that they were receiving drums of water. Allegations of fraud and falsified shipping documents soon followed. As a supplier of salad oil, a short position would have hedged the company’s exposure to price variations and guaranteed a sale at a given price. However, Tino’s speculative moves and long position culminated in 1962 when vegetable oil prices plunged. Unable to meet the mark-to-market and settling up provisions of the futures market, DeAngelis lost all the money he had borrowed. The loans fell back to American Express, who now owned a warehouse full of vegetable oil. FRAUD LOGISTICS Although the speculative moves had failed, proved unwise, and bankrupted Allied, the actions certainly were legal. Yet, after Allied went bankrupt, the fraud now suddenly began to become apparent, with inventory a prime area of fraudulent activity. American Express soon discovered that the vats contained not salad oil, but mostly seawater. Tino DeAngelis had filled many of the oil tanks with seawater and added just a small amount of salad oil to the top, just enough to fool the auditors when they would peer inside to confirm the salad oil’s existence. Secondly, DeAngelis had his henchmen direct an auditing team through the warehouse’s maze of rows of oil tanks, 18 CONCLUSION With a company, its chief executive, accountants, and even its chief lender all acting to trick the auditors, the Salad Oil King and Allied Crude Vegetable Oil Refining were able to orchestrate one of America’s classic frauds. As a result of the fraud, the 51 involved banking and brokerage firms sustained losses totaling $200 million. Anthony DeAngelis was sentenced to 10 years in prison. Coincidentally, the news of the fraud broke on the same day as President Kennedy’s assassination and was largely ignored by the public. Much later, the magnitude of the fraud finally became understood. Price Waterhouse was dismissed as American Express’s auditors and Arthur Young was hired. As a result of its actions, American Express's stock fell 45%, from $60 a share down to $35 a share by early 1964. Interestingly, Warren Buffett, the American billionaire and legendary investor, was just beginning a small investment partnership and boldly purchased five percent of American Express’s outstanding stock with 40% of his available capital. This purchase would result in a $20 million profit just two years later. 19 ZZZZ BEST “Complexity is a formal academic discipline with a focus on complicated organizations such as corporations.” Larry Elliott and Richard Schroth. How Companies Lie. As has been especially evident in recent years, “periodic high profile cases of fraudulent financial reporting raise concerns about the credibility of the US financial reporting process and call into question the roles of auditors, regulators, and analysts in financial reporting” (Beasley Fraudulent 1). The consequences of fraud can be unnerving. Frauds not only affect the fraudsters, auditors, and investors, but also communities, industries, and financial markets, while also influencing both accounting and auditing standards. In addition to the savings and loan scandal of the 1980s, the decade was also plagued by several other notorious scandals. Barry Minkow, a flamboyant entrepreneur, founded ZZZZ Best in his parent’s garage as a high school junior. A hyperactive youth, compulsive teenage achiever, and adult charmer, Minkow fits the classic mold of both an entrepreneur and a fraudster. He grew his business into one of the nation’s largest carpet cleaning and renovation services businesses in the 1980s and within five years of founding the venture, ZZZZ Best maintained a recognized position on Wall Street. Unfortunately, the multi-million dollar business’s growth would not prove to be genuine and Minkow would be exposed as the architect of one of America’s most outrageous accounting frauds. 20 BACKGROUND In 1982, Barry Minkow established ZZZZ Best at age 16. In the carpet cleaning business, “there are essentially no barriers to entry: no licensing requirements, no apprenticeships to be served, and only a minimal amount of start-up capital is needed…Minkow quickly learned that carpet cleaning was a difficult way to earn a livelihood…Customer complaints, ruthless competition, bad checks, and nagging months of striking out on his own…” (Knapp 5th Ed. 120-121). Additionally, local banks refused to lend the young entrepreneur any working capital. Nevertheless, Minkow was resourceful and knew how to network. After discovering how tough business was, Minkow resorted to several fraudulent schemes to raise the needed funds to grow his business. He started with credit card forgeries, insurance fraud, and check kiting, but “soon became even bolder and began reporting fictitious revenues from ‘insurance restoration’ contracts” (Knapp 4th Ed. 28) to coerce banks into approving his loans. He ultimately expanded the insurance restoration activities so much that they accounted for nearly 90% of the company’s annual revenues. The success let him take the company public in 1986 and “in the three-year period from 1984 to 1987, the company’s net income surged from less than $200,000 to more than $5 million on revenues of $50 million” (Knapp 5th Ed. 119). The company peaked with a market capitalization of $200 million in 1987. As a result, Minkow lived the high life, appearing on Oprah and driving a Ferrari. During the five-year span between 1982 and 1987, Minkow maintained financial records embellished with inflated numbers and phony accounts, serving to impress Wall 23 profits at ZZZZ Best, without the counsel of his auditors. At the same time, an informant approached Ernst & Whinney with information of the fraud at ZZZZ Best. With evidence of the fraud mounting, Ernst & Whinney resigned as auditors. Subsequently, securities investigators probed ZZZZ Best’s financials, finding countless fictitious accounts. The company immediately fell into bankruptcy and Minkow faced criminal action. While the company’s market capitalization reached $200 million, its assets were liquidated for just $62,000. WHERE WERE THE AUDITORS? After the fraud was exposed, much of the criticism fell on the auditors for failing to uncover the fraud and the numerous multi-million dollar insurance restoration contracts. The company’s first auditor was George Greenspan, a one-man operation. He confirmed ZZZZ Best’s material insurance restoration contracts through Tom Padgett, Minkow’s close friend. Minkow had earlier convinced Padgett to establish both Interstate Appraisal Services and Assured Property Management to generate the fake business for ZZZZ Best. Greenspan performed confirmations, analytical procedures, and reviewed key documents. All of his procedures showed nothing out of the norm. Following the IPO, Ernst & Whinney took over. After ZZZZ Best went public, stock underwriters had encouraged Minkow to hire a national Big 8 accounting firm. Accordingly, Minkow hired Ernst & Whinney, who initially performed a review of the company’s quarterly financial statements for the three months ending July 31, 1986. In early 1987, before completing its audit and prior to issuing an opinion, Ernst & Whinney resigned amid growing concern over the legitimacy of ZZZZ Best’s accounts. 