In December 1995, the flamboyant entrepreneur, Michael “Mickey” Monus, formerly president and chief operating officer (COO) of the deep-discount retail chain Phar-Mor, Inc., was sentenced to 19 years and seven months in prison. Monus was convicted for the accounting fraud that inflated Phar-Mor’s shareholder equity by $500 million, resulted in over $1 billion in losses, and caused the bankruptcy of the twenty-eighth largest private company in the United States. The massive accounting fraud went largely undetected for nearly six years. Several members of top management confessed to, and were convicted of, financial-statement fraud. Former members of Phar-Mor management were collectively fined over $1 million, and two former Phar-Mor management employees received prison sentences. Phar-Mor’s management, as well as Phar-Mor creditors and investors, subsequently brought suit against Phar-Mor’s independent auditors, Coopers & Lybrand LLP (Coopers), alleging Coopers was reckless in performing its audits. At the time the suits were filed, Coopers faced claims in excess of $1 billion. Even though there were never allegations that the auditors knowingly participated in the Phar-Mor fraud, on February 14, 1996, a jury found Coopers liable under both state and federal laws. Ultimately, Coopers settled the claims for an undisclosed amount. PHAR-MOR STORES1 Between 1985 and 1992, Phar-Mor grew from 15 stores to 310 stores in 32 states, posting sales of more than $3 billion. By seemingly all standards, Phar-Mor was a rising star touted by some retail experts as the next Wal- Mart. In fact, Sam Walton once announced that the only company he feared at all in the expansion of Wal-Mart was Phar-Mor. Mickey Monus, Phar-Mor’s president, COO and founder, was a local hero in his hometown ofYoungstown, Ohio. As demonstration of his loyalty, Monus put Phar-Mor’s headquarters in a deserted department store in downtown Youngstown. Monus—known as shy and introverted to friends, cold and aloof to others—became quite flashy as Phar-Mor grew. Before the fall of his Phar-Mor empire, Monus was known for buying his friends expensive gifts and he was building an extravagant personal residence, complete with an indoor basketball court. He was also an initial equity investor in the Colorado Rockies major league baseball franchise. This affiliation with the Colorado Rockies and other high profile sporting events sponsored by Phar-Mor fed Monus’ love for the high life and fast action. He frequently flew to Las Vegas, where a suite was always available for him at Caesar’s Palace. Mickey would often impress his traveling companions by giving them thousands of dollars for gambling. Phar-Mor was a deep-discount retail chain selling a variety of household products and prescription drugs at substantially lower prices than other discount stores. The key to the low prices was “power buying,” the phrase Monus used to describe his strategy of loading up on products when suppliers were offering rock- bottom prices. The strategy of deep-discount retailing is to beat competitors’ prices, thereby attracting cost- conscious consumers. Phar-Mor’s prices were so low that competitors wondered how Phar-Mor could turn a profit. Monus’ strategy was to undersell Wal-Mart in each market where the two retailers directly competed. 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 so that Phar-Mor never reported these losses in its financial statements. Federal fraud examiners discerned later that 1987 was the last year Phar-Mor actually made a profit. Investors, relying upon these erroneous financial statements, 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 say banks and investors put $1.14 billion into Phar-Mor based on the phony records. The fraud was ultimately uncovered when a travel agent received a Phar-Mor check signed by Monus paying for expenses that were unrelated to Phar-Mor. The agent showed the check to her landlord, who happened to be a Phar-Mor investor, and he contacted Phar-Mor’s chief executive officer (CEO), David Shapira. On August 4, 1992, David Shapira announced to the business community that Phar-Mor had discovered a massive fraud perpetrated primarily by Michael Monus, former president and COO, and Patrick Finn, former chief financial officer (CFO). In order to hide Phar-Mor’s cash flow problems, attract investors, and make the company look profitable, Monus and Finn altered Phar-Mor’s accounting records to understate costs of goods sold and overstate inventory and income. In addition to the financial statement fraud, internal investigations by the company estimated an embezzlement in excess of $10 million.2 Phar-Mor’s executives had cooked the books, and the magnitude of the collusive management fraud was almost inconceivable. The fraud was carefully carried out over several years by persons at many organizational layers, including the president and COO, CFO, vice president of marketing, director of accounting, controller, and a host of others. The following list outlines seven key factors contributing to the fraud and the ability to cover it up for so long.  The lack of adequate management information systems (MIS). According to the federal fraud examiner’s report, Phar-Mor’s MIS was inadequate on many levels. At one point, a Phar-Mor vice president raised concerns about the company’s MIS and organized a committee to address the problem. However, senior officials involved in the scheme to defraud Phar-Mor dismissed the vice president’s concerns and ordered the committee disbanded.  Poor internal controls. For example, Phar-Mor’s accounting department was able to bypass normal accounts payable controls by maintaining a supply of blank checks on two different bank accounts and by using them to make disbursements. Only those involved in the fraud were authorized to approve the use of these checks.  The hands-off management style of David Shapira, CEO. For example, in at least two instances Shapira was made aware of potential problems with Monus’ behavior and Phar-Mor’s financial information. In both cases Shapira chose to distance himself from the knowledge.  