financial accounting

Phar-Mor Summary

Pressures:

1. Competition with Wal-Mart to become the premiere deep-discount store

2. Rapid expansion which compounded the losses (since all stores were losing money, more stores meant more losses)

3. Need to increase valuation before going public

4. Use of company funds by owner to fund basketball league for “short” players (the league was making a loss)

5. Owner’s ego which prevented him from increasing sales prices at the appropriate time to reduce the losses

Opportunities:

1. Concentration of power and lack of appropriate internal controls which enabled the owner to blatantly change accounting numbers. This also enabled the top management to collude and hide the fraud.

2. Lack of proper oversight by the CEO who ignored red flags (mistakenly received correct financial statements and letter from the lady he appointed to keep tabs on the owner). It appeared as if the CEO was also interested in increasing the company’s valuation at any cost to increase his personal payout.

3. The auditors accepted Phar-Mor’s audit at a very low fee as they were more interested in the consulting business that they would receive from Phar-Mor. Hence they only audited 4 stores and that too after giving Phar-Mor prior notice of the audit. Such practices are violation of all auditing standards.

4. The owner hired relatively young people from small universities to top management positions. This was done so that they could be easily controlled and they would be less likely to blow the whistle on the fraud.

How was the fraud hidden?

1. By inflating inventory

2. By immediately recognizing all exclusivity fees as revenue rather than deferring their conversion to revenue over the period for which they were received.

Audit Failure:

1. No due diligence into management before accepting the audit

2. The auditor did not examine the appropriateness of overall business environment and business techniques being employed

3. External auditor appointment was used as a means to get more lucrative consulting work

4. Improper sampling techniques were employed

Financial Institutions:

1. Financial institutions did not do necessary due diligence

2. No independent oversight agencies were employed to look into the company’s finances before investing in the company.

3. Essentially bond issues do not put debt on bank balance sheets--there is a counterparty who ultimately buys the bond. The risk to bank is mostly in underwriting the bond issue. Therefore, the motivation for banks to be risk-averse is less strong.

4. Bond issues—bond investors have large portfolios. Syndication of debt through bonds presents low risk to bond investors—the likelihood of bond investors doing significant analysis before buying bonds is low.

5. IPO underwriters also do not take personal risk and hence are laxer in conducting due diligence.

6. Banks suffer from herd mentality and sever FOMO!!

Applicable Fraud Framework:

1. Fraud Triangle

2. MICE

(Please introspect on how these frameworks are applicable to this fraud)