24 Considering the limited duties and scope involved in a review, the review was not likely to uncover the fraud. After all, “the purpose of a review engagement is to obtain a reasonable basis for providing ‘limited assurance’ that a given client’s financial statements have been prepared in conformity with generally accepted accounting principles” (Knapp 4th Ed. 31). In contrast, the objective of an actual audit is more affirmative and is expected to provide a reasonable, versus limited, basis for expressing an opinion about the fairness of the financial statements. Ernst & Whinney was publicly chastised following the fraud. They allegedly missed several red flags, including the following facts: • virtually all of the insurance contracts were from the same party • a large number of contracts occurred immediately prior to the IPO • ZZZZ Best’s margins were not proportional to the industry averages • the internal controls of ZZZZ Best were limited and ineffective. In addition, prosecutors would also argue that Ernst & Whinney likely “was not completely familiar with certain key business practices prevalent in the insurance restoration industry” (29). The confidentiality agreement severely limited the auditors’ scope. While it is unclear if they even wanted to, the auditors were unable to contact the building’s owner, insurance company, or any other third party involved. When such a scope restriction occurs and the auditor is unable to overcome the limitation through additional procedures, the auditors should issue a disclaimer of opinion. A disclaimer of opinion is a report issued by the auditor when they have not been able to obtain satisfaction that the overall financial statements are fairly presented. 25 Additionally, the third audit standard of fieldwork mandates that an auditor must “obtain sufficient competent evidential matter to support the opinion ultimately rendered on a client’s financial statements” (31). It is expected that the evidence be both relevant and valid to provide proper assurance. While external confirmations are generally very reliable evidence in support of the existence assertion, they failed to provide the proper support because Minkow had established the businesses that returned the confirmations. Likewise, physical examination is also generally very reliable in support of the existence assertion. Although the auditors did prove some degree of existence with their site inspection, the client lacked the legal right to the particular assets. As a result, the auditors should have pursued the rights and obligation assertion, as dictated in SAS No. 31. Had the auditors pursued the contracts and the sites slightly further, in addition to the documents they had already received, they would have satisfied this assertion and discovered the fraud. ZZZZ Best contracted with three different auditing firms during their five years, and the communication between the first and second, and second and third auditors was questioned. SAS No. 7 “Communications between Predecessor and Successor Auditors,” later superseded by SAS No. 84, outlines the requirements for a change of auditors. The successor auditor is responsible for contacting the previous auditor after gaining permission from the prospective client, but before accepting the audit engagement. Further, the client should authorize the previous auditor to respond to the new auditor’s inquiries. The communication efforts allow the new auditor to gain knowledge of the 28 CRAZY EDDIE “Honesty pays, but it doesn’t seem to pay enough to suit some people.” F.M. Hubbard Currently, the accounting profession is undergoing a debate concerning the application of the Sarbanes-Oxley Act and the auditing standards established by the Public Company Accounting Oversight Board (PCAOB) to private companies. One argument holds that many private companies will eventually seek financing in the public capital markets and thus, should follow the same provisions as public companies. The Crazy Eddie fraud can be used as an excellent illustration of these arguments. In the 1980s, Crazy Eddie was a growing electronics retailer and sought to inflate their books for a better IPO. The Crazy Eddie fraud is also an example of both fraudulent financial reporting and misappropriation of assets. The company skimmed cash, overstated inventory, and used a number of memorandum entries to appear more financially lucrative prior to the IPO, and then continued and even expanded the fraud to boost its CRZY stock price after going public. BACKGROUND Eddie Antar grew up in his father’s retail business in a Syrian Jew neighborhood in Manhattan. Eddie was destined to follow his father in the retail business. Antar dropped out of high school at age 16 and began peddling electronics in his neighborhood. After dabbling in a number of sales positions on his own, Eddie teamed with his father and another family member to launch Sight and Sound, an electronics store. His aggressive sales techniques soon earned him the nickname “Crazy Eddie.” 