Assume you are on a jury hearing a trial involving a large national drugstore company. Your immediate task is to identify suspicious events in the following evidence that suggest financial fraud may have occurred.

In just seven years, the company grew from 15 to 310 stores, reporting sales of more than $3 billion. Some retail experts believed the company was going to be the next Walmart. The apparent secret of the company's success was its ability to attract customers to its stores by selling items below cost. Then the company would make it easy for customers to buy other items, particularly pharmaceuticals, which earned a high gross profit. This strategy appeared to be working, so the company's top executives built up massive pharmaceutical inventory at its stores, causing total inventory to increase from $11 million to $36 million to $153 million in the past three years. The company hadn't installed a perpetual inventory sys- tem, so inventory had to be physically counted at each store to determine the cost of goods sold. To help its auditors verify the accuracy of these inventory counts, top management agreed to close selected stores on the day inventory was counted. All they asked was that they be given advance notice of which stores' inventory counts the auditors were planning to attend, so that the temporary closures could be conveyed to employees and customers at those stores. The external auditors selected four stores to test each year and informed the company several weeks in advance. To further assist the auditors with counting the inven- tory, top management reduced the inventory levels at the selected stores by shipping some of their goods to other stores that the auditors weren't attending.

After the inventory was counted and its cost was calculated, the company applied the LC&NRV test. On a store-by-store basis, top management compared the unit cost and net realizable value of inventory items and then prepared journal entries to write down the inventory. Some of the journal entries were large in amount and involved debiting an account called "Cookies" and crediting the inventory account. Management reported that the Cookies account was used to accumulate the required write-downs for all the company's stores. Just before the financial statements were finalized, the Cookies account was emptied by allocating it back to each of the stores. In one instance, $9,999,999.99 was allocated from Cookies to a store's account called "Accrued Inventory."

Required:

Prepare a list that summarizes the pieces of evidence that indicate that fraud might have occurred and, for each item on the list, explain why it contributes to your suspicion.

Epilogue: This case is based on a fraud involving Phar Mor, as described by David Cottrell and Steven Glover in the July 1997 issue of the CPA Journal. Phar Mor's management was collectively fined over $1 million and two top managers received prison sentences ranging from 33 months to five years. The company's auditors paid over $300 million in civil judg- ments for failing to uncover the fraud.