The Rise and Fall of Phar-Mor Inc.
Luis W Lebron Fraud and Forensic Accounting College of Professional and Continuing Studies La Salle University 1900 W. Olney Avenue Philadelphia, PA 19141 Telephone: 215-951-1100 e-mail:
[email protected]
The Rise and Fall of Phar-Mor Inc.
Abstract The purpose of this study is to understand the success and failure of Phar-Mor, Inc. which was one of the largest super discount drugstores who competed with companies like Wal-Mart in the early 1980’s up until its demise in 2002. The company was a complete success with over 300 discount super stores across the United States and employing thousands of workers. This came at a price as the company was found to have engaged in some unlawful business practices that soon came crashing down as the scheme perpetrated by Michael Monus and other former Coopers & Lybrand employees would use their knowledge of the industry to deceive the public. This article goes into the methods used to defraud investors and how the external auditor failed to detect the financial statement fraud at Phar-Mor Inc. I also discuss how the fraud was uncovered and how the Securities Exchange Commission intervened to enforce punitive damages against parties responsible for one of the largest fraud cases in U.S. History. I also discuss whether the fraud could have been prevented and what lessons one can learn from this critical analysis regarding the rise and fall of Phar-Mor Inc.
Key words: Financial Statement Fraud, Improper Disclosure, Creative Accounting, Sarbanes Oxley Act of 2002, Coopers & Lybrand, Phar-Mor Inc., Internal Controls, Objectivity, Independence, Integrity
The Rise and Fall of Phar-Mor Inc. 1. Introduction David S. Shapira was the CEO and co-founder of Phar-Mor Inc., a discount chain of drug stores based out of Youngstown, Ohio. Once regarded by Sam Walton as one of his most feared competitors in the industry because he didn’t understand how the company grew so fast. (From Wikipedia, 2012) From its inception Phar-Mor Inc. became one of the five largest retail drug store chains in the U.S. The company grew in just seven years with over 300 stores and 25,000 employees nationwide. Its low cost strategy proved to be the key to its success; as company sales reached $3 billion in FY 1991. The success of Phar-Mor Inc. came to an abrupt halt in 1992 as Michael Monus, the companies president was fired that year and subsequently charged with committing fraud, embezzlement, and filed false tax returns to the IRS for its involvement in of the largest accounting scandals in US history. The company’s first signs of financial difficulty became apparent in 1988 as speculation mounted about Phar-Mor’s decreasing profit margins. The pressure became insurmountable and the opportunity to commit fraud would soon be a path towards failure as the SEC in its complaint alleged that from at least 1987 through 1992, Monus, Finn, Anderson and Walley (all former employees) engaged in a plot to defraud investors by falsifying the company’s books, records, and its financial statements thus inflating the company’s earnings by $290 million. (SEC, 1996) During the whole ordeal David Shapira was never charged and denied any involvement or knowledge of the fraud until after an investigation was conducted regarding a mysterious payment made to a travel agent that was brought to
his attention and would uncover the scheme which led to the departure of Monus from the company. 2. CEO & Methods Used in Phar-Mor Case Although David S. Shapira was never charged in the case there were accusations about his involvement; questionable judgment or the lack of human intuition regarding accounting irregularities facing the company, but in November of 1990, a secretary had mistakenly faxed a report with real numbers to Shapira. As the Chief Executive Officer of Phar-Mor Inc. Shapira delegated the day-to-day operations to President Mike Monus who was summoned to Pat Finn’s office to explain the report he had received from his secretary. The CFO Finn explained the numbers were preliminary and adjusting entries needed to be made to reflect an accurate assessment of the company’s financials. Shapira ignored the information presented to him as he entrusted Monus and Finn to effectively handle the company. David Shapira’s over-reliance of key employees in upper management proved to be fatal as he did not verify the information for accuracy and attest to its validity. Memorandum from Counsel
Another interesting revelation surfaced during the course of Phar-Mor’s financial woes which they tried to cover up, but another questionable event would soon prove to be part of the company’s financial collapse. There are some inconsistencies which point to CEO David S Shapira who was either accused of, but was not held liable for his lack of action or oversight when a memorandum was sent by Charity Imbrie, Phar-Mor’s general counsel, about some major financial issues and its relationships with its suppliers. The memo disclosed information that was quite disturbing and required immediate attention. The memo indicated inventory problems, a cash-flow
crisis, blank checks and even a questionable investment into a professional basketball league. (Olson, 1994) Chief Executive Officer Response
Shapira response was to rip up the memo as he mentioned the issues were being worked on and the timing of the letter and any leakage of this information would jeopardize the companies potential IPO with investment bank Corporate Partners, LLC. The management team at Phar-Mor, Inc. had to show the company was profitable and operated efficiently to justify and endorsement in investment capital by New York based investment bank Corporate Partners, LLC. The investment bank Corporate Partners sent their own auditors to verify the books, but did not uncover the fraud and embezzlement scheme at Phar-Mor. The investment company made its final assessment and endorsed Mike Monus’s vision of success with $200 million in capital. Weaknesses in Internal Controls