29 Accompanying his odd behavior, “his quick temper caused repeated problems with vendors, competitors, and subordinates. Antar’s most distinctive trait was his inability to trust anyone outside of his large extended family” (Knapp 5th Ed. 110). Eventually, Sight and Sound turned into Crazy Eddie’s, a big box electronics retailer. Eddie’s exuberant personality and charisma guided the company, its culture, and fueled the business’s growth, known for their INSA-A-A-A-ANE! prices and their pledge not to be undersold. Even without the fraud, Eddie’s business was legitimately successful and he was the first to prove that a freestanding electronics store could work profitably. Despite the stores’ success, Eddie was compelled to steal from the beginning, just as his father and all the other Antars had done with their previous retail businesses. The fraud began simply enough, paying some employees off the books, just as one would do a babysitter. In fact, tax records show that one store manager, Allen Antar, claimed that his entire compensation was $300 weekly. Of course, he managed to drive a Jaguar, while supporting a wife and three kids, “two of whom were in private school with a tuition of approximately $25,000” (Wells Frankensteins 225). Eddie personally skimmed cash from the beginning, choosing not to report some sales and distributing the excess cash to his family members. The schemes grew as the company did. The company went public in 1984, garnering capital to finance an aggressive expansion plan. In its first year as a public company, Crazy Eddie’s sales grew by 55% from $29 million to $46 million. Net income soared from $538 thousand to $1.141 million. As a result, investors loved the 30 company and it’s 17-cent per share dividend. Its price-to-earnings ratio was the highest in the industry and not in 15 years had one single store in the company reported a loss. Yet the IPO came a full year late. After discovering that the financial records were careless and incomplete, the underwriters delayed the IPO. The underwriters also expressed concern over the number of related-party transactions, amount of unqualified family members acting as executives, “interest-free loans to employees, and speculative investments unrelated to the company’s principal line of business” (Knapp 5th Ed. 111). The underwriters encouraged Eddie to hire a national accounting firm and an experienced CFO. Eddie hired the national accounting firm Main Hurdman as the auditors, but chose to tab his younger brother, Sammy, as the CFO. “Eventually, Antar’s father, sister, two brothers, uncle, brother-in-law, and several cousins would assume leadership positions with Crazy Eddie, while more than one dozen other relatives would hold minor positions with the firm” (110). Despite the concerns, the IPO was successful and, in fact, was even oversubscribed. By 1987, the company reported annual revenues of $350 million with 43 stores. Throughout the early 1990s, the VCR was fueling electronics sales. At the same time, “Antar blanketed this region with raucous, sometimes annoying, but always memorable radio and television commercials” (111). The consumer electronics industry experienced considerable growth between 1981 and 1984. However, in 1986, the growth plateaued and sales dipped. As Crazy Eddie’s growth trend continued, the auditors should have grown increasingly suspicious. 33 If the money can be gotten into a bank or other financial institution, it can be wired to any place in the world in a matter of seconds, converted to any other currency, and used to pay expenses and recapitalize the corrupt business. The problem for the…tax evader then, is how to get his money into a form in which it can be moved and used most effectively without creating a ‘paper trail’ that will lead law enforcement authorities to the illegal business. The process of doing that is…money laundering. There are many ways it is done (Keeney). After going public and needing to maintain the impressive sales growth, Sammy Antar created what came to be known as the Panama Pump. This fraud scheme manipulated the family’s international banking connections to bring the skimmed money back to the US and into the company as a method of managing earnings. The money was brought back to the US from the Israeli bank through a Panamanian bank using “double secrecy jurisdiction.” The money would then be recorded as sales revenue to help boost Crazy Eddie’s same-store-sales ratio, a critical growth measure used by stock analysts. Thus, the Antars, an extended family who all owned stock, were giving up the money they had illegally taken to increase the CRZY stock price, and of course in turn, increase their own wealth. Inventory In one of the most audacious parts of the fraud, Crazy Eddie employees literally broke into the auditor’s records and falsified their numbers, specifically increasing inventory counts. These actions illustrate to auditors the importance of properly securing records. Continuing, they would further maximize their inventory levels by shipping merchandise overnight from one store to another in preparation for the auditor’s count the next day. 34 Inventory was also said to have been “returned to manufacturer” that was actually still sitting in the warehouse. These moves allowed Crazy Eddie to book a credit from the manufacturer, while also still counting the merchandise as inventory. At one point, desperate for a better balance sheet, Crazy Eddie was able to convince a vendor to ship merchandise just prior to year-end, while deferring billing until the following year, ignoring the matching principle. The company’s assets were then even further overstated, while liabilities were understated. When auditors would question any of the transactions, Crazy Eddie would conveniently lose the needed report and the naive auditors would be unable to pursue the matter. The inventory hijinks continued, further implicating manufacturers. For certain items, Eddie was able to negotiate terms to be the sole provider of a product in his market. Eddie would place an order larger than he needed at the negotiated reduced rate and then conspire to ship the excess off to a distributor who would move the product to another retail market outside the NYC area. Conveniently, Eddie was able to arrange for the distributor to settle the account in a number of small $10,000 checks that he could then sprinkle around to the stores as sales revenue without attracting attention, again fraudulently increasing the essential same-stores-sales ratio. Finally, Crazy Eddie improperly valued its inventory through a number of schemes that overstated inventory by $65 million. Although the company used appropriate values for each inventory item, the company clearly used completely inaccurate quantities for inventory, thereby overstating its assets and consequently equity. 