Inadequate internal audit function. Ironically, Michael Monus was appointed a member of the audit committee. When the internal auditor reported that he wanted to investigate certain payroll irregularities associated with some of the Phar-Mor related parties, Monus and CFO Finn forestalled these activities and then eliminated the internal audit function altogether.  Collusion among upper management. At least six members of Phar-Mor’s upper management, as well as other employees in the accounting department, were involved in the fraud.  Phar-Mor’s knowledge of audit procedures and objectives. Phar-Mor’s fraud team was made up of several former auditors, including at least one former auditor who had worked for Coopers on the Phar- Mor audit. The fraud team indicated that one reason they were successful in hiding the fraud from the auditors was because they knew what the auditors were looking for.  Related parties. Coopers & Lybrand, in a countersuit, stated that Shapira and Monus set up a web of companies to do business with Phar-Mor. Coopers contended that the companies formed by Shapira and Monus received millions in payments from Phar-Mor. The federal fraud examiner’s report confirms Coopers’ allegations. The complexity of the related parties involved with Phar-Mor made detection of improprieties and fraudulent activity difficult. During its investigation, the federal fraud examiner identified 91 related parties. ALLEGATIONS AGAINST COOPERS Attorneys representing creditors and investors pointed out that every year from 1987 to 1992, Coopers & Lybrand acted as Phar-Mor’s auditor and declared the retailer’s books in order. At the same time, Coopers repeatedly expressed concerns in its annual audit reports and letters to management that Phar-Mor was engaged in hard-to-reconcile accounting practices and called for improvements. Coopers identified Phar-Mor as a “high risk” audit client and Coopers documented that Phar-Mor appeared to be systematically exaggerating its accounts receivables and inventory, its primary assets. Phar-Mor’s bankruptcy examiner would later note that the retailer said its inventory jumped from $11 million in 1989 to $36 million in 1990 to a whopping $153 million in 1991. Creditors suggested that the audit partner’s judgment was clouded by his desire to sell additional services to Phar-Mor and other related parties. Such “cross-selling” was common, and it was not against professional standards; however, the creditors claimed Coopers put extraordinary pressure on its auditors to get more business.3 The audit partner was said to be hungry for new business because he had been passed over for additional profit sharing for failing to sell enough of the firm’s services. The following year, the audit partner began acquiring clients connected to Mickey Monus and eventually sold over $900,000 worth of services to 23 persons who were either Monus’ relatives or friends. INVESTORS AND CREDITORS—WHAT COURSE OF ACTION TO TAKE? After the fraud was uncovered, investors and creditors sued Phar-Mor and individual executives. These lawsuits were settled for undisclosed terms. Although many of the investors were large corporations like Sears and Westinghouse, representatives from these companies were quick to point out that their stockholders, many of whom were pension funds and individual investors, were the ultimate losers. These investors claimed they were willing to accept the business risk associated with Phar-Mor; however, they did not feel they should have had to bear the information risk associated with fraudulent financial statements. One course of action was to sue Phar-Mor’s external auditors, Coopers & Lybrand. However, although the investors and creditors were provided with copies of the audited financial statements, they did not have a written agreement with the auditor outlining the auditor’s duty of care. As is common with many audits, the only written contract was between Coopers and Phar-Mor. Thirty-eight investors and creditors filed suit against Coopers, under Section 10(b) of the Federal Securities Exchange Act of 1934 and under Pennsylvania common law. All but eight plaintiffs settled their claims with Coopers without going to trial. However, the remaining plaintiffs chose to take their cases to a jury trial. COURTROOM STRATEGIES The Defense Attorneys for Coopers continually impressed upon the jury that this was a massive fraud perpetrated by Phar- Mor’s management. They clearly illustrated the fraud was a collusive effort by multiple individuals within the upper management at Phar-Mor who continually worked to hide evidence from the auditors. The auditors were portrayed as victims of a fraud team at Phar-Mor that would do, and did, whatever it took to cover up the fraud. After the verdict the defense attorney said: The jury [rightly] saw that a corporate fraud had been committed, but it mistakenly blamed the outside auditor for not uncovering something no one but the perpetrators could have known about…It’s a first...that effectively turns outside auditors into insurers against crooked management. (Robert J. Sisk, chairman of NewYork’s Hughes Hubbard & Reed) The Plaintiffs The plaintiffs opened their case by acknowledging the incidence of fraud does not, by itself, prove there was an audit failure. Moreover, they did not allege that Coopers knowingly participated in the Phar-Mor fraud; nor did they allege Coopers was liable because it did not find the fraud. Rather, plaintiffs alleged Coopers made misrepresentations in its audit opinions. The following quotes from plaintiff attorneys’ statements to the jury illustrate the plaintiffs’ strategy: . . . [W]e’re not going to try to prove in this case what happened at Coopers & Lybrand. That’s not our burden. We don’t know what happened. We do know that we invested in Phar-Mor on the basis of the financials of Phar- Mor, with the clean opinions of Coopers & Lybrand. We’ve now lost our investment, and it’s a very simple case. We just want our money back...