Mountain State Sporting Goods (Fraud Investigation Phases I-III.)

Appendix H: Interview of Charles Hess, CPA

MEMO TO FILE Date: Mar 15, 2009 (transcribed Mar 17) Re: Meeting with and interview of Charles Hess (8:00 – 11:15 am) Office of Hess & Associates, Charleston, WV Subj: Mountain State Sporting Goods – Nature of Engagements

Duties and responsibilities

Introduction of self and purpose of visit:

• Advised Hess that I have been engaged by Mr. Peoples, attorney representing shareholders of Mt. State Sporting Goods, to assess the operations of the business including its books and records.

• Advised Hess that Mr. Peoples was concerned about the viability of the business, its

current management and the accuracy of the accounting reports.

• Advised Hess that I had previously reviewed the following:

o The company’s income tax returns for years ’03–’08; o The company’s reviewed report for Dec 31, ’06 and compilation reports for ‘07

and ’08; o The company’s valuation report of Dec 31, ’06; o The company’s detailed general ledger and adjusting entries for years ’06-’08;

and o Workman’s employment contract

• Advised Hess that I had previously interviewed:

o Ms. Sue Bryant (the company’s former bookkeeper); o Anita Workman; and o The company’s banking agents.

Hess freely agreed to be interviewed and provided the following:

Personal Background

24. Personal profile: • Name – Charles Blevins Hess • DOB – June 14, 1965 (age 43) • Education – BS in Accounting (1990) • CPA – 1994

i. Annual CPE as required • No specialized training – valuation, tax, etc. • Work history

1994 to current Self Employed – Hess & Associates 1992 - 1994 Johnson & Cain, CPAs Staff accountant / tax returner preparer Received limited training or mentoring 1990 – 1992 Circuit City Asst Mgr

• Military service o None

25. Hess & Associates, CPAs

• Sole proprietorship • Formed after passing the CPA exam • Nature of business includes business startup, general ledger accounting,

payroll and tax returns • Does not do audits – no experience and too risky • Always looking for new business • Firm growing - recently hired second staff accountant • Prices determined by size of client and nature of work – usually hourly • Advertising limited to yellow pages and word of mouth • Rarely secures engagement letters – sometimes if special engagement – states

engagement letters not required • Member of KY Society and AICPA • Never been sued – does have malpractice insurance just in case • Not aware of any ethical complaints

Discuss Relationship with Workman and Mountain State

26. Hess advised as follows:

• Have known TW (Workman) since high school • TW known as outdoors man – camping, fishing and hunting • Occasionally socialize – dinner, fishing, poker • Acknowledged a couple of trips together – Fl and Vegas • Does accounting work for Black Oak Realty (landlord)

o First met JD in early ’06 regarding building • Visited with JD after he relocated to Black Oak building about his accounting needs

– he was happy with in-house bookkeeper and use of H&R Block for taxes o Tried to explain benefits of CPA v. bookkeeper o Met and renewed friendship with TW

• TW contacted him after JD died o Told me he was taking over the management of the business o Needed help getting it organized o Wanted me to take over accounting o Needed to finish ’06 financial reports

• Little or no knowledge about TW’s employment contract o Not sure who he used to help negotiate o May have seen it o Recalls general discussions about pay - $50k plus benefits and bonuses o Understand that TW has total authority – maybe an option to purchase

• Nature of engagement with Mt State includes quarterly and annual payroll tax reports, reconciliation of GL, financial statements and annual tax returns.

• Acknowledged training of Anita and Mia on accounting system – QuickBooks o They usually discuss problems with staff

• Available as needed • Charge by the hour—rate varies by staff member

o Agreed to provide copies of invoices • Does not recall being paid in cash or property • Mt State not largest client – top 50 • Firm also helped purchase and set up computers – allows Anita and Mia to work

from home • Acknowledged helping TW with bank loans and financing arrangements – business

and personal • Acknowledged discussions with TW on inventory; advised him to do YE physical

inventory – not aware of change after JD’s death – believe physical inventory better then perpetual – less expensive

• Understand store has pawn shop – believe small percentage of overall activity • Not aware how TW accounts for pawn loans – assumes he runs loans though the

books – does not recall discussing

• Understand that checks are cashed to make pawn loans – listing of checks presented memo indicates pawn loans (totals – ’07 = $91,230; ’08 = $97,315) – surprised at the level

