Phar-Mor, Inc. was a deep-discount store that had substantial growth in a short period of time. It started with 15 stores and grew to over 310 stores in thirty two states between 1985 and 1992.
At first Phar-Mor was seen as a major prospect in the retail market. With sales of over $3 billion and growing, Phar-Mor’s success even worried some of the biggest retail giant, including Wal-mart. The president, founder, and COO of Phar-Mor was Mickey Monus, who became quite extravagant with his money as Phar-Mor grew.The key to the company’s success was “power buying” a phrase coined by Mr.
Monus, it was a practice of stocking up on products when suppliers where offering rock-bottom prices. After using this “power buying” strategy Phar-Mor then sold the products at deep discounts, beating any competitor’s prices. This practice was indeed a key practice that attracted many price conscious consumers and led to the company’s rapid success. However, the deep discount prices where so low that eventually Phar-Mor was no longer able to turn up a profit.
In fact, it is believed that there were no profits generated after 1987. This is how the problem began, because Monus and other executives did not want the truth about there losses to damage the success and favorable reputation of Phar-Mor, they began to use imaginative accounting practices to hide their losses on the financial statements. Phar-Mor’s cover up and fraud was very extensive and went on for many years without being uncovered. In fact, Phar-Mor was deemed a hot commodity and attracted many large investors.
These investors were eager to invest and willingly forked over more then $1. 14 billion for further growth. These investors included some big names such as Westinghouse, Sears Roebuck ; Co. , Edward J.
De Bartolo, and Lazard Freres ; Co. The fraud was extensive and involved inventory overstatements, misappropriation of assets, and fraudulent financial reporting. The interesting thing was that the scale of collusion by management it was almost unthinkable, because it involved many people in the organization who worked together over many years to carefully cover up the fraud.The members that contributed included the president and COO, CFO, vice president of marketing, director of accounting, the controller, and many other key figures.
The fact that these individuals all worked together is why the massive fraud went undetected for so many years. Eventually, the fraud was uncovered, not by the external auditors or the SEC, but by a travel agent. This unlikely event took place when a travel agent received a Phar-Mor check signed by Mickey Monus for expenses that had nothing to do with Phar-Mor.The agent was suspicious and showed the check to her landlord who happened to be an investor in the Phar-Mor Company.
The Landlord called David Shapira Phar-Mor’s CEO and told him about his concern. David Shapira made an announcement in mid-1992, disclosing to the public that Phar-Mor was involved in a huge fraud that was instigated mainly by Mickey Monus the prior president and COO. The outcome of the Phar-Mor fraud was quite substantial.It landed Mickey Monus in prison for over nineteen years, he was convicted of fraudulent accounting that inflated shareholder equity by a half a billion dollars, which ended up causing over one billion dollars in losses and Phar-Mor’s bankruptcy.
Also, several top managers admitted to their roles in the fraud and where convicted of financial fraud. Two were given prison sentences and the group was communally fined over one million dollars for their involvement.Eventually, lawsuits were filed against Coopers ; Lybrand LLP currently known as Price Waterhouse Coopers, who were Phar-Mor’s independent audits. The suits were brought by Phar-Mor’s creditors, investors, and even some of Phar-Mor’s management.
The suits alleged that Coopers & Lybrand were reckless in performing their audits, the claims were for over one billion dollars. Although Coopers & Lybrand were never charged with knowingly assisting in the fraud they were ultimately found liable, and settled the claims for an unknown amount.The Fraud Phar-Mor, Inc. applied a variety of different fraudulent reporting techniques to “cook the books” and commit one of the biggest corporate frauds in American history.
A number of things were done to cover up the massive losses the company was taking including issuing fake invoices for merchandise purchases, making fake journal entries in order to increase inventory and decrease cost of sales, recognizing inventory purchases but then not accruing the corresponding liability, and over-counting merchandise.Since their prices were way too low, eventually profit margins began to decline very fast, this resulted in millions of losses. Instead of disclosing and recording these losses, President Monus along with the CFO Pat Finn and two other high ranking officials, decided to cross out the correct numbers insert highly inflated numbers, during this a sub ledger with the real numbers was also being kept. After a few months of this practice Pat Finn the CFO took on the responsibility of altering the numbers.
By mid 1990 Monus’s refusal to raise prices led to even more cover ups and eventually more members of the organization began to get involved in the fake reporting including the manager of accounting and the Controller. By the time the fraud was discovered executives at Phar-Mor had misstated financial statements by over $500 million. Overstating inventory was a major part of the fraud. Phar-Mor executives hid the losses and made the books balance by significantly overstating inventory.
Phar-Mor used the complex retail method to account for inventory. This method records inventory at the retail price and then converts it to GAAP cost by applying a cost complement percentage. When using this method the company ignored the lower of cost or market rule. Inventory was also shared between stores, therefore inventory overstatement was a result of being both incorrectly valued and incorrectly counted.
So when problems arose with inventory during audits, Phar-Mor debited a made up “bucket account”, which collected all the fake entries.These accounts were given the name accrued inventory, and were very suspicious, but for some reason were never investigated by auditors. Phar-Mor also misappropriated assets, over ten million dollars was directed from Phar-Mor into Mr. Monus’s private venture, the World Basketball League, which was a failing venture that was losing funding, and therefore Monus used Phar-Mor funds to cover growing World Basketball League expenses.
Another fraudulent activity that was later found in the Phar-Mor case was that the company had 91 related parties. These were set up mainly by Monus; a main one was with the World Basketball League, which many new Monus’s involvement however it was never disclosed. This was a violation of the full disclosure principle and SFAF No. 57; “related party disclosures”.
Not disclosing related parties is a serious financial statement fraud, however they are very hard to detect.Knowing that they are difficult to detect takes some blame off the independent auditors, but 91 related parties is a bit much, one would think the auditors should have detected at least a few or at the very least had a few suspicions. The Auditors With all the fraud and misstatements one might want to know how it all slipped past the auditors for so many years. As we mentioned earlier the independent auditors representing Phar-Mor was the firm of Coopers ; Lybrand, a well established firm that would become the now industry leading firm of Price Waterhouse Coopers.
Now the first problem with the auditors was that the Partner in charge of the Phar-Mor audit was under pressure from the firm to stay under budget, since he had gone over previously and he was also being pushed to get more business. The fact that he could get more business from Mickey Monus led him to try to please Monus. In fact, it was discovered that the audit partner got over $900,000 in new business from friends and relatives of Monus.Another fault, also a result of trying to stay within budget was that Coopers decided to audit the inventory of only four out of 133 of Phar-Mor’s stores; this was definitely not enough to get reasonable assurance of the inventory.
Also, Phar-Mor knew in advanced the stores that were going to be audited, therefore it was easy to get around. The same clumsy procedures by the auditors and corrupt moves by Phar-Mor management occurred repeatedly throughout the entire fraud. Phar-Mor’s big growth levels went unquestioned and uninvestigated by the auditors year after year.The entries involving the “bucket” accounts were clearly suspicious, yet were never looked into.
Finally, Coopers failed to follow the appropriate auditing standards of fieldwork governing inventory. Another big point was that some members of the Phar-Mor fraud were former auditors one of which used to work for Coopers ; Lybrand on the Phar-Mor audit. As a result, these former auditors were able to easily disguise the fraud to avoid the auditor’s materiality levels, tests, and procedures because they knew what the current auditors would be looking for.