[I]f Coopers can demonstrate to you that they performed a GAAS audit in the relevant time periods, then you should find for them. But if you find based upon the testimony of our experts and our witnesses that Coopers never, ever conducted a GAAS audit...then I submit you should ultimately find for the [plaintiffs]. (Ed Klett, attorney forWestinghouse) So the question, ladies and gentlemen, is not whether Coopers could have discovered the fraud. The question is whether Coopers falsely and misleadingly stated that it conducted a GAAS audit and falsely and misleadingly told [plaintiffs] that Phar-Mor’s worthless financial statements were fairly presented. And the answer to that question is yes. (SarahWolff, attorney for Sears) Throughout the five-month trial, the plaintiffs continually emphasized the following facts in an effort to have the jury believe the auditors were motivated to overlook any problems that might have been apparent to a diligent auditor: The fraud went on for a period of six years, and, therefore, should have become apparent to a diligent auditor. Coopers was aware that Phar-Mor’s internal accountants never provided the auditors with requested documents or data without first carefully reviewing them. Greg Finnerty, the Coopers partner in-charge of the Phar-Mor audit, had previously been criticized for exceeding audit budgets and, therefore, was under pressure to carefully control audit costs. Mickey Monus, Phar-Mor’s president, was viewed by Finnerty as a constant source of new business. The areas where the plaintiffs alleged the auditors were reckless and did not perform an audit in accordance with GAAS centered around the accounting for inventory and its corresponding effects on both the balance sheet and the income statement. The plaintiffs’ allegations centered on the five major issues detailed below. EARLY WARNING SIGNS—THE TAMCO SETTLEMENT The Fact Pattern In 1988, internal gross profit reports at Phar-Mor indicated serious deterioration in margins. Phar-Mor was facing an unexpected $5 million pretax loss. It was determined, with the assistance of a specialist from Coopers, that the drop in margins was due mainly to inventory shortages from one of Phar-Mor’s primary suppliers, Tamco. Tamco, a subsidiary of Giant Eagle, Phar-Mor’s principal shareholder, had been shipping partial orders, but billing Phar-Mor for full orders. Unfortunately,Tamco’s records were so poor that it could not calculate the amount of the shortage. Likewise, Phar-Mor had no way to determine the exact amount of the shortage because during this time period Phar-Mor was not logging in shipments from Tamco. A Phar-Mor accountant performed the only formal analysis of the shortage, which he estimated at $4 million. However, negotiations between Phar-Mor and Tamco (along with its parent company Giant Eagle) resulted in a $7 million settlement. Phar-Mor recorded the $7 million as a reduction to purchases, resulting in a pretax profit of approximately $2 million in 1988. Because Tamco and Phar-Mor were both subsidiaries of Giant Eagle, the settlement was disclosed in a related-party footnote to the financial statements. Trial evidence indicates the final settlement amount was determined, in part, by looking at Phar-Mor’s profitability in prior years. After the settlement, Phar-Mor’s gross margin was nearly identical to the prior year. After the fraud was uncovered, it was determined there were signals that Phar-Mor’s profitability had slipped in 1988. Plaintiff Allegations The plaintiffs claimed the settlement was a disguised capital contribution and thus simply a vehicle to artificially inflate Phar-Mor’s earnings. The plaintiffs alleged Coopers acted recklessly by not obtaining sufficient persuasive evidence to support this highly material transaction. The following excerpts are from testimony given (in a deposition) by Pat Finn, former CFO of Phar-Mor, and Charles Drott, an expert witness for the plaintiffs: There was really no way to support the amount of the settlement. We did a number of tests, but based on our in-house review, we didn’t think that we could support $7 million. Mickey [Monus] did an excellent job of negotiating with David [Shapira] and he got us $7 million. (Pat Finn, former CFO of Phar-Mor) What Mr. Finn is basically describing is that, although there may well have been some shortages, that what Phar-Mor was really doing was entering into a transaction, which would enable them to manipulate its profit to overcome losses, to hide losses. So, essentially what he’s describing is fraudulent financial reporting...[T]he Coopers & Lybrand workpapers contain no independent verification, nor was there any attempt by Coopers & Lybrand to determine the actual amount of the shortages. It simply just was not done. (Charles Drott, expert witness for the plaintiffs) Plaintiffs also alleged the footnote documenting the receipt and the accounting treatment of the settlement was misleading. Although the footnote disclosed the nature and amount of the related- party transaction, the plaintiffs argued the footnote should have more clearly indicated the uncertainty in the settlement estimate. And plaintiffs felt the footnote should have explicitly stated that without the settlement, Phar-Mor would have shown a loss. Defense Response A copy of the analysis conducted by the Phar-Mor accountant indicating a $4 million shortage was included in Coopers’ workpapers. However, Coopers considered the analysis very crude and included it only as support for the existence of a shortage, not the dollar amount. Although the workpapers contained relatively little documentation specifically supporting a $7 million settlement, Coopers, who audited all three companies party to the negotiation, did perform a number of procedures to satisfy themselves of the propriety of the settlement. After the internal investigation pointed to Tamco, Phar-Mor began to maintain a log of Tamco shipments. Coopers tracked the results of the log and in every subsequent Tamco shipment shortages were found. Coopers also contacted another company that had received Tamco shipments during this time period and learned that retailer was also experiencing shortages from Tamco Coopers’ experts examined Tamco’s operations and confirmed the shortages were due to a new computer inventory system at Tamco. Greg Finnerty, Coopers’ partner in charge of the audit, explained the auditors’ position as follows: ...