35 By sharing inventory between stores, inventory was double counted. In addition, after breaking into the auditor’s records, Crazy Eddie easily altered the quantities involved. In its first year as a public company, inventory and gross profit were overstated by $2 million. In its second year, inventory was overstated by $9 million and accounts payable was understated by $3 million. In the end, inventory would be overstated by $65 million. Liabilities As the New York metro area’s premier electronics retailer, the largest consolidated retail market in the nation, Eddie was able to leverage his suppliers to his advantage. Eddie would simply vow not to carry a manufacturer’s products if they didn’t succumb to his terms. As a result of his coercion, suppliers gave Crazy Eddie considerable discounts and advertising rebates. The Antars further used the aforementioned discounts to their advantage. As needed, the company would split a payable on its books, claiming as much as half was resolved through bogus discounts and ad credits, thereby fraudulently decreasing the company’s liabilities. As some of the discounts were legitimate and some weren’t, it was “tough to know what was smoke and what was fire” (qtd. in Wells Occupational Fraud 442). Often due to pressure to meet goals, the timely recording of expenses and liabilities is compromised, despite GAAP’s requirement to “match” accounts in the same period. The matching principle is one of the fundamental assumptions underlying accrual accounting. Eddie had the inventory on hand just before year-end and appropriately 38 Inventory is a significant asset for a retailer and received considerable attention from the auditors as a result. Inventory grew from $23 million in 1984 to $110 million in 1987. Additionally, inventory turnover slowed and the average age of inventory rocketed in 1987. Both measures increased the risk of inventory obsolescence and created potential valuation problems for the auditors. Of further concern, although inventory grew, accounts payable fell during 1987. Continuing, although assets grew each year, accrued expenses fell in 1987. Likewise, accounts receivable turnover plummeted in 1987. Thus, the account balances showed some unusual relationships and fluctuations that should have prompted additional investigation. Crazy Eddie employed four different auditors during their chaotic history. The first auditor, a local firm, was dismissed at the urging of the underwriters. Main Hurdman was then hired. Main Hurdman would then merge with Peat Marwick to become the third auditor. After the takeover, Peat Marwick was terminated and Touche Ross was brought on board. Despite the number of auditors or perhaps because of, the fraud was never uncovered by any of them. Main Hurdman had allegedly “lowballed” their initial bid to win the audit, charging a meager $85,000. Consequently, they were more likely to limit their tests to the minimum. Main Hurdman’s independence and objectivity were also criticized. Some of Eddie’s accountants were former Main Hurdman auditors. In addition, Main Hurdman developed Eddie’s inventory system, the very system it was supposed to audit. Despite the high-tech inventory system, Eddie refused to utilize it, instead relying on an old- fashioned, manual system that he could more easily manipulate. 39 CONCLUSION The shear magnitude of the Crazy Eddie fraud is daunting. Likewise, it took years for the federal government to build their case to prosecute the Antars after digging through the financial data. This case again shows the extent that fraudsters go to simply to cover their con. In June 1989, following the takeover, the new owners of Crazy Eddie filed for Chapter 11 bankruptcy. Eddie was finally arrested in June 1992 in Israel. He was convicted in July 1993 on 17 counts of financial fraud, including racketeering, conspiracy, and mail fraud. He was sentenced to prison and ordered to repay some $121 million to his stockholders and creditors. Likewise, Sammy Antar and several other family members and executives were also convicted. Years later, after being released early from prison, Eddie joined two nephews in reviving the Crazy Eddie business. The company largely operates through the Internet with telephone sales as well. For their involvement, both Peat Marwick and Crazy Eddie’s first auditor, the local firm, contributed to a $42 million settlement pool. 40 PHAR-MOR “The art of capitalism at work is getting to the edge without going over.” Larry Elliott and Richard Schroth. How Companies Lie. Akin to the Crazy Eddie fraud, the Phar-Mor case again involves a retail enterprise, inventory overstatements, and both fraudulent financial reporting and misappropriation of assets. Indeed, the adage held true and history was bound to repeat itself. Despite the remarkable similarity between the two well-known cases, the auditors again completely failed to discover the fraud, missing the many warning signs and ignoring the high-risk elements of the engagement. Yet again, the scrupulous, yet dedicated, fraudsters showed that they were capable of fooling everyone for an extended period of time. Based in the industrial town of Youngstown, Ohio, also appropriately known as “Crimetown USA,” Phar-Mor was a deep discount retailer that, during its heyday, took on the likes of Walmart. Under the direction of high-rolling entrepreneur, hometown hero, and COO, Mickey Monus, the company, which was formed in 1982, quickly expanded, locating some 310 stores in 32 states with over $3 billion in sales. After the fact, Phar-Mor was named a “white-hot commodity in a sizzling industry” by PBS’s investigative show “Frontline.” From his prominent position, Monus lived lavishly with his half million-dollar salary. Rather than just playing corporate hardball as he claimed, Monus managed a corporate fraud that soon got out of hand and, until recent years, remained one of the largest US corporate frauds of all time. 43 “Phar-Mor’s executives had cooked the books and the magnitude of the collusive management fraud was almost inconceivable. The fraud was carefully carried out over several years by persons at many organizational layers, including the president and COO, CFO, vice president of marketing, director of accounting, controller, and a host of others” (Beasley Auditing 27). Inventory Overstating inventory was at the heart of the Phar-Mor fraud. To hide the losses and make the books balance, inventory was grossly overstated. The company used the complex retail method of accounting for inventory. Although the auditors recognized the high-risk nature of this treatment, they failed to thoroughly investigate this accounting procedure. Accompanying the chain’s rapid expansion, inventory grew from a paltry $11 million in 1989 to $36 million in 1990 to $153 million in 1991. Despite the considerable growth and reflective of the company’s limited use of MIS, Phar-Mor did not utilize a perpetual inventory system. The company relied on the retail method to value inventory. Typically the retail method is used by businesses that sell a large volume of items with relatively low unit costs. The retail method records inventory at the retail price and then coverts