CASE 2.9

PERRY DRUG STORES, INC.

For decades, the corner drug store served as a hub of activity on Main Street of most small towns and cities across the country.¹ Many of Norman Rockwells most popular works picture Moms and Dads, boys and girls, and homecoming soldiers enjoying the friendly and familiar confines of the hometown drug store. The latter part of the 20^th century, however, dealt harshly with the neighborhood drug store. Nationwide drug store chains and large discount retailers, most notably Wal-Mart, forced a multitude of small drug stores out of business. To stave off larger competitors, many locally owned drug stores consolidated into regional chains. In the early 1990s, Michigan-based Perry Drug Stores, Inc., ranked as one of the largest of these regional chains.

In 1957, a 27-year-old pharmacist, Jack Robinson, founded Perry Drug Stores by buying an existing business, which had been established in 1920. Perry Drug Stores grew rapidly under Robinsons leadership. Robinson incorporated his business in 1980 and later took the company public, listing its stock on the New York Stock Exchange. By 1994, Perry operated more than 200 retail outlets, had a workforce of approximately 5,000 employees, and boasted annual revenues of $700 million.

Although the 14^th largest drug retailer in the United States by the early 1990s, Perry Drug Stores could not compete with the much larger nationwide drug store chains. Rite Aid, Eckerd, and other nationwide drug retailers benefited from economies of scale unavailable to Perry. Perrys larger competitors had invested millions of dollars in state-of-the-art inventory management systems that linked these companies to their major suppliers via electronic data interchange (EDI) networks. These systems allowed the nationwide chains to maximize sales while minimizing inventory-related carrying costs, including losses due to inventory obsolescence. By comparison, Perry relied largely upon outdated inventory management and control systems. For example, Perrys retail stores did not have point-of-scale scanning devices at sales terminals. Likewise, Perry had not installed computer-based logistics systems to ensure timely and accurate deliveries to retail stores from the companys merchandise distribution centers. Perrys inability to monitor precisely daily inventory movements and balances complicated the efforts of company executives to evaluate the results of chain-wide sales promotions and other special programs. At the store level, the absence of detailed inventory data forced the companys store managers to rely heavily upon their own intuition in making critical decisions, such as which products to stock in their individual stores.

Perrys inventory control problems were magnified greatly in the early 1990s. To compete more effectively with the national drug store chains, Perry rapidly expanded its product line in the front end of its stores to include a wide array of cosmetics, personal beauty treatment products, and home office supplies. One company executive noted that by 1991 Perrys retail outlets stocked approximately two hundred shampoos, more than one hundred hair sprays, and two dozen mousses. In 1992, Perrys inventory problems contributed to the companys losing its position as the number-one drug store chain in the metropolitan Detroit area, which easily ranked as Perrys largest sales region.

A former Perry executive who accepted a position with one of the large nationwide drug store chains in the early 1990s commented on the stark differences between the nationwide chain and Perry. The executive noted that Perry lacked sufficient funds to invest in technology needed to effectively and efficiently manage a large retail business. He also observed that leaving Perry and accepting a position with the nationwide chain was comparable to going from the Dark Ages to the 21^st Century.²

In 1992, Perrys financial fortunes took a sharp turn for the worse when company executives discovered an inventory shortage of approximately $20 million, a shortage that went unreported in the companys financial statements. The following year, Perry wrote off the inventory shortage, which contributed to the company suffering a huge loss. Late in 1994, Rite Aid, the nations largest drug retailer with 2,500 stores and $4 billion in annual revenues, purchased Perry for $132 million. Exhibit 1 presents key financial data for Perry Drug Stores for the period 1989-1993.

--Insert Exhibit 1--

Perrys Inventory Problems

Perry Drug Stores used a periodic inventory system and both the LIFO and FIFO costing methods. In a typical year, Perry applied the LIFO method to approximately 70 percent of its total inventory and the FIFO method to the remainder. Throughout the early 1990s, Perry retained an outside firm to count the inventory of each of its stores. The firm performed these counts in regular cycles, meaning it counted the same group of Perry stores at approximately the same point each year. Following the completion of each cycle count, Perry adjusted the given stores recorded inventory balances to agree with the physical inventory results and recorded a collective book-to-physical inventory adjustment for the general ledger inventory account at corporate headquarters. Between the annual physical inventory counts, Perry used the gross profit method to estimate each stores inventory and to arrive at a collective inventory figure (estimate) for the company as a whole.