[I]t’s a related-party transaction, and we don’t have the responsibility to validate the amount. The responsibilities in accordance with GAAS standards are twofold. One, in any related-party transaction, is to understand the business purpose of the transaction; and two, to agree to the disclosure of the transaction...[W]e understood the business transaction, and the disclosure was adequate. It talked about the $7 million transaction; and we saw a check, not just an intercompany account. We did a lot of those transactions, so we fulfilled our two responsibilities that are the standards for related-party transactions. I was not in that settlement session, nor should I have been.That was between the two related parties. When the discussions were over with, I talked to both parties separately, myself, and talked to them about the settlement, the reasonableness of that settlement. I, in fact, asked David Shapira—and I specifically recall asking David Shapira—of the $7 million, is that all merchandise or is there any sense that you are—you or the board of directors of Giant Eagle—passing additional capital into Phar-Mor through this transaction? And I was given absolute assurance that he was satisfied that the $7 million was a reasonable number; and, in fact, he indicated that this was a number much lower than what Phar-Mor thought it should have been. So it seemed to me that there was a reasonable negotiation that went on between these parties. (Greg Finnerty, engagement partner for the Phar-Mor audit) Regarding the footnote disclosure, Coopers pointed out the footnote was typical of related-party footnotes, and that it was rather obvious that without the $7 million settlement, Phar-Mor would have reported a loss. Evidence also showed that, prior to the release of the financial statements, Phar-Mor met with investors and creditors to cover the terms and significance of the settlement. Finally, to this day, none of the parties involved—not Tamco, Phar-Mor, or Giant Eagle—have suggested the settlement was part of the fraud. Further testimony in the trial suggested the Tamco settlement was not an issue of concern with investors and creditors until their attorneys made it an issue years later in the litigation. THE PRICE TEST The Fact Pattern Inventory at Phar-Mor increased rapidly from $11 million in 1989 to $36 million in 1990 to $153 million in 1991. Phar-Mor’s inventory system did not include a perpetual inventory record. Therefore, Phar-Mor used the retail method for valuing inventory. Phar-Mor contracted with an outside firm to physically count and provide the retail price of each item in inventory twice per year. Phar-Mor would then apply a cost complement to determine the cost of inventory. Phar-Mor’s initial strategy was to mark all merchandise up 20%, resulting in a gross margin of 16.7% and a cost complement of 83.3%. However, to be competitive, Phar-Mor lowered the margins on certain “price sensitive” items to get customers in the door. As a result, Phar-Mor’s overall budgeted gross margin fell to 15.5%, resulting in a cost complement of 84.5%. Coopers identified inventory valuation as a high-risk area in its workpapers. As a detailed test of Phar- Mor’s inventory costing, Coopers annually attended the physical inventory count at four stores and selected from 25 to 30 items per store to perform price testing. Sample items were selected by the attending auditor in a haphazard fashion. Purchase invoices were examined for the items selected and an overall gross margin for the sample was determined. In the years 1988 through 1991, Coopers’ sample gross margins averaged from 16.1% to 17.7%. Coopers explained the difference between the expected 15.5% gross margin and the sample gross margin resulted because the sample taken did not include many price sensitive items, and, therefore, the sample gross margin was higher than Phar-Mor’s overall margin. Coopers concluded the difference noted was reasonable and consistent with expectations. After the fraud was uncovered, it was determined that Phar-Mor’s actual margins were really much lower than the budgeted 15.5%, because the price sensitive items made up a relatively large percentage of sales. When Phar-Mor’s management saw the fiscal 1989 gross profit reports were coming in below historical levels, it started changing the gross margin reports because it feared Giant Eagle would want back some of the $7 million paid in Tamco settlement money. Management continued to alter the gross profit reports from that time until the fraud was uncovered. Plaintiff Allegations The plaintiffs argued that had the Coopers auditors employed a more extensive and representative price test, they would have known what Phar-Mor’s gross margins actually were, no matter what the fraud team was doing to the gross profit reports. Plaintiffs alleged the way the auditors conducted their price test and the way they interpreted the results, were both woefully inadequate and unreliable due to the sample size and acknowledged lack of representativeness. ...