- Rationalization:
Mickey is very confident. He always believed that “things would improve”; “future profits will reverse temporary "adventure". Every time Monus would divert company funds to pay the operating expenses of his basketball league he maintained that they were advances backed by his word to some day pay them all back. He admitted that he did accounting fraud intentionally to avoid detection of audit techniques and procedures.
- Capability:
Mickey had a strong personality. Although he is not the CEO, Phar-Mor was under the control of Mickey himself. Monus’ management team either feared physical harm or disappointment. It is also possible that the fraud team honestly believed that Monus could turn the company around if they could only hide the fraud a little longer. More likely, Mickey had an uncanny ability to keep straight face. Even though the evidence at trial showed Monus was guilty of criminal fraud beyond a reasonable doubt, he continued plead his case that he acted in good faith in directing the fraud and did nothing criminal.
Audit Failures
Insufficient and Unreliable Evidence
Coopers relied heavily on the Phar-Mor accounting department’s compilation of evidence of account balances and details instead of independently verifying management assertions in high risk areas. Coopers was aware that Phar-Mor’s accountants never provided the auditors with requested documents or data without first carefully reviewing them. Evidence at trial revealed that Coopers would have uncovered fraudulent account balances and journal entries had they reviewed sub-ledger accounts and supporting documents. Coopers would have likely uncovered the unauthorized checks written for Mickey Monus’ basketball league expenses by focusing on controls over the cash disbursement process at Phar-Mor. Substantive tests of details with respect to the authorization, valuation, and existence assertions would have revealed fraudulently overstated inventory. Scanning for unusual journal entries or investigating zero-balance accounts with management may have uncovered the existence of fraud.
The Perfect Storm: Management Fraud and Inexperienced Auditors
Phar-Mor’s fraud team was well-versed in the art of auditing accounting firms; two of the five members of the fraud team were former Coopers and Lybrand auditors. Additionally, Coopers’ audit team was composed largely of junior level staff inexperienced in detecting fraud, let alone management fraud. The auditors based their assessment of Phar-Mor’s books primarily on compilations of data and documents that were carefully screened and manipulated by Phar-Mor management to conceal any evidence of fraud. The audit team alerted Phar-Mor management well in advance of any planned visits to individual stores for a physical inventory inspection. During a given year, the auditors would verify the existence and valuation assertions at four individual stores by haphazardly sampling 25 – 30. By 1990, Phar-Mor’s fraudulent subledger accounts concealed almost $40 million. In order to hide these losses from year-end auditors, the fraud team added $200,000 to the inventory account of each store that they knew would not be audited.
The auditors tested the reasonableness of Phar-Mor’s cost of inventory ending based on management’s gross profit margin schedule and a third party’s physical count and valuation of inventory items. The auditors concluded that Phar-Mor’s ending inventory was fairly stated because their gross profit margin schedules were reasonable. Oddly enough, the auditors then concluded that Phar-Mor’s gross profit schedules were reasonable because the cost of inventory was fairly stated (which was originally derived from the gross profit schedules). The auditors claimed to have performed additional procedures on the gross profit schedules by tracing inventory costs to purchase orders. Any differences the auditors noticed between their expected gross profit margin and the recomputed gross profit margin were excused as sampling error.
Physical Inventory
Inventory at Phar-Mor increased rapidly from $11 million in 1989 to $36 million in 1990 and $153 million in 1991. Coopers identified inventory valuation as a high-risk area in its working papers. However, Coopers told Phar-Mor beforehand which locations it would be testing for inventory. Only 4 of 310 stores were tested and only 25-30 items were selected at those stores to perform price testing. Although, Coopers claimed they did additional procedures on inventory schedules to compensate for weaknesses in the "price test", these additional tests were based on locations Phar-Mor had already manipulated inventory prices. The holes in Coopers’ inventory audit left Phar-Mor management free to overstate inventory at all other unaudited locations. Phar-Mor’s fraud team admitted to increasing the price of Coke, which normally sold for $0.89, to more than $2 a bottle.