it to GAAP cost by applying a cost complement percentage. When in a competitive situation, Phar-Mor would lower a price and then lower the gross margin. The company ignored the lower of cost or market guidelines. Inventory was shared between stores as the audit fieldwork progressed. Thus, the 44 inventory overstatement was a result of being both incorrectly valued and incorrectly counted. When an inventory discrepancy arose in the audits, inventory would be appropriately credited to reduce the amount. However, rather than debiting the expense cost of goods sold, Phar-Mor debited a “bucket” account that collected all of the fraudulent entries. The “bucket” was then emptied at year-end by “allocating a portion back to the individual stores as inventory or some other asset” (35). These entries were labeled “Accrued Inventory” or “Alloc Inv” and, although both large and unusual, failed to draw the attention of the auditors. Misappropriation of Assets In addition to all of the losses that were masked and the accounts that were altered, the same executives misappropriated Phar-Mor’s assets, directing over $10 million to Monus’s now defunct World Basketball League (WBL). Initially, Monus squeezed Phar-Mor suppliers for sponsorship funding in the league, its 6’5” and shorter players, and the All-American Girls dance squad. Yet, despite the obvious appeal of the All-American Girls, fans simply didn’t want to see short guys playing basketball. With the league failing and fan attendance dwindling, Monus was forced to use Phar-Mor funds to cover numerous WBL expenses. When a Phar-Mor check was sent directly to a WBL vendor, the fraud began to unravel. CEO David Shapira announced the fraud in August 1992. 45 Related Parties Phar-Mor maintained 91 related parties, as identified after the fraud. These related parties, many set up in a network by Shapira and Monus, created a complex situation that Coopers & Lybrand (Coopers) would later claim prevented them from detecting the fraud. Notably, a highly material settlement with Tamco, a related party, over inventory shortages was largely ignored. Monus’s involvement with both Phar-Mor and the WBL also created a related- party situation that should have been disclosed in the notes to the financial statements. The auditors should have performed a review for related-party transactions at year-end that may have uncovered some of the transactions. At the very least, a simple inquiry of management should have unearthed the WBL related party. After all, the WBL and Monus were well known throughout the region. Monus’s involvement with the WBL certainly was not hidden from the auditors. The omission of the note disclosure violates the full disclosure principle and Statement of Financial Accounting Standard (SFAS) No. 57 “Related Party Disclosures,” which holds that related party transactions deemed to be material must be adequately disclosed. The standard states, “relationships between parties may enable one of the parties to exercise a degree of influence over the other” and that “the financial position (may be) significantly different from that which would have been obtained if the enterprises were autonomous.” Inadequate disclosure of related-party transactions is one of the most serious of financial statement frauds. It is also one of the most difficult to detect. AU Section 334 48 statements” (Wells Ghost Goods). In this case, armed with only his gift of gab and a set of highly inflated numbers, Monus became a local icon and Phar-Mor gained cult-status in Northeastern Ohio. Despite Phar-Mor’s consistent losses, Monus pumped $10 million of Phar-Mor’s money into the World Basketball League. Altering numbers and misappropriating assets, Monus led the company to bankruptcy. The ineffective and limited audit work of Coopers & Lybrand allowed the fraud to continue for so long. Monus was ultimately convicted of accounting fraud and sentenced to 19 years and seven months in prison. Pat Finn was also sentenced to prison, while others received hefty fines. The combined five-year fraud inflated equity by $500 million, while also causing $1 billion in losses and bankrupting Phar-Mor, then the 28th largest private company in America. Consequently, Phar-Mor laid off 16,000 employees, and closed 200 stores. Auditing firms must now recognize that their integrity, key to providing their services, rides on every engagement and must take appropriate actions to ensure that this integrity is upheld. Currently, accounting firms, with the leverage provided by Sarbanes- Oxley, are shifting from the cost-pressured audit situation of the past to more quality audits. The massive “fraud was a collusive effort of multiple individuals within the upper management at Phar-Mor who continually worked to hide evidence from the auditors” (Beasley Auditing 29). Although the fraud itself did not indicate that the audits had failed, the investors and creditors held that Coopers failed to follow GAAS throughout their audit. Consequently, these plaintiffs felt the auditors were responsible for the 49 losses. The five-month trial concluded that a five-year fraud should have become evident to an attentive audit team. Initially, 38 suits were filed against Coopers. Many settled out of court for undisclosed sums, but eight chose to pursue their claims in a jury trial where Coopers was found guilty under both state and federal law. 50 FOUNDATION FOR NEW ERA PHILANTHROPY “Any fool can tell the truth, but it requires a man of some sense to know how to lie well.” Samuel Butler Although many of the previous cases have focused on inventory fraud, this definitely is not the only account that can be manipulated. Likewise, both profit and non- profit, public and private, service and retail companies can all falsify their financial records. Given these circumstances, the following description of a recent non-profit fraud is certainly appropriate. In fact, with the breadth of such actions continually growing, the current cost of fraud is estimated at $600 billion annually by the Association of Certified Fraud Examiners. John “Jack” Bennett was certainly ambitious. While he claimed his intentions were worthwhile, his actions failed to back up these assertions. He failed to deliver on a number of promises and commitments to his clients and investors. While currently there are no definitive, “empirical studies on the frequency of fraudulent acts committed by charities, existing data strongly suggests that a wide range of criminals are stealing more than $21 billion from charities in the United States each year” (Mizel 