[T]he attitudes of the people involved in this were simply that even though there was clear recognition in the workpapers that this test was so flawed that it was virtually worthless, did not produce anything to them that they could use in their audit, yet they still concluded year after year that everything was reasonable, and that’s—that defies my imagination. I don’t understand how that conclusion can come from their own recognition of that, the test was so severely flawed. Also, they gave consideration to doing a better price test, but in fact never made any attempt to do so because in each of the four years they did the same exact kind of test, year after year after year, even though they knew the test produced unreliable results. (Charles Drott, expert witness for the plaintiffs) The plaintiffs also pointed to Coopers’ workpapers where the auditors had indicated that even a one-half percent misstatement in gross margin would result in a material misstatement. Plaintiffs argued the auditors recklessly ignored the sample results indicating a material misstatement. The plaintiffs also argued the gross profit schedules could not be used to independently test the cost complement because the calculated profit margin and ending inventory were a function of the standard cost complement that was applied to the retail inventory balance derived from the physical inventory. So, what we have here is a daisy chain...the price test is the basis for the gross margin test. The price test is reasonable because the gross margins are reasonable. But, the only reason the gross margins are reasonable is because they are based on the price test. It keeps ping-ponging back and forth. And the problem is, none of this was tested.And when it was tested...the price tests [and] the cost complement did not meet Coopers’ expectations. It was not what it was supposed to be. (SarahWolff, attorney for Sears) Defense Response Coopers explained to the jury that the price test was simply a reasonableness test intended to provide limited assurance that Phar-Mor was properly applying its methodology for pricing and costing inventory. ...[I]n the context of all our inventory testing and testing the gross profit, which is a continuous testing of the pricing philosophy, we felt it was adequate testing for our purposes...[T]he price test is just one element of what we did to confirm our understanding and the representation of management as to their pricing philosophy. The primary test of all that is the continuation of taking the physical inventories that they did throughout the year, reconciling that through the compilation and determining the gross profit. If [Phar-Mor is] receiving the gross profit that [they] expected, that is the truest indication and the most valid indication that the pricing philosophy is, in fact, working. It was a valid test, it still is a valid test after reviewing it time and time again. And the staff person suggesting we drop it was just not...right. And throughout the whole time that we audited Phar-Mor, we continued to do the price test. It was a valid test, and it still is. (Greg Finnerty, engagement partner for the Phar-Mor audit) Further, Coopers pointed out that differences are expected in reasonableness tests and those differences do not represent actual misstatements. It was obvious to Coopers that while Phar-Mor’s costing method was applying one standard cost factor, Phar-Mor was applying a variety of pricing strategies. Coopers’ price tests on the individual items selected resulted in a wide range of gross margins from items sold below cost to margins of 30% or higher. Coopers also pointed out that the auditors performed a number of other procedures that compensated for the weaknesses in the price tests. The primary testing was performed on Phar-Mor’s gross profit reports. For a sample of gross profit schedules, Coopers recalculated percentages and traced inventory balances back to the physical inventory report submitted by the independent count firm. This was an important procedure for Coopers because, if the margins were consistent, this indicated that the controls over purchases and sales were operating properly. In addition to these procedures, the control environment over purchases and inventory was documented, and certain controls were tested. Individual store and overall company inventory levels and gross margins were compared to prior years. Analytics, such as inventory turnover and days in inventory, were also examined. INVENTORY COMPILATIONS The Fact Pattern After the outside inventory service submitted a report of its physical count, Phar-Mor accountants would prepare an inventory compilation packet. The package included the physical counts, retail pricing, Phar-Mor’s calculations of inventory at cost, and cost of goods sold. Based on the compilation, a series of journal entries were prepared and recorded in the operating general ledger to adjust inventory per books to the physical count. Each year, the auditors randomly selected 1 compilation packet for extensive testing and 14 other packets for limited testing. The auditors reviewed journal entries for reasonableness for all 15 packets. The postfraud examination determined that many of Phar-Mor’s inventory compilations packets contained fraudulent journal entries. The entries were often large, in even dollar amounts, did not have journal entry numbers, had no explanation or supporting documentation, and contained suspicious account names like “Accounts Receivable Inventory Contra” or “Cookies.” Phar-Mor’s fraud team used these entries to inflate inventory and earnings. Based on the physical count and results of the compilation, an appropriate entry was made to reduce (credit) inventory. However, rather than record the offsetting debit to cost of goods sold, a debit entry was recorded to a “bucket” account. The bucket accounts accumulated the fraudulent entries during the year. At year-end, to avoid auditor detection, the bucket accounts were emptied by allocating a portion back to the individual stores as inventory or some other asset. Plaintiff Allegations The plaintiffs alleged that some of the compilations reviewed by the auditors contained fraudulent entries. Plaintiffs’ experts claimed Coopers should have noticed these unusual entries. Coopers’ audit work in this inventory compilation area, because of its failure to investigate all of these fraudulent entries which were obvious, suspicious entries on their face, their failure to do this is a failure, in my opinion, that is reckless professional conduct, meaning that it is an extreme departure from the standard of care. They had the entries