Perry would add to the amount of the [recorded] beginning inventory the actual cost of its goods purchased through its accounts payable system (cost of goods acquired for sale). Perry would then reduce the inventory by an estimate of the cost of goods sold calculated using the estimated gross profit margin. Perry included the estimated inventory balance on its general ledger, until the actual inventory was verified through a new physical count.³

Arriving at a reasonable estimated gross profit margin percentage is the most critical step in applying the gross profit method. If an entitys estimated gross profit margin percentage varies significantly from the actual percentage, the resulting estimates of cost of sales and inventory will be unreliable. The estimates yielded by the gross profit method can be made more reliable by applying an estimated gross profit margin percentage to each major inventory group. However, Perry used an overall estimated gross profit margin percentage in applying this method. Perrys management regularly reviewed the estimated gross profit margin percentage used in applying the gross profit method. Among other factors, the companys management considered changes in merchandising plans and the year-to-date results of its cycle inventory counts during these reviews. Perry typically revised its estimated gross profit margin percentage more than once per year.

Perrys cycle counts in early fiscal 1992 revealed much larger differences than normal between the book inventories and inventory values determined by physical inventory counts. (Recognize that the book inventories reflected estimates resulting from yearlong application of the gross profit method.) By the end of the second quarter of fiscal 1992, these differences totaled $7.6 million. Following the completion of all cycle counts for fiscal 1992, the collective difference amounted to more than $20 million. This figure alarmed Perrys management since it represented approximately 14 percent of the companys collective book inventory of $140.2 million.⁴

Unlike in previous years, as fiscal 1992 progressed, Perry did not immediately adjust the corporate inventory account to recognize the book-to-physical differences uncovered by the cycle inventory counts because Perrys management believed the large discrepancies between stores book and physical inventories were not reasonable. Instead of adjusting the corporate inventory account, management created a suspense account to which it transferred the differences between given stores book and physical inventories. That is, after adjusting a stores book inventory to agree with its physical inventory results, Perry transferred the difference to a general ledger account referred to as the Store 100" inventory account. (Store 100 was a fictitious store.) Perrys management included Store 100's inventory balance in the total inventory figure reported for the company in its interim financial statements for 1992. Again, by the end of fiscal 1992 (October 31, 1992), the balance of the Store 100 inventory account exceeded $20 million.

Shortly after the 1992 cycle counts began revealing large inventory shortages, Perrys chief financial officer (CFO), Jerry Stone, initiated a company-wide investigation to uncover the source of the shortages. Stone retained Arthur Andersen & Co., Perrys independent audit firm, to perform a study to determine whether systems problems were the cause of the discrepancy. This study was carried out by members of Andersens computer risk management group, none of whom were involved in the annual audits of Perry. When that study suggested that computer breakdowns were not responsible for the inventory shortages, Stone hired private detectives. These detectives, along with Perrys internal auditors, searched for evidence of large-scale inventory thefts. These efforts also failed to reveal the source of the inventory shortages. Finally, Stones subordinates performed an intensive study of a Perry store that had recently installed a point-of-sale system. The data collected by that stores point-of-sale system allowed Stone to more accurately assess the companys actual gross profit margins on the products it sold. Although Perry did not publicly reveal those data, they apparently failed to convince Stone that the estimated gross profit margin percentage being applied by the company was unreasonable.⁵

Resolving the Inventory Crisis: Input from Andersen

Before becoming Perrys CFO, Stone served for twelve years as an audit partner with Arthur Andersen & Co. Quite naturally, then, Stone relied heavily on his contacts at his former firm in deciding how to resolve Perrys 1992 inventory crisis.

Richard Valade, an Andersen audit partner, supervised the annual audits of Perry Drug Stores from 1984 through 1987 and again from 1991 through 1993. Stone notified Valade of the $20 million inventory shortage before Andersen began its audit of Perrys 1992 financial statements. In September 1992, shortly after learning of the inventory shortage, Valade and a subordinate prepared a General Risk Analysis (GRA) memorandum for the 1992 Perry audit. Andersen prepared this document for audit engagements to identify the financial statement items requiring particular attention during each engagement. A GRA memo also identified the apparent overall audit risk posed by the engagement and the planned materiality level for the engagement.

The GRA memo for the 1992 Perry audit indicated that Andersen expected an overall moderate audit risk for that engagement. This assessment reflects that auditor expects errors but has reason to believe they are not likely to be material in relation to the financial

statements. Andersen established an overall materiality standard of $700,000 for the engagement.⁶

During the 1992 Perry audit, the Andersen audit engagement team applied a wide range of audit tests to Perrys inventory, tests more extensive than those normally performed on that inventory.⁷ The auditors applied many of these tests expressly to determine the source of the large inventory shortage revealed by Perrys 1992 cycle inventory counts. The SEC identified the following inventory audit procedures, among others, that Andersen completed during the 1992 Perry audit:

1. Conducted extensive analytical tests to evaluate the reasonableness of the estimated gross profit margins Perry used during 1992. These procedures included testing the actual gross profit margins of individual stores and examining Perrys historical sales and inventory data and comparable industry data.