98-99). BACKGROUND After taking seven years to complete his undergraduate education at Temple University, Jack landed a teaching job and then surprisingly was granted admission to medical school. He flunked out in his third year and, through his wife’s obstetrician, landed a position as a drug counselor. Social work was just gaining popularity and Jack and a few others formed the non-profit Community Organization for Drug Abuse Control (CODAC). CODAC secured some government funding and set up seven chapters 53 New Era operated solely through its Ponzi scheme, akin to Charles Ponzi’s fraud in Boston in 1919. “By constantly robbing Peter to pay Paul, Ponzi schemes are able to pay generous returns to some investors” (Mizel 102), but require an ever-growing number of contributions to keep it afloat. In addition to a hundreds of other non-profits, many wealthy individuals fell for the scheme. Former Treasury Secretary William E. Simon, Laurance Rockefeller, and John C. Whitehead, former cochairman of Goldman Sachs, all contributed millions. New Era filed for bankruptcy in May 1995. At the time, the non-profit had liabilities of $551 million and assets of just $80 million. The collapse threatened “hard times and even extinction for many schools, museums, ministries, libraries, and other groups that had entrusted their futures to the foundation” (102). In orchestrating the fraud, Bennett misappropriated over $55 million during the first four months of 1995 alone. Additionally, much of the fortune was diverted to private businesses that Jack Bennett owned. The foundation also violated tax laws. New Era’s 1993 IRS tax return claimed the foundation donated $34 million in charitable gifts that year, yet those who were to receive the gifts had never heard of New Era, let alone received funds from them. Although the auditors just performed a review, New Era distributed an audit report. While New Era did not have a board, they maintained a list of members that they referred to as the board when pressed. An accounting professor from Michigan exposed the fraud. After reviewing the financial statements and its glaring inaccuracies, the professor sought out both the auditors and Jack himself for answers. The professor recognized the Ponzi scheme 54 immediately. While New Era claimed to invest $100 million a year, they earned just $33,000 in interest dividends in 1993. If the investment account were even just $10 million, yearly dividends would have ranged from $600,000 to $1 million. Clearly, they weren’t holding the funds to earn interest. The professor was finally able to attract the attention of a Wall Street Journal reporter who took the story national. New Era employees could not believe the allegations and Jack himself insanely claimed that he thought the anonymous donors really did exist. WHERE WERE THE AUDITORS? McCarthy & Company (McCarthy) served as the financial statement auditors for New Era throughout the fraud. The audit engagement began soon after Bennett donated $15,000 to McCarthy’s campaign for a failed run for Congress. Already, the auditor’s independence and objectivity were impaired. Independence is an essential characteristic of an auditor, providing the basis for public confidence in the integrity of the auditor’s opinion. McCarthy directed Andy Cunningham to lead the audit with the instructions to keep Bennett happy. Indeed, over one third of the accounting firm’s business would be from Jack’s New Era group. In 1994, Cunningham questioned $100,000 in personal loans on the New Era financial records. Jack urged Cunningham to call it a “deposit in transit” and promised to write a check for the amount immediately. Likewise, Jack insisted on ignoring any related-party transactions and the board meeting minutes, which of course did not exist. 55 Even more concerning was the $41 million in donor’s contributions. The money was called “charitable contributions” and listed as revenue. No liability existed for the amount that New Era had to repay. Jack assuaged the concerns, stating that the donor’s had already been repaid. When Cunningham mentioned to Jack his personal financial troubles, Jack immediately wrote a $50,000 check. Ironically, the check bounced and Jack had to write another from his personal account. Cunningham would later collect an additional $25,000 check with the understanding that Jack would not have to answer any more tough questions. The auditors failed to maintain a level of independence, objectivity, or professional skepticism in their audits. They lacked the audacity to stand up to their high-profile client and were muscled into succumbing to Bennett’s demands. Their audits were limited, indeed, only a review was performed, and were completely ineffective. CONCLUSION In defrauding investors and donors of some $135 million, Jack Bennett was sentenced to 12 years of prison, convicted of 82 counts of fraud and related charges. Cunningham was convicted for knowingly issuing false financial information. He was able to testify against Bennett in exchange for a reduced sentence. Today, and perhaps as a result of such fraudsters as Jack Bennett, non-profits are more heavily scrutinized. The organizations are regulated at both the federal and state level through reporting requirements and tax regulation. Financial statement, 58 BACKGROUND Enron evolved from a series of mergers and acquisitions. Its roots can be traced to the Northern Natural Gas Company (Northern), which was founded in 1930. During the Great Depression, the cheap cost of natural gas spurred Northern’s growth. The company created a network of pipelines to transport natural gas to its markets. The company went public in 1947 with a listing on the New York Stock Exchange. The company was a key player in the development of the Alaskan pipeline throughout the 1970s. In 1980, Northern became InterNorth, Inc. The company began to diversify its operations, seeking investments in oil exploration, chemicals, coal mining, and fuel-trading operations. In 1985, InterNorth acquired Houston Natural Gas Company, giving InterNorth control of some 40,000 miles of pipeline. In 1986, InterNorth changed its name to Enron and Kenneth Lay, former chairman of Houston Natural Gas, became CEO. Lay relished the growth strategy and the aggressive exploration of new revenue sources that InterNorth adopted in the early 1980s. Lay brought Jeffrey Skilling, a former McKinsey & Co. consultant, on board. Together, propelled by the deregulation of the electrical power markets, the executives led Enron’s move to an energy-trading company, acting as an