in front of them, and they chose to do nothing whatsoever to investigate. Had they done so, they would have found the fraud right then and there. (Charles Drott, expert witness for the plaintiffs) Defense Response Coopers was able to prove with its workpapers that none of the compilations selected by the auditors for extensive review over the years contained fraudulent entries. Although Coopers did retain an entire copy of the extensively tested compilation packet in its workpapers, it noted only key information from the packets on which it performed limited testing. In preparation for the trial, the packets that had been subjected to only limited testing were pulled from Phar-Mor’s files, many of them containing fraudulent journal entries. However, there was evidence suggesting these compilations may have been altered after Coopers reviewed them. For instance, in many cases even the key information Coopers had noted in its workpapers no longer agreed to the file copies. Mark Kirsten, a Coopers audit manager who was the staff and senior auditor on the Phar-Mor engagement, testified why he believes the compilations retrieved from Phar-Mor’s files were altered after Coopers performed its audit work: I never saw this entry or any other fraudulent entries. When we got these packages, we got them from John Anderson who was part of this fraud. And I refuse to agree that John Anderson walked into my audit room, and we are poring over these for a couple days at a time, and says, here, if you happen to turn to the third page, you are going to find a fraudulent entry that has no support. That’s unimaginable...we know there is a fraud. That’s why we are here. I know I did my job. My job was to review the packages. These packages went through extensive reviews. So, I am saying when you show me a package that has on one page something that...is fraud, I can’t imagine that I saw that. We didn’t see these packages for ten seconds during the audit. We spent days with these. I am a staff accountant who is doing my job, and I am poring through these and asking questions. We don’t audit in a box. (Mark Kirsten, engagement senior for the Phar-Mor audit) GENERAL LEDGER The Fact Pattern A monthly operating general ledger (GL) was prepared and printed for each store and for corporate headquarters. The plaintiffs argued that not only could the fraud have been uncovered by examining the journal entries proposed on the inventory compilations, but also by scanning the GL. Post-fraud reviews of the GLs revealed the fraudulent entries from the compilation reports were posted directly to the GLs. The GLs contained other fraudulent entries as well. Because the fraud team was aware that zero balance accounts typically draw little attention from the auditor, they recorded numerous “blow-out” entries in the last monthly corporate GL to empty the bucket accounts that had fraudulently accumulated during the year. The bucket accounts were emptied by allocating a portion, usually in equal dollar amounts, back to the stores as inventory or other assets. These entries were typically very large. For example, in 1991, there was an entry labeled “Accrued Inventory” for $9,999,999.99. Also, in 1991, there was an entry labeled “Alloc Inv” (Allocate Inventory) for $139 million. Plaintiff Allegations The plaintiffs pointed out that scanning the GL, which was a recognized procedure in Coopers’ audit manual and training materials, would certainly and easily have uncovered the fraud. Further, plaintiffs pointed to Coopers’ inventory audit program for Phar-Mor that included procedures requiring the examination of large and unusual entries. The following comments from plaintiff attorney, Sarah Wolff, to the jury illustrate the plaintiffs’ allegations. I want to talk about the issue of general ledger...All we ask you to do in this issue is, don’t listen to what the lawyers have told you...what we ask you to do is look at Coopers’ own words. Look at Coopers’ training materials. The auditor must also review for large or unusual nonstandard adjustments to inventory accounts. Read Coopers & Lybrand’s own audit program for this particular engagement that has steps nine and steps eleven that say look for fourth quarter large and unusual adjustments. Those are their words, ladies and gentlemen. That’s their audit program, and you have seen witness after witness run from those words. (SarahWolff, attorney for Sears) Although a witness for the plaintiffs agreed it would not have been practical to carefully scan all the operating GLs, (which would have been a pile of computer paper 300 hundred feet tall), they felt it was reckless, and a failure to comply with GAAS, to not carefully scan at least the last month of the corporate office GL. The plaintiffs repeatedly played a video clip of one of the chief perpetrators of the Phar-Mor fraud, the former CFO, saying that if Coopers had asked for the backup to any one of the fraudulent journal entries, “It [the fraud] would have been all over.” Defense Response Coopers’ audit program did have a step to obtain selected nonstandard adjusting journal entries so that any large and unusual items could be further examined. The step was signed-off by staff auditors without further explanation. Coopers witnesses testified that the fact that the step was signed-off indicated that either the step was performed or was considered not necessary. Trial testimony indicated Coopers auditors asked Phar- Mor accountants if there were any large and unusual adjusting entries and the auditors were told there were none. Coopers pointed out it is normal for the client to provide the auditor with an audit packet including lead schedules that agree to the GL and tie to the financial statements. None of the lead schedules contained fraudulent or “bucket” accounts. When it was suggested by plaintiff attorneys that if the auditors had reviewed the operating general ledgers, there would have been a high probability that they would have discovered the fraud, the partner responded: No. I would say that it