2. Performed tests to investigate whether theft or changes in Perrys merchandising plans and business policies likely accounted for the inventory shortage.

3. Observed and tested physical inventory counts at five Perry stores. These audit procedures revealed that the physical inventory at these stores was much smaller than each stores book inventory. (Note: Similar to its procedure involving other stores, Perry transferred the book-to-physical differences for these stores to the Store 100 inventory account.)

4. Reviewed the results of Perrys investigations to identify the source of the inventory shortage.

5. Reviewed the results of the study performed by Arthur Andersens computer risk management group that was intended to uncover the source of the inventory shortage.

Andersens 1992 inventory audit procedures failed to uncover the source of the large inventory shortage. Before Andersen completed the 1992 Perry audit, Perrys management decided not to write off the $20.3 million balance of the Store 100 inventory account. Instead, it chose to include the $20.3 million in the dollar amount reported for inventory in the companys 1992 balance sheet. Perry executives presented this decision to the companys board of directors during a meeting that Richard Valade attended.

Before the December 1992 meeting with Perrys board of directors, Valade discussed the large inventory shortage with several fellow Andersen partners, including the Regional Practice Director. Valade asked two of these partners to attend the meeting with Perrys board. During the meeting, Valade did not object to the boards decision to ignore the apparent inventory shortage in preparing the companys 1992 financial statements.

At that meeting, Valade reported that he did not object to including the Store 100 inventory as an asset on Perrys balance sheet and that he would sign an unqualified opinion. . . . The minutes [of the meeting] also reflect that Valade recommended that Perry conduct a simultaneous chain-wide [physical] inventory as soon as possible to discover the reasons for the discrepancy.

Perry filed its fiscal 1992 10-K with the SEC in late 1992. Perrys income statement included in the 10-K reported a net income of $8.3 million, as reflected by Exhibit 1. Had Perry written off the $20.3 million balance of the Store 100 inventory account, the company would have reported a net loss of approximately $6 million for fiscal 1992. Also included in the 10-K was Andersens unqualified audit opinion on Perrys 1992 financial statements, an opinion signed by Richard Valade on December 15, 1992.

SEC Investigates Perry Drug Stores

The management of Perry Drug Stores followed the recommendation of Richard Valade and took a company-wide physical inventory in the spring of 1993. That physical inventory confirmed the large inventory shortage discovered by the company in fiscal 1992. Near the end of fiscal 1993, Perrys management decided to write off the balance of the Store 100 inventory account. Perry included this write-off in a $33.4 million fourth-quarter adjustment. Since management deemed that the $20.3 million inventory write-off resulted from a change in estimate, it did not report the write-off separately in its fiscal 1993 income statement, nor did the company restate its 1992 financial statements for the item. Exhibit 2 presents the paragraph from the Managements Discussion & Analysis (MD&A) section of Perrys 1993 annual report that disclosed the inventory adjustment. Valade did not object to Perrys financial statement treatment of the large inventory adjustment.⁸

--Insert Exhibit 2--

While reviewing the MD&A section of Perrys 1993 10-K, the SEC discovered the $33.4 million adjustment recorded by the company during the fourth quarter of fiscal 1993. In July 1994, after discussing this matter with Perrys management, the SEC insisted that the company restate its 1992 and 1993 financial statements. The SEC required Perry to treat the $20.3 million write-off of the Store 100 inventory account as a correction of an error. This treatment increased Perrys cost of sales for fiscal 1992 by that amount, while decreasing 1993's cost of sales by the same figure. Exhibit 3 presents the key items affected by Perrys restatement of its 1992 and 1993 financial statements. Exhibit 4 contains a portion of the financial statement footnote Perry included in its 1994 10-K to disclose the restatement of its 1992 and 1993 financial statements.

--Insert Exhibits 3 & 4--

Following Perrys restatement of its 1992 and 1993 financial statements, the SEC launched an investigation of the company. The investigation centered on the circumstances surrounding Perrys decision not to write off the balance of the Store 100 inventory account in fiscal 1992. In 1998, the SEC issued two enforcement releases reporting the results of that investigation.