According to the fraud examiner’s investigation Phar-Mor was practically insolvent at the time of the transaction and the capital raised was actually used to pay off creditors. Looking at the events in this case, David S Shapira’s nonchalant approach may have contributed to the oversight of its internal operations and exposed weaknesses in the company’s internal controls resulting in the improper valuation of inventory; as the company failed to record the purchase of inventory on their books avoiding the recognition of expenses associated with the sale of goods. This event contributed to the premature recognition of revenue on its books as the major objective of inventory accounting is matching the appropriate costs against revenues. (ACFE, 2011) David S Shapiro and Board Members knew prior to the investment deal with Corporate Partners LLC. that the company was holding back $155 million it owed to
vendors. (Gilmore, 1994) This in effect violated Generally Accepted Accounting Principles as the company’s financial statements included inaccurate information about the company’s true performance and that by withholding checks owed to its vendors Phar-Mor Inc. failed to disclose violations of any loan covenants or information regarding loans considered in default. In event that a company defaults on its loan agreement by not meeting it loan covenants, the loan default must be disclosed in the financial statements. (ACFE, 2011) 3. The Causes and Failures at Phar-Mor Inc. Coopers & Lybrand Held Liable
According to testimony provided in the Phar-Mor Inc. scandal the court found auditor Coopers & Lybrand failed to show there audit was in compliance with Generally Accepted Auditing Standards. The fraud continued for a period of six years and the attorneys claimed that had the auditor been more diligent they would have been able to uncover the actions of its audit client Phar-Mor Inc. The attorney claimed the internal auditors did not provide sufficient documentation to the external auditor, Coopers & Lybrand, and failed to acquire pertinent information regarding highly material transactions during the course of its audit engagement. 1The fraud centered on the failures of improper asset valuation of its inventory ultimately impacting the company's financial statements as reported earnings projected created an illusion to investors regarding the financial health of the company.
1
During an audit, management makes many representations both oral and written to the auditor in response to specific inquiries or through the financial statements. Written representations from management ordinarily confirms representations explicitly or implicitly given to the auditor, indicate and document the continuing appropriateness of such representations, and reduce the possibility of misunderstanding concerning the matters that are subject of the representations. AU Section 333A
Improper Disclosure
During one of the largest fraud cases in US History Phar-Mor executives failed to report the declining numbers as the fraud examiner said profit losses was not the result of a flawed inventory accounting system. Apparently one of its major suppliers TAMCO was billing Phar- Mor for shipping items at full cost, but was providing less than the amount of the goods received in inventory. The two parties came to an agreement and settled the discrepancy, but Phar-Mor reported the event as a reduction to purchases which was intended to cover up the companies declining profits. Attorney Sarah Wolf pleaded in this case that the transactions resulted in the improper disclosure of financial transactions and misclassified the event as a capital contribution; the footnote provided in the financial statements were misleading and the auditor failed to obtain persuasive evidence regarding this material transaction. (Cottrell & Glover, 2009) Former employee of Cooper’s & Lybrand
One of the critical elements regarding the causes and failures in this particular case stem from a lack of oversight and regulatory provisions which would later lead to the creation of the PCAOB and legislative action by Congress known as the Sarbanes-Oxley Act of 2002. The Phar-Mor employees who were charged with violating the antifraud provisions of the federal securities laws had one thing in common. The fraud team consisted of several former Big Six auditors, including auditors who had worked for Coopers & Lybrand on prior Phar-Mor audits. The culprits involved in this case Finn, Walley, and Cherelstein admitted that one of the reasons the fraud was not detected by the auditors because Phar-Mor executives knew what the auditors were looking for, and ensured that the financial statements reflected positive figures regarding the company’s business operations.
Creative Accounting
A critical element noted in this case which led the perpetrators to exploit, manipulate, and rationalize an opportunity occurred when the fraud team targeted the accounting methods used in the valuation of it inventory. Phar-Mor relied on the retail method to account for its inventory. 2 Phar-Mor’s initial strategy was to mark up merchandise up 20% resulting in a gross margin of 16.7% and a cost compliment of 83.3%. This strategy would not last due to increase pressure in the industry amongst rival competitors. The company decided deviate from standard accounting policies and procedures by lowering the margins on certain price sensitive items to stimulate sales growth. The budgeted gross margins were adjusted to reflect a declining number of15.5% and a cost compliment of 84.5%. Weaknesses in Audit Procedures
The inherent flaws in Coopers & Lybrand audit during 1988-1991, were the direct result of the flawed audit procedures performed by the external audit team. As part of its audit program the auditors took a sample test which obtained prices that did not include many price sensitive items. Coopers & Lybrand concluded in its audit client’s financial estimates an opinion that was considered reasonable and consistent with their expectations. After the fraud was uncovered the accounting estimates used to determine its budgeted amount of 15.5% was actually much lower because the price sensitive items made up a large percentage of its sales.