• Understand that all loan payments (except interest) must be cash • Believe that source of all deposits specified on slip, especially cash deposits • Believe that interest on pawn loans made by check • Acknowledged buying a few forfeited items – couple of handguns • Acknowledged attending annual Board meetings and presenting financials –

understand JD’s kids not happy • Not aware that annual audits required – seems like a waste of time and money – his

firm does not do audits; would be auditing own work – could not do if requested • Acknowledged advising Workman to present compilation reports – little or no added

value to reviewed report • Has no specific expertise in pawn business – not aware how forfeited items booked –

not aware how loans booked • Acknowledged helping Anita with adj entries / YE GL; financial statements basis for

tax returns. • Corp is Sub S; K-1s issued to kids (50/50) • Knows TW is not a shareholder • No detailed knowledge of TW’s specific duties and responsibilities – he’s the CEO • Firm also does TW’s personal income tax returns • Helped TW set up IRAs for ‘07 • Acknowledged discussing hiring Anita and Mia and acceptable levels of pay

Review of Financial Statements and Tax Returns Presented Hess with copies of financial statements and related tax returns (and summaries) for inspection and confirmation (’06 – ’08). Hess confirmed they were prepared by his firm.

27. Hess advised as follows: • Believes financial statements and tax returns are reasonably accurate – not

perfect • Relied on management – TW and Anita • Understands the importance of meaningful financials given nature of TW’s

responsibility to kids • Acknowledges that the kids rely on TW; TW relies on him to some extent

28. Review of income statement summary (’03 – ’08); Hess states as follows:

• Profit margins surprising – appear to be going in wrong direction • Issue may be inventory – would have to check • Have done no analysis • Believes interest from pawn loans simply being run through sales • No specific knowledge on total pawn loans made – would guess small • Assumes all income being reported

• Acknowledges trends seem misplaced – will investigate if necessary • No specific knowledge about car leases

29. Review of balance sheet (’02 – ’08); Hess states as follows:

• Not sure what was purchased ($40k) in ’08; took IRC 179 • Agrees money could have been used as down payment on building - not sure

how TW made the decision • Agrees account balance for payroll tax payable seems high • Confirms note balances – recalls seeing adj entries • Not sure where or how payday loans (receivable) accounted for on balance

sheet • Assumes cash on hand for loans included in cash balance • Inventory value provided by TW – he knows best • Acknowledges it does not include forfeited pawn items

30. Review of Cash Flow Analysis

• Cannot explain difference between implied cash balance and reported cash balance – ($33k in ’06); must be dividends

• Bryant processed the ’06 GL – relied on her work

31. Discussion of Valuation Report (Dec 31, 2006); Hess states as follows: • Aware that one was done - $350K • Does not recall seeing • Believes valuation completed before his firm was hired • Acknowledged doing ’06 review • Relied on Sue Bryant; long term in-house accountant • Recalls that ’06 review requested by valuator • Does not recall any discussions with valuator • Acknowledged ’06 review logically considered in Dec 31, ’06 valuation • Acknowledged that misstatements or errors in review could result in

erroneous value – no specialized training in valuation. • Acknowledged that understatement of assets would impact valuation.

32. Sue Bryant; Hess stated as follows:

• Met once or twice – understands she was a long term employee – retired after JD’s death

• Recalls she helped with ’06 review • Understand she could not work with TW, Anita / Mia • Understand she resented not being hired as manager – resented TW

Discussion of Specific Transactions I advised Hess that I had identified specific transactions of concern:

33. Check for $45,000 on Dec 23, 2006 payable to Workman

• Initially recorded as employee loan i. Adjusting entry to reclassify

Debit to sales ($45,000) • Hess stated he had no knowledge – Bryant would have made the ‘06 YE

adjustments • Hess stated he had not discussed with Bryant or TW • Hess acknowledged reduction of sales might impact valuation – not certain

34. Dec 31 ’06 Posting to Payroll Taxes Payable

• Posting appears erroneous – overstates payroll taxes payable by exactly $20k i. $20k dawn on LOC on Dec 23 to cover above check to Workman

