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 of Youngstown, 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 ofthe 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..........

REQUIRED [1] 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?
[2]

(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?
[3]

(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?
[4] 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?
[5] 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?
[6] 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?
[7]

(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?