The SECs first enforcement release focused on Jerry Stone, the former Arthur Andersen audit partner who served as Perrys CFO during the early 1990s. In this release, the SEC chastised Stone for signing Perrys 1992 10-K: ... by signing Perrys 1992 Form 10-K Stone caused Perry to file with the Commission financial statements that did not accurately reflect the value of Perrys inventory.⁹ The SEC also sanctioned Stone for failing to correct Perrys 1992 financial statements. This sanction ordered Stone to cease and desist from causing any violation and future violation of federal securities laws.

The SECs second enforcement release involving Perry Drug Stores focused on Richard Valade, Perrys audit engagement partner during the early 1990s. This release criticized Valade for allowing Perrys management to include the balance of the Store 100 inventory account in the companys year-end inventory for fiscal 1992. According to the SEC, Valade overlooked a key auditing precept during the 1992 audit. Auditing standards explicitly state that evidence obtained by physical examination is more persuasive than evidence produced by indirect tests.¹⁰ During the 1992 audit, Valade collected and reviewed significant physical evidence yielded by his firms and Perrys physical inventory counts. This evidence indicated that the companys inventory was overstated. Nevertheless, Valade eventually chose to rely on the results of analytical tests that suggested the data produced by the physical inventory counts were unreliable. These analytical procedures consisted principally of Arthur Andersens tests of the gross profit margins actually realized by a small sample of stores, tests that suggested the estimated gross profit margin percentage used by Perry in applying the gross profit method was reasonable.

Despite Valades consultations with his partners and the additional audit procedures he performed, he nevertheless failed to obtain sufficient competent evidential matter to resolve the inventory discrepancy issue. Valade failed to either: a) require Perry to reconcile the recorded inventory and the physical inventory and record the proper adjustment to the books and records; (b) discredit either the recorded inventory or the physical inventory and require Perry to adjust the books and records accordingly; (c) issue a qualified opinion; or (d) refrain from issuing an audit opinion until the matter was resolved.

The SEC publicly censured Valade for his conduct during the 1992 Perry audit. This censure simply required Valade to comply in the future with all applicable practice requirements for auditors of SEC registrants. Both Richard Valade and Jerry Stone consented to the SEC sanctions imposed on them without admitting or denying the federal agencys reported findings summarized in this case.

Exhibit 1

Perry Drug Stores, Selected

Financial Data, 1989-1993 (in thousands)

1993 1992 1991 1990 1989

Net Sales $698,432 $674,431 $640,821 $633,207 $645,209

Cost of Sales 544,029 494,314 464,454 459,795 468,460

Pre-tax Operating

Earnings (26,028) 11,357 6,884 2,856 8,503

Interest Expense 8,483 10,430 12,606 13,148 13,053

Income Tax Expense (7,519) 3,043 800 -- 141

Net Income (18,509) 8,314 3,097 (6,205) 7,112

Inventory 111,263 140,202 123,674 121,351 124,934

Current Assets 146,488 175,463 161,302 155,007 150,648

Current Liabilities 95,506 93,488 89,262 113,895 91,672

Total Assets 239,454 270,508 260,141 260,138 251,148

Stockholders

Equity 51,154 69,456 48,509 44,479 50,314

Note: Perry reported total assets of $258,716,000, inventory of $124,770,000, and stockholders equity of $42,904,000 at the beginning of fiscal 1989.

Exhibit 2

Perry Drug Stores Disclosure

of 1993 Inventory Adjustment

Cost of goods sold in fiscal 1993 increased 4.6% as a percentage of net sales to 77.9% compared to 73.3% in fiscal 1992. Profit margins were impacted by many variables including sales mix, promotional activity and inflation. Prescription margins decreased and continued to be impacted by third party provider pressures and increasing pharmaceutical product costs. Competition, primarily from nondrugstore businesses, has pressured general merchandise margins. Most of the increase in cost of goods sold was reflected in a fourth quarter noncash charge of $33.4 million pretax ($24.0 million after tax) relating primarily to an inventory adjustment identified through the taking of a chain-wide store physical inventories following the installation of new electronic inventory management systems.

Source: Perry Drug Stores 1993 Annual Report, Managements Discussion and Analysis of Results of Operations and Financial Condition.

Exhibit 3

Perry Drug Stores, Restated

Financial Data, 1992-1993 (in thousands)

1993 1992

Cost of Sales $523,765 $514,578

Pre-tax Operating

Earnings (5,764) (8,906)

Income Tax Expense (1,542) (2,934)

Net Income (4,223) (5,972)

Inventory 111,263 119,939

Current Assets 146,060 157,726

Total Assets 239,454 256,222

Stockholders

Equity 51,154 55,170

Note: Perry reported these data in a footnote to its 1994 financial statements. Notice that, as expected, the companys restated inventory, total assets and stockholders equity for 1993 equaled the corresponding amounts originally reported by the company, as shown in Exhibit 1. For undisclosed reasons, the companys restated current assets for 1993 ($146,060,000) were slightly less than the figure ($146,488,000) originally reported by the company, as reflected by Exhibit 1.