intermediary between producers and users of energy products, such as electricity and natural gas. The new Enron focused on four business segments. Energy Wholesale Services was the largest, maintaining EnronOnline, a business-to-business commodity trading site. Enron Energy Services, Enron Transportation Services, and Enron Broadband Services completed the company’s product line. No longer was Enron stuck in a stagnant 59 industry. In contrast, the company’s 2000 annual report boasted that it was now “a marketing and logistics company whose biggest assets are its well-established business approach and its innovative people.” “At its peak, Enron owned a stake in nearly 30,000 miles of gas pipelines, had access to a 15,000-mile fiber optic network, and had a stake in several electricity- generating operations around the world. In 2000, the company reported gross revenues of $101 billion” (Beasley Auditing 46). In addition, Enron offered its customers an array of financial hedges and contracts. In 2000, EnronOnline produced $1 billion in transactions daily. Accordingly, Enron received tremendous praise as an innovative company. It had grown to become the seventh largest company in the US. Lay became active in the national political arena. Skilling, who became CEO when Lay solely became chairman in early 2001, was dubbed one of America’s top CEOs. CFO Andrew Fastow was recognized for his achievements, seemingly bringing order to the complex financial structure that the transactions created. The company maintained such political clout that they influenced Vice President Cheney’s national energy plan. In 2001, Enron’s stock began to tumble, falling from $80 a share in October 2000 into the mid-$30s a year later. Also in 2001, after just six months, Jeff Skilling resigned as CEO for “personal reasons” and Ken Lay was forced to return to his CEO position. In October 2001, the company’s third-quarter earnings revealed a huge loss and an unexplained $1.2 billion reduction in owners’ equity and assets. The markdown came as a result of the swap of Enron stock for notes receivable. “Enron had acquired the notes 60 receivables from related third parties who had invested in limited partnerships organized and sponsored by the company” (Knapp 5th Ed. 9). The company and its auditors determined that the earlier entries were wrong and that the markdown was necessary to correct the earlier entries. Despite the troubles, Lay continued to tell shareholders that the stock was undervalued and encouraged further investment. However, just three weeks after the first restatement, earnings were restated for the entire preceding five years. Consequently, with diminishing liquidity and a loss of trust by investors and creditors, Enron filed for bankruptcy on December 2, 2001. More than $60 billion in losses fell to the shareholders, marking this as the largest bankruptcy to date (it was exceeded by WorldCom the following year). FRAUD LOGISTICS The use of Special Purpose Entities (SPEs) was central to the Enron fraud. The SPEs, dubbed by Enron as Braveheart, Rawhide, Raptor, Condor, Talon, LJM2, Chewco, and Whitewing, among countless others, were used to move the company’s debt off the balance sheet. Furthermore, some of the deals were structured so that Enron could receive borrowed funds and record them as revenues while ignoring the associated liability. SPEs “can take several legal forms, but are commonly organized as limited partnerships. During the 1990s, hundreds of large companies began establishing SPEs. In most cases, SPEs were used to finance the acquisition of an asset…fund a construction 63 Enron’s disclosure of the SPEs was inadequate, failing to clearly state the purpose and activities of the ventures. The related-party transactions that the SPEs created were also completely ignored. After the earnings restatements and the ensuing public outcry over the SPEs, the Enron board reacted by appointing an investigative committee, which labeled the SPEs as “byzantine” and found that in many instances Enron was able to recognize an increase in the value of its own capital stock on the income statement. In using the SPEs and shielding the debt from the balance sheet, Enron was able to maintain a high credit rating, needed to continue to secure loans to grow the company and expand its many new ventures. In addition, many of the SPE loans contained provisions that would force additional contributions if the Enron stock price fell. Indeed, when the stock did fall in 2001, these provisions in the SPE contracts exacerbated the earnings restatements. Prior to 2001, in continually using the SPEs to an even greater degree, Enron was able to appear increasingly profitable and avoid making these additional contributions. In addition to the SPE abuse, Enron aggressively employed mark-to-market accounting techniques for their long-term contracts. These long-term contracts often stretched for 20 years or longer. Although not even a fraction of the revenue had been earned, energy companies were able to book the profits from the contract in the quarter that the deal was made. Doing so, companies were forced to estimate the costs of providing the contract over the long-term period. Enron frequently made unrealistic forecasts, underestimating expenses and overestimating profits. The accounting rules 64 governing such transactions were greatly supported and influenced by US Senator Phil Gramm, whose wife Wendy sat on the Enron board. Many observers would later state that the company’s culture made a tremendous contribution to the fraud. As Enron was reeling, Dynegy, a rival firm, considered acquiring Enron. The deal fell through and Dynegy’s CEO later concluded that the lack of internal controls at Enron was mind-boggling. Furthermore, affairs were rampant within the company, particularly among the senior-level executives. Employee concerns, including those of whistleblower Sherron Watkins, were largely ignored. WHERE WERE THE AUDITORS? Arthur Andersen became an orphan early in life and was forced to take night classes to graduate from high school. Through the adversity, he learned to maintain a strong work ethic, coupled with discipline and honesty. These traits carried Andersen to the University of Illinois. Following his graduation, he joined Price Waterhouse in 1908 and became the state of Illinois’s youngest CPA at age 23. Just a few years later, Andersen and a friend left Price Waterhouse and established an accounting firm of their own, Andersen, Delany & Company. Delany soon departed and Andersen renamed the venture Arthur Andersen & Company. He earned a reputation as a stern practitioner, carefully adhering to accounting guidelines. In one well-known example, in 1915, he pressed a client to disclose a subsequent event, insisting that the freight company’s financial statement users needed to know that a ship had sank after the fiscal year-end. Years later, Andersen and DuPont, one of the firm’s largest clients, quarreled over the definition of operating income. Refusing to back down, 65 Andersen was terminated as DuPont’s auditors. Such instances of unyielding ethics and honesty added to the firm’s image and character. By the 1940s, “Arthur Andersen and Co. had offices scattered across the eastern one-half of the United States and employed more than 1,000 accountants” (Knapp 5th Ed. 5). Arthur Andersen died in 1947 and Leonard Spacek rose to the firm’s lead position, while maintaining the same values that Andersen had built the firm on. Spacek retired in 1973 after growing the business into one of the nation’s largest and most respected accounting firms. By 2001, Arthur Andersen and Co. had adopted the one-word name Andersen and divested their Accenture consulting arm, formerly Andersen Consulting. With the Enron bankruptcy gripping the nation, investors and retirees collectively losing billions, and Enron executives staying mum, criticism fell to the auditors. Several months prior to the bankruptcy, Andersen auditors became aware of Enron’s deteriorating financial condition and worked with Enron executives to weather the storm. The auditors even assisted in restructuring the SPEs to keep them from being consolidated. Meanwhile, others in the firm, frustrated with the overly aggressive accounting treatment, proposed dropping Enron as a client as early as February 2001. In their defense, Andersen executives stated that they ordered Enron to correct an SPE error as soon as they discovered it, leading to the first earnings restatement. In another 2001 example, the Andersen executives also asserted that while half of the needed three percent of another highly material SPE was contributed directly by Enron, Enron had failed to present this information. When Andersen did make the discovery, they again reported the error. Although they had served as Enron auditors for fifteen 68 function and to improve accounting and financial reporting practices” (Knapp 5th Ed. 22). While some argue that the accounting standards failed to provide proper guidance, others dispute that the rules are too specific and merely encourage companies to push the rules. Many of the proposals and arguments are now included in the Sarbanes-Oxley Act, which strongly increases the responsibility that a company’s executives take for their financial statements. Likewise, Sarbanes-Oxley also resolves many of the other highlighted problems, such as the issues surrounding the auditors’ independence. The fraud forced changes in SPE accounting. FASB Interpretation No. 46 was issued in January 2003 to restrict the use of SPEs, while raising the three percent threshold to 10 percent. In addition, the Enron fraud sparked tremendous interest in corporate culture, governance, and business ethics. For its prominence and the headlines it received, the Enron case has and will continue to alter the accounting and auditing arenas. 69 CONCLUSION Professional financial analysis and appropriate decision making is based on a thorough understanding of the development of the historic accounting landscape. To understand the present and plan for the future requires an understanding of the past. Thus, there is a long lineage of companies throughout history that have offered inflated stock to the public. This study has discussed some of these cases with companies that have all “cooked the books” to impress investors. While the discussion involved colorful characters and interesting stories that make for excellent reading, meaningful conclusions can also be drawn. The most significant conclusion comes simply through demonstrating that fraud can occur in a number of companies and across a wide time frame. Likewise, while inventory and revenue recognition are frequently exploited, fraud can involve any of a number of accounts. Such findings demonstrate the ever-present potential for fraud and have a powerful influence on an auditor’s work and preconceptions going forward. Competitiveness and aggressive business leadership continue to create pressures for fraud. While all of the frauds discussed were directed from the top levels of senior management, this certainly isn’t always the case. In fact, although executive-level frauds represent the financial bulk of activity, fraud actually occurs much more frequently at the employee level. The current auditing environment has changed considerably in the past few years. Following the myriad of accounting frauds beginning with Enron, the profession vowed, through the AICPA, to change and approved new audit standards language, creating more audit procedures, tests of controls, and interpretations of accounting standards. The 70 Panel on Audit Effectiveness of the Public Oversight Board performed the most comprehensive study of the profession ever, calling for the use of forensic techniques in every audit and the incorporation of an element of surprise in audits. Their suggestions would emerge in SAS No. 99 in 2002, which modifies “the otherwise neutral concept of professional skepticism and presumes the possibility of dishonesty at various levels of management, including collusion, override of internal control, and falsification of documents.” SAS No. 99 also called for auditors to vary materiality levels, start thinking like a fraudster to uncover schemes, and ordered that auditors should not assume that management is honestly reporting results. Additionally, the auditors new role in detecting fraud was clearly stated when one of the most important paragraphs in the authoritative auditing literature was put into practice (AU Section 110, paragraph 2): The auditor has the responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements are detected. “Capital markets are complex, global, operate 24 hours a day, and rely on accounting information” (Giroux). The role of accountants continues to expand as technology advances and modern capital markets depend on an abundance of reliable financial information. Thanks to decades of change, opportunity, and disasters, financial data in most forms is largely relevant, reliable, and regulated. Yet others, including Wall Street historian John Steele Gordon, contend “it's never going to change. As long as