On May 19, 1987, a short article in The Wall Street Journal reported that ZZZZ Best Company, Inc., of Reseda, California, had signed a contract for a \($13.8\) million insurance restoration project. This project was just the most recent of a series of large restoration jobs obtained by ZZZZ Best (pronounced “zee best”). Located in the San Fernando Valley of southern California, ZZZZ Best had begun operations in the fall of 1982 as a small, door-to-door carpet cleaning operation. Under the direction of Barry Minkow, the extroverted 16-year-old who founded the company and initially operated it out of his parents’ garage, ZZZZ Best experienced explosive growth in both revenues and profi ts during the fi rst several years of its existence. In the three-year period from 1984 to 1987, the company’s net income surged from less than \($200,000\) to more than \($5\) million on revenues of \($50\) million.

When ZZZZ Best went public in 1986, Minkow and several of his close associates became multimillionaires overnight. By the late spring of 1987, the market value of Minkow’s stock in the company exceeded \($100\) million, while the total market value of ZZZZ Best surpassed \($200\) million. The youngest chief executive offi cer in the nation enjoyed the “good life,” which included an elegant home in an exclusive suburb of Los Angeles and a fi re-engine red Ferrari. Minkow’s charm and entrepreneurial genius made him a sought-after commodity on the television talk show circuit and caused the print and visual media to tout him as an example of what America’s youth could attain if they would only apply themselves. During an appearance on The Oprah Winfrey Show in April 1987, Minkow exhorted his peers with evangelistic zeal to “Think big, be big” and encouraged them to adopt his personal motto, “The sky is the limit.”

Less than two years after appearing on Oprah, Barry Minkow began serving a 25-year prison sentence. Tried and convicted on 57 counts of securities fraud, Minkow had been exposed as a fast-talking con artist who swindled his closest friends and Wall Street out of millions of dollars. Federal prosecutors estimate that, at a minimum, Minkow cost investors and creditors \($100\) million. The company that Minkow founded was, in fact, an elaborate Ponzi scheme. The reported profi ts of the fi rm were nonexistent and the large restoration contracts, imaginary. As one journalist reported, rather than building a corporation, Minkow created a hologram of a corporation. In July 1987, just three months after the company’s stock reached a market value of \($220\) million, an auction of its assets netted only \($62,000.

Unlike\) most fi nancial frauds, the ZZZZ Best scam was perpetrated under the watchful eye of the Securities and Exchange Commission (SEC). The SEC, a large and reputable West Coast law fi rm that served as the company’s general counsel, a prominent Wall Street brokerage fi rm, and an international public accounting fi rm all failed to uncover Minkow’s daring scheme. Ultimately, the persistence of an indignant homemaker who had been bilked out of a few hundred dollars by ZZZZ Best resulted in Minkow being exposed as a fraud.

How a teenage fl imfl am artist could make a mockery of the complex regulatory structure that oversees the U.S. securities markets was the central question posed by a congressional subcommittee that investigated the ZZZZ Best debacle. That subcommittee was headed by Representative John D. Dingell, chairman of the U.S. House Committee on Energy and Commerce. Throughout the investigation, Representative Dingell and his colleagues focused on the role the company’s independent auditors played in the ZZZZ Best scandal.

The ZZZZ Best prospectus told the public that revenues and earnings from insurance restoration contracts were skyrocketing but did not reveal that the contracts were completely fi ctitious. Where were the independent auditors and the others that are paid to alert the public to fraud and deceit?1 Like many other daring fi nancial frauds, the ZZZZ Best scandal caused Congress to reexamine the maze of rules that regulate fi nancial reporting and serve as the foundation of the U.S. system of corporate oversight. Daniel Akst, however, a reporter for The Wall Street Journal who documented the rise and fall of Barry Minkow, suggested that another ZZZZ Best was inevitable. “Changing the accounting rules and securities laws will help, but every now and then a Barry Minkow will come along, and ZZZZ Best will happen again. Such frauds are in the natural order of things, I suspect, as old and enduring as human needs.”

Barry Minkow was introduced to the carpet cleaning industry at the age of 12 by his mother, who helped make ends meet by working as a telephone solicitor for a small carpet cleaning fi rm. Although the great majority of companies in the carpet cleaning industry are legitimate, the nature of the business attracts a disproportionate number of shady characters. There are essentially no barriers to entry: no licensing requirements, no apprenticeships to be served, and only a minimal amount of startup capital is needed. A 16-year-old youth with a driver’s license can easily become what industry insiders refer to as a “rug sucker,” which is exactly what Minkow did when he founded ZZZZ Best Company. Minkow quickly learned that carpet cleaning was a difficult way to earn a livelihood. Customer complaints, ruthless competition, bad checks, and nagging vendors demanding payment complicated the young entrepreneur’s life. Within months of striking out on his own, Minkow faced the ultimate nemesis of the small businessperson: a shortage of working capital. Because of his age and the fact that ZZZZ Best was only marginally profi table, local banks refused to loan him money. Ever resourceful, the brassy teenager came up with his own innovative ways to finance his business: check kiting, credit card forgeries, and the staging of thefts to fleece his insurance company. Minkow’s age and personal charm allowed him to escape unscathed from his early brushes with the law that resulted from his creative financing methods. The ease with which the “system” could be beaten encouraged him to exploit it on a broader scale........ 

Questions

1. Ernst & Whinney never issued an audit opinion on financial statements of ZZZZ Best but did issue a review report on the company’s quarterly statements for the three months ended July 31, 1986. How does a review differ from an audit, particularly in terms of the level of assurance implied by the auditor’s report?

2. SAS No. 106, “Audit Evidence,” identifies the principal “management assertions”
that underlie a set of financial statements. The occurrence assertion was particularly critical for ZZZZ Best’s insurance restoration contracts. ZZZZ Best’s auditors obtained third-party confi rmations to support the contracts, reviewed available documentation, performed analytical procedures to evaluate the reasonableness of the revenues recorded on the contracts, and visited selected restoration sites. Comment on the limitations of the evidence that these procedures provide with regard to the management assertion of occurrence.

3. In testimony before Congress, George Greenspan reported that one means he used to audit the insurance restoration contracts was to verify that his client actually received payment on those jobs. How can such apparently reliable evidence lead an auditor to an improper conclusion?

4. What is the purpose of predecessor-successor auditor communications? Which party, the predecessor or successor auditor, has the responsibility for initiating these communications? Briefl y summarize the information that a successor auditor should obtain from the predecessor auditor.

5. Did the confi dentiality agreement that Minkow required Ernst & Whinney to sign improperly limit the scope of the ZZZZ Best audit? Why or why not? Discuss general circumstances under which confi dentiality concerns on the part of a client may properly affect audit planning decisions. At what point do clientimposed audit scope limitations affect the type of audit opinion issued?

6. What procedures, if any, do professional standards require auditors to perform when reviewing a client’s pre-audit but post-year-end earnings press release?