wouldn’t be a high probability of that because we are doing a GAAS audit. A GAAS audit requires us to do the procedures that we did. There is no requirement in GAAS—none of my partners or I have ever followed a procedure that says you review operating general ledgers line by line, or whatever, unless you are doing a fraud audit. In the course of doing our GAAS audit, we would look to the general ledgers to the extent necessary in order to do our work on the account balances. We don’t audit all the various ways that the balances are arrived at. We don’t look at day-to-day activity. This is not what we do as accountants, not only at Phar- Mor, but in every audit we do. We look at the ending balances and audit the ending balances. (Greg Finnerty, engagement partner for the Phar-Mor audit) Although Coopers was aware of the operating GLs, it worked primarily with the consolidated GL, which combined all the operating GLs and included only ending balances and not transaction details. In the consolidated GL, the “bucket” or fraud accounts were either completely absent or had zero balances. To counter the plaintiffs’ video clip of the CFO saying the auditors never asked for backup to the blowout entries, the defense played its own video clip of this same CFO (who was a former Big Six auditor), testifying he and his fraud team went to great lengths to prepare for the audit. On this same video clip, the former CFO also testified that if Coopers had asked for the closing journal entry binder, he would have removed the journal entries that emptied the fraud bucket before giving it to the auditors. Members of the fraud team also testified that had Coopers changed its approach to more carefully scrutinize the operating GLs, they would have changed their approach to cover up the fraud. ROLL FORWARD The Fact Pattern Because the physical inventories were completed during the fiscal year, it was necessary to roll forward or account for the inventory purchase and sales transactions between the inventory count date and the balance sheet date. Coopers’ roll-forward examinations always revealed there was a large increase in the ending book inventory balance. Phar-Mor explained to the auditors that the “spike” was due to two factors. First, inventory levels at the physical count date were always lower than normal because a store would reduce inventory shipments in the weeks prior to the physical inventory to prepare for the physical count. Second, since the fiscal year-end was June 30, there was always a buildup of inventory to handle the big July 4th holiday demand. The drop-off in inventory just after year-end was attributed mainly to the large amounts of inventory sold over July 4th. Although the client’s explanation did account for a portion of the spike, investigations performed subsequent to the discovery of the fraud indicate that a large portion of the spike was due to the fraud. Plaintiff Allegations Plaintiffs claimed the spike was a big red flag that Coopers recklessly overlooked. And what this is simply showing is that the increase is a sharp spike upward at fiscal year-end. Interestingly, also, is that subsequent to the fiscal year, just a short time thereafter—the inventory levels drop off. Now, that is a very interesting red flag as to why would that be. If I were an auditor, I’d certainly want to know why the inventories increase sharply, reaching its crest right at the fiscal year-end date. In other words, when the financial statements were prepared, and why they drop off again after fiscal year-end, just two weeks later, as a matter of fact, and go down that much. It’s what I call the spike. Clearly the spike, in my opinion, was caused in large part by the actual fraud at Phar-Mor, because if you recall, these fraudulent entries, these blow-out entries that I described, were these very large journal entries that were adding false inventory to each of the stores, and it was done at fiscal year-end; so if you’re adding—and we’re talking like entries as high as $139 million of false inventory being added in one journal entry to these stores. When you have that, being false inventory, added to the stores at fiscal year-end, that’s obviously going to spike up the books at year-end. And then subsequent to year-end, many of these entries are what we call reversed or taken out of the stores, which would cause some of that spike, if not all of it, to come down. (Charles Drott, expert witness for the plaintiffs) The plaintiffs also argued that auditing texts and an AICPA practice guide describe tests of controls and tests of detail that must be performed for the interim period. In addition, plaintiffs pointed to a procedure described as scrutinizing the books of original entry to identify unusual transactions during the roll-forward period. Defense Response When asked if the spike would cause an experienced retail auditor to have suspicions about inventory at Phar- Mor, the audit partner responded: Well, no, it wouldn’t. But, let me give you an example. At Christmastime, it’s the same concept. There is a tremendous spike in inventory of retailers at Christmastime, and then after that, after Christmas, sales go down. That is, you are going to see a natural decline in the inventory levels of a retailer after Christmas. So, it so happens in this analysis, this has to do with the year-end of Phar-Mor, June 30. (Greg Finnerty, engagement partner for the Phar-Mor audit) Given that this sort of spike was not unusual, Coopers expected the inventory roll forward comparisons to result in differences. Coopers explained the difference noted in its reasonableness test comparing year-end inventory and the previous physical inventory was within expectations and differences in reasonableness tests do not represent known, actual misstatements. Coopers elected not to test specific purchases or sales transactions during the roll-forward period. Rather, it relied on its tests of the gross profit schedules both before and after year-end, which suggested that controls over purchases and sales were functioning