Exhibit 4

Perry Drug Stores, Footnote Disclosure in 1994 10-K

Reporting Restatement of 1992 and 1993 Financial Statements

As previously reported, the Company recorded a charge of $33.4 million pretax ($24.0 million after tax) in its 1993 fourth quarter relating primarily to an inventory adjustment. After further analyzing this adjustment, the Company restated its 1993 and 1992 Consolidated Statements of Operations (including the respective quarters) to more appropriately reflect its results of operations

for the periods believed to be affected by the adjustment.

Questions

1. Develop an example to illustrate how using an improper gross profit margin percentage in applying the gross profit method can significantly distort a companys reported inventory and cost of goods sold.

2. Do you believe the inventory accounting procedures Perry applied were reasonable? What criteria are relevant in deciding whether a given companys accounting methods are reasonable or acceptable?

3. Identify specific misrepresentations in Perrys 1992 financial statement data and related financial ratios that resulted from the companys failure to write off the Store 100 inventory balance. Were these misrepresentations material? Explain.

4. Compare and contrast a change in accounting estimate and a correction of an error. Do you agree with the SEC that Perrys 1993 fourth-quarter adjustment qualified as a correction of an error and not a change in accounting estimate? Why or why not?

5. Assess Richard Valades conduct in this case. Why do you believe he accepted his clients accounting treatment for the Store 100 account?

Footnotes

1. This case was originally published by the American Accounting Association in Issues in Accounting Education, Vol. 15, May 2000, 237-255. I would like to thank Tracey Sutherland, Executive Director of the American Accounting Association, for granting permission to include this case in this edition of Contemporary Auditing: Real Issues and Cases.

2. T. Serju, Rite Aid Puts on a Bright, New Face, The Detroit News (November 14), B1.

3. This and all subsequent quotations, unless indicated otherwise, were taken from Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1037, 19 May 1998.

4. Sources used in developing this case did not disclose the actual dollar amount of the differences noted in earlier years between Perrys book and physical inventories. In Accounting and Auditing Enforcement Release No. 1037, the SEC simply reported that, the amount of these discrepancies (book-to-physical differences for individual Perry stores during fiscal 1992) was far in excess of discrepancies identified in prior fiscal years.

5. During late 1992, Perry began installing a chain-wide, electronic perpetual inventory system. Such a system allows a business to update its inventory records instantaneously when employees enter in a computer terminal a sale, sales return, purchase or other transaction affecting inventory. This installation was completed in late 1993. As noted earlier in the case, Perrys major competitors had previously installed such systems. No doubt, Perrys executives realized that to compete effectively with those firms, they had to obtain the cost savings and strategic benefits yielded by an electronic inventory system. The new inventory system included point-of-sale terminals, electronic surveillance technology to detect theft, and a computer-based distribution network to provide for timely and accurate shipments from Perrys warehouses to its retail outlets. Most important, the new electronic inventory system allowed Perrys store managers to closely monitor the sales volume of individual products.

6. The SECs enforcement releases did not indicate how Arthur Andersen applied this materiality standard. Most likely, Arthur Andersen intended that any error or collective errors that reduced Perrys net income by $700,000 or more would be considered material.

7. Recall that Stone had retained Arthur Andersens computer risk management group earlier in 1992 to investigate the source of the large inventory shortage. As previously noted, that groups study concluded that computer breakdowns were not the cause of the shortage. The audit procedures discussed in this section of the case were performed entirely by the Arthur Andersen audit engagement team assigned to the 1992 audit of Perry Stores.

8. Perry Drug Stores issued a news release on October 12, 1993, to announce the fourth-quarter write-down of inventory (PR Newswire, Perry Reports Noncash Charge for Inventory Adjustment, October 12, 1993). In that news release, Perry management reported that the gross profit margin percentages used in the past by the company to estimate its inventories had apparently differed from the companys actual gross profit margin percentages. The news release speculated that these differences were likely due to several factors, including an unanticipated negative impact on Perrys gross profit margins of various sales promotions carried out by the company.

9. Securities and Exchange Commission, Accounting and Auditing Enforcement Release #1015, March 10, 1998.

10. The independent auditors direct personal knowledge, obtained through physical examination, observation, computation, and inspection, is more persuasive than information obtained indirectly. (AU Section 326.21.)