• Hess stated he had no knowledge – would have to discuss with TW or Bryant • Hess stated he did not review adjusting entries when doing ’06 review – relied

on Bryant • Hess acknowledged that posting might impact valuation – not certain – no

specialized training

35. Checks to Cash – Charged to COGS ($91,230 in ’07 and $97,315 in ’08) • Hess stated his understanding that cash needed to make pawn loans • Hess stated he has no knowledge of how cash on-hand is reconciled • Hess surprised that checks to cash less than pawn sales

36. History of ’07 Credit Line

• 3 checks ($5,000, $10,000 and $10,000) drawn on LOC -- Payable to TW -- Not recorded on books

• ‘07 adjusting entry to reduce sales and increase debt. • Hess stated he had no knowledge – ’07 adjusting entries made by Anita • Hess stated firm did compilation – not audit – would not have detected

37. Checks payable to Classic Construction – 5 in ’07 totaling $5k ($1k each) and 2 in’08

totaling $8k ($3k and $5k) • Disbursements initially coded as outside labor; adjusting entry to reduce

outside labor and increase insurance • Hess stated he has no knowledge –YE adjustments made by Anita

38. Checks payable to Ford Leasing - $6,000 in ’07 and ‘08

• Initially classified as auto lease – adjusting entry each year to reclassify to COGS.

• Hess stated he was aware they had purchased new cars – had discussed the purchase / lease options

• Hess stated he was not aware the company was paying leases • Hess stated one car might be reasonable – not two • Hess advised he had no knowledge of adjusting entries – would talk with

Anita

39. Checks payable to AMX (personal credit card) – 10 cks in ’07 totaling $13,212 and 12 cks in ’08 totaling $21,409

• Payments made on Workman’s personal credit card • Payments initially coded as travel – adjusted to advertising, $12,500 and

$20,000 respectively • Hess stated using personal card and getting reimbursed was ok – IRS did not

care • Hess advised he had no knowledge of adjusting entries – could not explain

why – not sure what difference it makes

40. Check payable to TW May 3, 2008 ($40,000) • Initially recorded as loan to employee

i. Adjusting entry on Dec 31 ‘08 to reclassify to furniture and fixtures • Hess stated that he and TW had jointly purchased some rental property in May

of ’08 – TW’s share of the down payment was $50,000 – thought TW had borrowed from the bank – not the company

41. Checks (3) payable to Fidelity Investments on March 3, 2008 ($3,000 each)

• Disbursements made by company and recorded as COGS. • Hess stated payments for company sponsored IRAs – not sure why coded as

COGS Concluding Discussions I concluded my interview and presented the following summary concerns.

1. Documents indicate a false accounting to the shareholders ($250k to $400k) – maybe even fraud:

a) Hess stated he was surprised b) Hess stated he thought TW had the authority to made decisions – even make

loans to himself – happens every day on Wall Street c) Hess stated TW worked the business the same way JD did – cannot believe

TW knew he was doing something wrong d) Hess agreed items discussed, if added back, would change the outlook of the

company

2. Duty of Hess to the Company and its shareholders v. relationship with Workman: a) Hess acknowledged other people relied on his compilation reports b) Hess stated his role was after-the-fact – compilations not audits c) Hess stated he did not know company was required to have an annual audit

i. No specific knowledge of TW’s employment contract d) Hess stated he was never hired to do analysis – may have uncovered problems

– no guarantee e) Hess acknowledged monies take by TW…if not properly reported or paid

back… was a problem

f) Hess fears he trained TW and Anita too well g) Hess acknowledged taking trip to Vegas with TW; also acknowledged that

TW picked up the tab – they did discuss business h) Hess acknowledged visiting the bank with TW for purposes of borrowing

money – business and personal i) Hess stated his role always after-the-fact j) Hess stated he did not notice or think that TW was living beyond his means –

that all three worked all the time

I asked if he had any final comments or anything else to add; Hess stated as follows:

• TW and Anita were friends – maybe he should have paid more attention • Do not believe TW thought about what he was doing – would not steal • TW loves his job – the business and its customers • Need to arrive at an agreeable number – maybe buy JD’s boys out – $350k • The family would be devastated • TW needs a good lawyer

End.