Sunday, December 10, 2006

Hiding Your Dirty Laundry in the Footnotes: Anatomy of the Crazy Eddie Accounts Payable Fraud

I once listened to a presentation about white collar crime by reformed criminal now Pastor, author, and crime fighter Barry Minkow (ZZZZ Best fraud) at the Value Investing Congress in New York City.

Barry Minkow explained to the audience of large investors something called the “iceberg” analysis. According to Barry, an iceberg is only 10% visible and the rest of it lies beneath the surface. It is often difficult to detect fraud and misrepresentation just by looking at financial statements.

Financial statements are often accompanied by footnotes which are seldom read and more often not thoroughly analyzed by investors. A great blog footnoted.org written by Michelle Leader sorts through the footnotes of companies and provides excellent analysis.

One of the many frauds committed by me at Crazy Eddie involved manipulating just two words in our footnotes.

Prior to 1987, Crazy Eddie accounting policy for purchase discounts and allowances was:

Purchase discounts and trade allowances are recognized when received

This accounting policy meant that even if Crazy Eddie had “earned” a discount it could not be recognized as income until a credit was received from the vendor.

In fiscal year 1987, I changed Crazy Eddie’s accounting policy (as reflected in the footnotes) to:

Purchase discounts and trade allowances are recognized when earned

Now, in theory, Crazy Eddie could recognize a discount as income when it is earned (for example when we reached the manufacturer’s benchmark of buying 10,000 units to qualify for a volume rebate) and not have to wait for a credit from the vendor. I could simply write a debit memo (an offset to what I owed the vendor) to recognize the discount and increase our reported profits.

A change of accounting policy would normally give rise to a separate disclosure about its effect on earnings. However, in the Crazy Eddie fraud we made no such disclosure and the auditors made no relevant computations despite change in accounting principle. The auditors simply ignored the effects of the change in accounting for discounts.

By now being able to recognize discounts "when earned” instead of having to wait for credits to be received from vendors, I had the opportunity to add $20 million on phony debit memos (phony discounts and trade allowances) charged to vendors.

Crazy Eddie’s accounts payable was reduced from about $70 million to $50 million through the use of phony debit memos that was facilitated by our change in accounting policies for purchase discounts and trade allowances by changing just two words in our footnotes.

You may ask: How did we do it and how could the auditors allow this to happen?

The staff auditor primarily responsible for the accounts payable part of the audit had no retail accounts payable audit experience and only six months experience in auditing. He did not know what a debit memo was until he came to the Crazy Eddie audit.

We engaged in a scheme of obstruction by distraction. Most staff accountants feel that audits are boring and they really are. As soon as the young relatively inexperienced staff members walked into our premises, my staff was instructed to be overly friendly so that they could be distracted from their work. We would constantly take the staff auditors out for long coffee breaks and lunches and engage in friendly conversations about mutual topics of interest unrelated to the audit in an effort to distract them from their work.

About two weeks before the audit was due to be completed and the accountants should have completed about 85% of the their work, they would have only about 25% of their work done. During the remaining two weeks they would scramble to finish the audit on time.

When people “cram” or rush they make extra mistakes and tend to skimp on their work. In addition, the auditors could not blame the overly friendly Crazy Eddie staff for obstructing them. Therefore, in a mad scramble to “cover their asses” they covered ours. In the process they left out some very important audit procedures.

In fiscal year 1987, the staff auditor assigned to analyze accounts payable did not begin his work until the very day his firm had signed off on Crazy Eddie’s “clean” audit opinion.

The actual audit of the accounts payable was concluded weeks after the auditors signed off on our financial statements and gave our Board of Directors their approval for its release.

For fiscal year 1987, the auditors did not compute how many debit memos offseted our gross accounts payable and they never generated an aging schedule of accounts payable. (Note: In the previous fiscal year audit the auditors generated an accounts payable aging schedule.) An aging schedule would have listed for how long we owed vendors amounts listed in accounts payable at year end and likewise how long such debit memos were not applied against amounts owed to vendors.

The computation of the total debit memos was especially important in determining the effects of the change in accounting for discounts and allowances. Such a computation combined with an accounts payable aging schedule would have determined that excessively large amounts of debit memos were never actually used to offset amounts owed to vendors. This procedure would have alerted the auditors to the excessive amounts of phony debit memos and their lack of validity.

The auditors only received three accounts payable balance confirmations from our vendors and suppliers. One vendor confirmation received by the auditors had over $4 million in phony debit memos. They simply traced those debit memos to our accounts payable records which listed the phony debit memos. They never contacted the vendor after receiving the confirmation about reconciling items.

There are many lessons to be learned from the Crazy Eddie accounts payable fraud.

People (even sophisticated investors) do not read footnotes. Had they read the footnotes carefully perhaps the proper critical questions would have been asked. All too often audits are over-used as training grounds for relatively inexperienced staff accountants who are not adequately supervised.

The audit was poorly planned, executed, and supervised. The auditors lost their requisite professional skepticism and objectivity by permitting Crazy Eddie staff to distract them from their work by “bonding” with them. They did not follow basic audit procedures and permitted deadlines to guide to quality of their work.

Crazy Eddie had weak internal controls over the issuance of debit memos. There was no documentation from external sources supporting any of the phony discounts. Sarbanes-Oxley would have required the auditors to evaluate our internal controls.

Finally, as Joseph T. Wells (retired founder and Chairman of the Association of Certified Fraud Examiners) who wrote about this same fraud in his award winning article “So That’s Why They Call it a Pyramid Scheme” published in the Journal of Accountancy in October 2000:

....Were the auditors stupid? No, just too trusting. After all, no one wants to think the client is a crook. But it happens too often. That's why the profession requires the auditor to be skeptical.

Written by:

Sam E. Antar (former Crazy Eddie CFO & convicted felon)

No comments: