1.5 An Example

While the percentage of financial statements that are fraudulent is relatively small, the damage caused by even one fraudulent set of financial statements is staggering. Consider, for example, the Satyam fraud. At the time of the fraud, Satyam was one of the world's leading technology and software consulting companies, with offices in more than 66 countries and 53,000 employees (even this number was inflated by 30%). A large number of Fortune 500 firms used Satyam for various software implementation projects. In early 2009, it was revealed that Satyam had overstated revenues by 76% and income by 97%. Nearly all the reported income of this very successful, worldwide consulting firm – despite being audited by a "Big 4" firm – was fraudulent.

In a letter to Board Members on January 7, 2009, then CEO B. Ramalinga Raju stated:

Only days after the fraud was exposed, regulators barred the current board of directors and appointed 10 nominal directors, Merrill Lynch immediately terminated its relationship with Satyam and trading of the company was halted on the New York Stock Exchange. Both the CEO and CFO were also arrested for further questioning and investigation into the fraud. Over the last five years, the Satyam scandal has cost countless jobs, caused individuals to lose retirements and savings (in less than three days, the stock went from $29.10 per share to $1.80 per share), and created an overall loss of confidence in the markets.

To further highlight the consequences of fraudulent financial reporting consider the example of Phar-Mor. In that case, the COO, Michael "Mickey" Monus, was sentenced to 19 years and seven months in prison; the fraud resulted in more than $1 billion in lost market value and, at the time, the bankruptcy of the 28th largest private company in the United States. The company's former auditor, a "Big 4" firm, faced claims of more than $1 billion (which it settled for significantly less).

While now nearly 25 years old, the Phar-Mor case provides a good illustration of how financial statement fraud occurs. Mickey Monus opened the first Phar-Mor, a deep discount store, in 1982. Phar-Mor sold a variety of household products and prescription drugs at prices substantially lower than even other discount stores. The key to the low prices was supposed to be "power buying," a phrase Monus used to describe his strategy of loading up on products when suppliers were offering rock-bottom prices. When he started Phar-Mor, Monus was President of Tamco, a family-held distributing company that had recently been acquired by the Pittsburgh-based Giant Eagle grocery store chain. In 1984, David Shapira, president of Giant Eagle, funded the expansion of Phar-Mor with $4 million from Giant Eagle. Shapira then became the CEO of Phar-Mor, and Monus was named president and COO. By the end of 1985, Phar-Mor had 15 stores. By 1992, a decade after the first store opened, Phar-Mor had grown to 310 stores in 32 states, posting sales of more than $3 billion.

Phar-Mor's prices were so low that competitors wondered how Phar-Mor could sell products so cheaply and still make a profit. Phar-Mor appeared to be on its way to becoming the next Wal-Mart. In fact, Sam Walton once stated that the only company he feared at all in the expansion of Wal-Mart was Phar-Mor. Unfortunately, Phar-Mor's prices were so low that Phar-Mor began losing money. Unwilling to allow these shortfalls to damage Phar-Mor's appearance of success, Monus and his team began to engage in creative accounting, which resulted in Phar-Mor never reporting losses in its financial statements. Federal fraud examiners later discerned that Phar-Mor's reported pre-tax income was significantly overstated for a number of years.

Relying upon these erroneous financial statements, investors saw Phar-Mor as an opportunity to cash in on the retailing craze. Among the big investors were Westinghouse Credit Corp., Sears Roebuck & Co., mall developer Edward J. de Bartolo, and the prestigious Lazard Freres & Co. Corporate Partners Investment Fund. Prosecutors stated that banks and investors put $1.14 billion into Phar-Mor based on the phony records.

In order to hide Phar-Mor's cash flow problems, attract investors, and make the company look profitable, Michael Monus and his subordinate, Patrick Finn, altered the inventory accounts to understate costs of goods sold and overstate income. In addition to the financial statement fraud, internal investigations by the company estimated embezzlement in excess of $10 million. Most of the stolen funds were used to support Michael Monus' defunct World Basketball League. Michael Monus and Patrick Finn used three different methods of fraud – income statement account manipulation, overstatement of inventory, and accounting rules manipulation. With respect to income statement account manipulation, Monus directed Finn to tamper with general income statement accounts. In 1985 and 1986, well before the large fraud began, Michael Monus was directing Patrick Finn to understate certain expenses that came in over budget and overstate those expenses that came in under budget in order to make operating results appear more in line with budgeted results; these adjustments made operations look more efficient. Although the net effect of these first manipulations eventually evened out, the accounting information was not accurate. Finn later suggested that this seemingly harmless request by Monus was an important precursor to the fraud.

With respect to inventory, Finn increased Phar-Mor's actual gross profit margin of 14.2% to around 16.5% by inflating inventory accounts. Phar-Mor hired an independent firm to count inventory in its stores. After the third-party inventory counters submitted a report detailing amount and retail value for a store's inventory, Phar-Mor accountants would prepare what they called a compilation packet. The packet calculated the amount of inventory at cost and journal entries were prepared. Based on the compilation, Phar-Mor accountants would credit inventory to properly report the sales activity, but rather than record a debit to cost of goods sold, they debited so-called "bucket" accounts. To avoid auditor scrutiny, at the end of each fiscal year, the bucket accounts were emptied by allocating the balance to individual stores as inventory. Because the related cost of goods sold was understated, Phar-Mor made it appear as if they were selling merchandise at higher margins. As cost of sales was understated, net income was overstated.

The accounting rule manipulations involved up-front payments by vendors. Phar-Mor would regularly pressure vendors for large, up-front payments for not selling competitors' products. These payments were called "exclusivity payments," and some vendors paid up to $25 million for these rights. Monus would use this money to cover Phar-Mor's hidden losses and to pay suppliers. But instead of deferring the revenue from these exclusivity payments over the life of the vendor's contracts – consistent with GAAP – Monus and Finn would recognize all the revenue up front. As a result of this practice, Phar-Mor was able to show impressive results in the short-run. These schemes resulted in financial statements that were erroneous with assets and revenues grossly overstated.