Mechanics of the Fraud
Conditions for the Fraud
A primary driver of the fraud on Phar Mor stakeholders was the increasingly competitive landscape in which Phar-Mor operated. The deep-discount retail market had virtually cornered its marketplace within a relatively short period. Between 1985 and 1990, the number of deep discount stores increased from 313 to over 700 stores, with at least 300 of them being Phar-Mor. The chain itself had over that time become Wal-Mart’s primary competitor, vowing to undersell its ambitious competitor by low margin selling and “power buying” business strategies. However, as competition in this market continued to increase, Phar-Mor’s gross margins (a key factor for its retail performance) eroded rather significantly. In fact, by 1990, its real gross margin had been reduced to less than 15.5%, a fact that demonstrates that Phar-Mor could no longer maintain its existing price structure.
Obstinate and ambitious as he was, Monus pushed Phar Mor’s expansion ahead refusing to believe his low margin, power buying model could not sustain the companies’ blistering pace8. Rather than identifying practical ways to remain competitive, Monus resorted to fraud to maintain the healthy appearance of his company. Monus was able to temporarily offset the companies’ yearly losses by booking as sales revenue multi-million dollar exclusivity payments he had negotiated with vendors. As gross margins continued to go south, so did Phar Mor’s ability to pay off its vendors. Monus nearly avoided bankruptcy amid pressure from his suppliers by a last minute $200 million capital infusion from private investor Corporate Partners, LLC. Monus believed that by temporarily understating liabilities on Phar Mor’s books he could buy enough time to reverse the effects of the fraud when Phar Mor’s gross margins improved.
Company Appearances
Monus had the innate ability to maintain the appearance of control over his business and over his business associates, including those employed within the Phar-Mor accounting and financial reporting functions. He was able to accomplish this in a number of ways, but most notably through his continual appearance in charitable, social, and athletic spheres. His World Basketball League was his primary outlet to establish the greatness and the presence of Phar-Mor as a large company. The league was a collection of 11 teams represented small towns across the country (like Youngstown). Monus personally oversaw the development of the league, and used Phar-Mor funding to finance its success.
In the midst of the company’s struggle to secure private equity financing, Phar-Mor hosted its own golf tournament, where Monus personally distributed thousands of dollars in award checks to participants. The extravagance of Monus’ social display closely mirrored his modus operandi at Phar-Mor, which was to maintain the appearance of a healthy company at any cost. By the time the fraud at Phar-Mor had been exposed, it appeared that Monus’ primary responsibility was managing the fraud through his power over the accounting and financial reporting staff.
Lessons To Be Learned
Auditors
In this case, Coopers didn’t knowingly participate in the Phar-Mor fraud. Coopers was nevertheless sued under a theory of fraud for not performing its audit in accordance with GAAS. The plaintiff-stakeholders argued that Coopers’ audit was deficient in not discovering management’s fraud over period of five years; its issuance of an unqualified opinion constituted recklessness. There are some lessons that auditors can learn from this litigation to avoid becoming insurers of management fraud in the future. In this case, Coopers’ only defense was that, at a bare minimum, it complied with GAAS principles in performing its audit. When billions of investors’ dollars are at stake, the bare minimum audit is simply not sufficient to avoid civil liability.
Auditors should maintain independence as the number one rule in their work. The auditors should be aware and avoid any possible taint on his independence; Coopers risked losing its independence by allowing the audit of a company in which two of its former accountants became employees in the accounting department. The public should be skeptical where an audit firm engages a client with potential conflicts of interest. Coopers needed to be aware that it had become more susceptible to failing to detect fraud when its audit techniques were predictable and familiar with management staff. The auditor should not accept collateral engagements with his audit clients unless he can maintain the appearance of independence and fulfill his audit duties in a professional manner.
Maintaining a good relationship with the client may help auditors to get more information about the company and uncover problems. But over-friendly relationships with management sometimes have an adverse effect, such as reducing the auditor’s ability to maintain his professional skepticism and detect fraud. To avoid such a risk of fraud, different audit partners can and should rotate who conducts the audit over a given client every year or so. Prior knowledge of client's business can prevent a complete audit from taking place. Things may change with the change of business environment and management structure. Rotating audit partners may help ensure that future auditors conduct an annual reassessment of the risk for fraud. Presuming the absence of fraud based on historical data or audits and conducting fewer audit procedures as a result of such a presumption gives management an opportunity to perpetrate fraud.
Corporate Management Team
There are some lessons that management can learn in the future to avoid the risk of succumbing to fraud. Management fraud is the hardest type of fraud to detect and prevent given the power management usually has to override controls over the financial reporting process. Management fraud usually starts at the top with the most powerful officer wielding control over those underneath him. Power is usually exercised in the form of threats, bribes, or unfulfilled promises. Sometimes the threats of termination of employment or physical harm or bribes are enough to cause the most honest individuals to succumb to complicity in fraud.
The tone at the top is absolutely important to adopting and enforcing corporate management policies that will deter management from committing fraud. Phar-Mor may have avoided fraud if its biggest stakeholder (Giant Eagle) had been more actively involved in running the day-to-day operations of the company. Giant Eagle and Phar-Mor CEO, David Shapira, was amazingly oblivious to the fact that Mickey Monus had spearheaded a massive five year fraud on the company. In hindsight, it is apparent that Shapira did no more than review periodic compilations of financial results by Phar-Mor’s fraud team. It is possible that Shapira was too preoccupied with fulfilling his responsibilities as CEO of Giant Eagle that he neglected to oversee the operations of Phar-Mor. In the future, the law should provide an incentive for private companies’ corporate management to share in the responsibility for preventing management fraud. The imputation of joint and several liability to executive officers may help deter the possibility of management fraud.
In Phar-Mor’s case, COO Mickey Monus made unfulfilled promises and threatened physical harm to those underneath him. In hindsight, had the law afforded whistleblower protection to those under Monus’ direction, the fraud may never have occurred. The key to deterring fraud in the first place, of course, is awareness of the protection whistleblowers have in the law. Additionally, corporate management should be made aware of the consequences for committing fraud against the company include career-ending criminal liability and potentially large civil liability.
Investors and Suppliers
Monus and his staff were not held to higher standards of accountability during the course of the fraud. This was the result of a number of reasons, including the fact that Phar-Mor was not a publicly traded company and only had a few key investors, the private investors made little or no effort to become more active in the management oversight. Moreover, the investors and suppliers continued to work with Phar-Mor based on the appearance of its rapid growth. As the company opened new store after new store, the thought that Phar-Mor’s ability to compete with Walmart could be financial fiction was completely sidestepped by the showmanship and aggression that Monus used to direct the business.
People who commit fraud do so when they perceive a low propensity of getting caught. Phar-Mor’s investors and suppliers could have modified this perception by instilling greater risks of getting caught. The board of directors that represented the investors should have demanded more profound financial reports, and making inquiries of the CEO, COO, and CFO about the financial condition of the company. Relying on the observations and perception of only one person for information (In this case, Monus) is not as effective as inquiring on all senior management, because it usually takes more than one person to manage a fraud effectively.
Regulators
One primary lesson for regulators, such as the SEC, is to improve the visibility of whistleblower protection laws. CFO Pat Finn, who Monus targeted to construct the fraud, was well aware of his predicament years before Phar-Mor ultimately met its demise. He openly discussed his concerns with former colleagues and friends, yet remained firm in his belief that circumstances would improve and the fraud would eventually be phased out. Despite the fact that the conditions grew progressively more troublesome for Finn, he continued the fraud for fear of retaliation and fear of potential jail time. He Finn come forward earlier, either to the board, or to the authorities, the extent of the losses would likely not have been as significant. Whistleblower protection laws need to be strong enough to create incentive to overcome such fears, and be clear enough to demonstrate how coming forward has its advantages.
Conclusion
The Phar-Mor Case is a classic example of how inside management colluded and turned to fraud to cover up large company losses. Phar-Mor’s management, as with other management-perpetrated frauds, believed in the fraud and executed it with the misplaced hope that everything would one day turn around. Unfortunately, Phar-Mor’s fraud team lacked the foresight and wisdom to see their end from the beginning; in the end, whether in this life or the next, the wrongdoer must pay for his crimes.
Phar-Mor Company History, www.fundinguniverse.com/company-histories/PharMor-Inc-Company-History.html
US v. Michael Monus, 1997 FED App. 0311P (6th Cir.)
Finding Auditors Liable for Fraud: What the Jury Heard in the Phar-Mor Case, CPA Journal (July 1997)
Finding Auditors Liable for Fraud: What the Jury Heard in the Phar-Mor Case, CPA Journal (July 1997)
US v. Michael Monus, 1997 FED App. 0311P (6th Cir.)
“Finding Auditors Liable for Fraud: What the Jury Heard in the Phar-Mor Case,” CPA Journal (July 1997)
How to Steal $500 Million, Public Broadcasting Service (1994)
8 How to Steal $500 Million, Public Broadcasting Service (1994)
“Let Them Know Someone’s Watching.” Journal of Accountancy (May 2002)