The Cover-up 2
The retail method is used by merchandising firms to properly assess the amount and value of its ending inventory. The retail method works only when there is a consistent mark-up on its inventory.
The Phar-Mor fraud had gone even further as accountants prepared inventory sheets documenting physical counts, retail pricing, calculations for cost of inventory, and cost of goods sold. The case would reveal that Phar-Mor had two sets of books. The post fraud examiner determined that the inventory sheets contained fraudulent journal entries, missing explanations or supporting documentation, and contained obscure account names that should have raised suspicion. The analysis performed revealed journal entries recorded to identify events associated with the sale of items and inventory reflected a reduction in its goods on hand, but failed to record the appropriate entry to offset the cost of goods sold. The entries made to cover-up the scheme was made possible with the creation of a bucket account and at year end would be reconciled to avoid any detection. (Cottrell & Glover, 2009) 4. Phar-Mor Fraud Uncovered The Traveler’s Check
The Phar-Mor Inc. scandal came to a climatic ending as Mike Monus was later found to have embezzled millions of dollars from the company’s operations and redirected those earnings for his World Basketball League. The scheme was uncovered when a travel agent discovered something rather suspicious about a check made out to travel agency for WBL expenses and passed the information to her landlord who was a Phar-Mor investor. This turn of events was brought to the attention of David S Shapira who immediately called the Chief Financial Officer for an explanation; Finn’s response was that Monus was using Phar-Mor’s holdings to fund the World Basketball League. After the investigation was complete David Shapira made the shocking announcement to the public that Phar-Mor was involved in a huge fraud scheme perpetrated by President Mike Monus. (Gilmore, 1994)
5. The Fall of Phar-Mor The $500 million scheme came to an abrupt halt as Phar-Mor Inc., filed for Chapter 11 bankruptcy in 1993; closed 167 of the 300 stores and laid off 15,000 employees. The Securities Exchange Commission would file a complaint in the summer of 1995 against the following: Accounting Manager John Anderson, VP of Finance Jeffrey Walley, Chief Financial Officer Patrick Finn, and President Michael Monus; alleging they had committed acts that violated the antifraud provisions of the securities laws. The defendants were found to have engaged in a fraudulent scheme in which they falsified Phar-Mor’s company books, records and financial statements in order to inflate earnings. The court also found that from 1987 through 1991, Phar-Mor employees inflated revenues by $290 million. The commission also alleged that Phar-Mor had created false financial reports in order to induce investors into committing over $500 million. The architect of this devised scheme, Mike Monus, was sentenced to 19 years, 7 months in prison. The external auditor in this case, Cooper’s & Lybrand were sued $1billion for failing to detect the financial statement fraud at Phar-Mor, but settled for an undisclosed amount. (Zabihollah & Riley, 2010) 6. Conclusion Legislative Action
The case involving Phar-Mor Inc. is very similar to Enron and the WorldCom accounting scandals. Which prompted U.S. Congress to enact new legislation to increase investors’ confidence, regulation of corporate governance and financial practices with the creation of the PCAOB and other authoritative provisions referred to as the Sarbanes Oxley Act of 2002. While enforcement and regulatory provisions play a vital role this alone cannot prevent the actions that have plagued corporate America.
Auditors should conduct the audit of financial statements of an entity with integrity, objectivity, and independence. 3 Failure to Detect Fraud
The first sign of financial trouble surfaced in 1988, when its sister company Tamco Distributors Co. a major supplier for Phar-Mor Inc. settled a dispute about inventory shortage/overbilling for $7 million. The problem in this particular matter is neither company kept good financial records or documentation to substantiate any of its claims regarding the exchange of goods. This related party transaction revealed PharMor profited from this capital contribution, but should have recorded a reduction in inventory and not recognize revenue because the event triggered an adjustment to reflect accurate data regarding its inventory held for sale. The external auditor Cooper’s & Lybrand should have been able to locate and interpret footnotes disclosing a valid explanation and provided with sufficient evidence that substantiates an event management has asserted in its financial statements that is in accordance with US GAAP. From the testimony of Sears Attorney Sarah Wolf this was neither followed nor did Cooper’s & Lybrand rely on evidence to attest to the validity of this transaction that was material and not in compliance with generally accepted accounting practices. This leads me to my opening discussion about governmental regulation and the implementation of oversight committees which may assist in the prevention and detection of fraud, but cannot prevent management override and the weakening of corporate governance. Transcripts from the lawsuit following the accounting failure at 3
ET Section 101 - Independence .01 Rule 101 A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council. ET Section 102 - Integrity and Objectivity .01 Rule 102 In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others.