properly. Coopers contended that if any large or unusual journal entries were recorded after the last physical inventory and before year-end, they should affect the gross profit of the general ledger, which was one of the comparisons made on the gross profit reports. Unfortunately, the fraud team was falsifying the gross profit reports. VERDICT On February 14, 1996, a federal jury found Coopers & Lybrand, LLP guilty of fraud under both state and federal law. Even though neither Phar-Mor’s management, the plaintiffs’ attorneys, or anyone else associated with the case ever alleged the auditors knowingly participated in the Phar-Mor fraud, Coopers was liable under a fraud claim. The crux of this fraud charge was the plaintiffs’ allegation that Coopers made representations recklessly without regard to whether they were true or false, which legally enabled plaintiffs to sue the auditors for fraud. After the verdict, plaintiff attorney Sarah Wolff indicated this case could prove to be the model for getting a jury to find a respected accounting firm behaved recklessly. Ultimately, Coopers settled the claims for an undisclosed amount. POSTFRAUD PHAR-MOR Discovery of the fraud resulted in immediate layoffs of over 16,000 people and the closure of 200 stores. In September of 1995, after over three years of turmoil, Phar-Mor emerged from Chapter 11 bankruptcy. Phar- Mor’s CEO at that time, Robert Half, was optimistic about the company’s future: “You can make money in this business. It’s our job to prove it.”4 In September 2001, Phar-Mor operated 139 stores in 24 states under the names of Phar-Mor, Rx Place, and Pharmhouse. However, on September 24, 2001, Phar-Mor and certain of its affiliates filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code to restructure their operations in an effort to return to profitability. Management determined that the reorganization was necessary to address operational and liquidity difficulties resulting from factors such as the slowing economy, increased competition from larger retail chains, the reduction of credit terms by vendors and the service of high-cost debt. Phar-Mor was not able to recover from these problems and liquidated the last of its assets in 2002. In 1998, Mickey Monus was back in court to hear another jury’s decision. Monus was charged with obstruction of justice related to a jury tampering charge from his first trial. One of Monus’ friends did plead guilty to offering a $50,000 bribe to a juror. Monus was sentenced to 19 ½ years in federal prison for his involvement in the corporate fraud, he denied any knowledge of the bribery and cried when a U.S. District Court jury acquitted him on the jury tampering charges. His sentence was later reduced to about 12 years in prison and 5 years of supervised release when Mickey and wife Mary Ciferno cooperated with the FBI in a case against anotherYoungstown fraudster. Mickey and Mary were married at the Elkton, Ohio prison camp in 1998. Mary served as a paralegal on Mickey’s defense team.5 Monus reportedly now lives in Florida.6 REQUIRED  Some of the members of Phar-Mor’s financial management team were former auditors for Coopers & Lybrand. (a) Why would a company want to hire a member of its external audit team? (b) If the client has hired former auditors, would this affect the independence of the existing external auditors? (c) How did the Sarbanes-Oxley Act of 2002 and related rulings by the PCAOB, SEC or AICPA affect a public company’s ability to hire members of its external audit team? (d) Is it appropriate for auditors to trust executives of a client?  (a) What factors in the auditor-client relationship can put the client in a more powerful position than the auditor? (b) What measures has and/or can the profession take to reduce the potential consequences of this power imbalance?  (a) Assuming you were an equity investor, would you pursue legal action against the auditor? Assuming the answer is yes, under what law(s) would you bring suit and what would be the basis of your claim? (b) Define negligence as it is used in legal cases involving independent auditors. (c) What is the primary difference between negligence and fraud; between fraud and recklessness?  Coopers & Lybrand was sued under both federal statutory and state common law. The judge ruled that under Pennsylvania law the plaintiffs were not primary beneficiaries. Pennsylvania follows the legal precedent inherent in the Ultramares Case. (a) In jurisdictions following the Ultramares doctrine, under what conditions can auditors be held liable under common law to third parties who are not primary beneficiaries? (b) How do jurisdictions that follow the legal precedent inherent in the Rusch Factors case differ from jurisdictions following Ultramares?  Coopers was also sued under the Securities Exchange Act of 1934. The burden of proof is not the same under the Securities Acts of 1933 and 1934. Identify the important differences and discuss the primary objective behind the differences in the laws (1933 and 1934) as they relate to auditor liability?  (a)The auditors considered Phar-Mor to be an inherently “high risk” client. List several factors at Phar-Mor that would have contributed to a high inherent risk assessment. (b) Should auditors have equal responsibility to detect material misstatements due to errors and fraud? (c) Which conditions, attitudes, and motivations at Phar-Mor created an environment conducive for fraud could have been identified as red flags by the external auditors?  The popular press has indicated that inventory fraud is one of the biggest reasons for the proliferation of accounting scandals. (a) Name two other high profile cases where a company has committed fraud by misstating inventory. (b) What makes the intentional misstatement of inventory difficult to detect? How was Phar-Mor successful in fooling Coopers & Lybrand for several years with overstated inventory? (c) To help prevent or detect the overstatement of inventory, what are some audit procedures that could be effectively employed?