Phar-Mor Inc. showed Coopers & Lybrand auditor received bonuses and performance evaluations based at least in part on its ability to cross-sell the firm’s non-audit services. Auditors Independence
Experts have suggested that if Title II Section 203 of the SOX act existed 10 years earlier it may have prevented the hire of some of the key culprits in the $500 million fraud scheme. The legislative action was designed to incorporate an audit partner rotation to enhance the auditors independence and audit quality by reducing partner-client familiarity where it was evident that judgment may be impaired with situations like Phar-Mor Inc. whose management team responsible for committing fraud where in fact former employees of Cooper’s & Lybrand. (Williams, 2011) Executive Duties & Responsibilities
The regulatory provisions, Title III section 302 provides additional requirements for corporate executives namely the CEO and CFO to certify in each annual report that the signing officer has review the report, there are no untrue statements, provides a fair presentation of its financial condition, and is responsible for maintaining a company’s internal controls. This section would have challenged President Monus and CFO Finn to disclose that the statements asserted in its financial statements were true and presented a fair representation that did not omit or make any misleading statements that would impact the company’s performance and its ability to provide truthful information to its investors. There is a strong indication from current accounting scandals that financial statement fraud is not impacted by legislation, deterred or second guesses the acts of individuals who commit violations of the Securities Exchange Act of 1934. (Williams, 2011) The Strengthening of Internal Controls
Finally, Title IV section 404 requires management to include an internal controls assessment in its annual report to the SEC. The purpose of this legislative action now requires management to be responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting; provide an assessment of the effectiveness of the company’s internal controls. (Williams, 2011) The Impairment of Good Judgment
There is very little indication that the rationalization of committing acts deemed unethical looked at in a positive light would have affected the judgment of CFO Finn or President Monus to reconsider engaging in such acts. As they orchestrated a plan to override internal controls by establishing a second set of books to hide and conceal the fraud due to ongoing pressure to meet performance expectations and to continue a lie about the success of the company. The end game for Finn and Monus was in order to achieve growth it had to cut corners at the expense of investors and employees who had no knowledge of such actions committed by a few. Who believed that self-enrichment and failure is not an option and that if given a chance or placed in a situation that required you to act responsibly is not always predictable outcome in society. The subtleties and imperfections in Corporate America may never cease to exist.
Works Cited 1.
From Wikipedia, T. F. E. (2012, January 09). Phar-mor. Retrieved from http://en.wikipedia.org/wiki/Phar-Mor
2.
SEC, 1. Securities and Exchange Commission, ALJ Initial Decisions: Administrative Law Judges. (1996). Sec v. michael monus, patrick finn, john anderson and jeffrey walley, case no. 4:95 cv 975, (n.d. oh, filed may 2, 1995). Retrieved from Washington website: http://www.sec.gov/litigation/litreleases/lr14819.txt
3.
Olson, T. (1994, January 24). Inside the phar-mor scam.Pittsburgh Business Times, Retrieved from http://www.accessmylibrary.com/article-1G1-15104036/inside-phar-morscam.html
4.
ACFE. (2011). How to detect and prevent financial statement fraud. (2nd ed. ed., Vol. 1, pp. 186-188). Austin: Association of Certified Fraud Examiners, Inc.
5.
Gilmore, J. (Producer) (1994). How to steal $500 million[DVD]. Available from http://www.pbs.org/wgbh/pages/frontline/programs/transcripts/1304.html
6.
ACFE. (2011). How to detect and prevent financial statement fraud. (2nd ed. ed., Vol. 1, pp. 186-188). Austin: Association of Certified Fraud Examiners, Inc.
7.
Cottrell, D. M., & Glover , S. M. (2009). Finding auditors liable for fraud. The CPA Journal, Retrieved from http://www.nysscpa.org/cpajournal/1997/0797/features/f1.htm
8.
Cottrell, D. M., & Glover , S. M. (2009). Finding auditors liable for fraud. The CPA Journal, Retrieved from http://www.nysscpa.org/cpajournal/1997/0797/features/f1.htm
9.
Gilmore, J. (Producer) (1994). How to steal $500 million[DVD]. Available from http://www.pbs.org/wgbh/pages/frontline/programs/transcripts/1304.html
10. Williams, S. L. (2011). The case of phar-mor inc. THe CPA Journal, 11(3), 58-63.
