Case 5-2 ZZZZ Best The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year-old boy from Reseda, California, who was driven to be successful, regardless of the costs. His name is Barry Minkow. Although this case dates back over 30 years, it does serve as an example of what can happen when auditors do not look too hard to find fraud. Minkow had high hopes to make it big-to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. Minkow realized early on that he was not going to become a millionaire cleaning other people's. carpets, but that he could in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Because the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done, and perhaps not be all that concerned with how much it would cost. The only problem with Minkow's insurance restoration idea was that it was all a fiction. Allegedly, over 80 percent of his revenue was from this work. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst \& Whinney (now EY), into thinking the insurance restoration business was real. The auditors never caught on until it was too late. How Barry Became a Fraudster Minkow wrote a book, Clean Sweep. A Stor) of Compromise, Corruptom. Colkapse, and Conneback, 2 that provides some insights into the mind of a IS-year-old kid who was called 3 "wouder boy" on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in his garage office. Minkow ealled Channel 4 in Los Angeles. He disguised his voice so he wouldn't sound like a teenager and told a prodecer that he had just hitd his carpets cleaned by the 16 yearold owner of Z2ZZ Best. He sold the producer on the ideat that it would be good ror sociely to hear the success story about a high school junior running his own business. The producer bought it lock, stock. and capel cleaner Minkaw gave the producer the phone number of Z7ZZ Best and waited. It took less than five minutes for the call fo come in. Minkow answered the phone and when the producer asked to speak with Me Barry Minkow. Minkow side who may I say is calling? Within days, a film crew was in his garage shooting 2.72Z Best at wor. The story aired that nighx, and it was followed by more calls from radio stations and other television shows wanting fo do interviews. The culls llooded in with customers demanding that Barry Minkow personally clean their carpets. As his incomic increased in the spring of 1983. Minkem found increasingly difficult to rum the company without a checking account. He managed to find hanker that wisso moved by his story that the banker agreed to allow an underage customet lo open a checking uecount. Minkow wed the money to buy cleaning supplies and other necessities: Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage-where all his great ideas first began-and looked at his bank account statement, which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers, so they didn't yet show up on the bank statement. Voila! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best account on the last day of the reporting period and deposit it into another. The cheek wouldn't clear Bank tI for at least one day so he could count the cash in both accounts (back then, checks weren't always processed in real time the way they are today). It wasn't long thereafter that Minkow realized he could kite checks big time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in Bank #1 and carry it onto the balance sheet. Because Minkow did not count the check written on his account in Bank #1 as an outstanding check, he was able to double-count. Time to Expand the Fraud Over time, Minkow moved on to bigger and bigger frauds, like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance resteration jobs. Minkow used the phony jobs and phony revenue to convince baokers to make loins to 2727 Best. Hejnd cast remicance forms made up from nonexistent custoniers with whatever sales amount he wanted to apjear on the document He civen had a co-conspintor write on ZZZZ Best. Of course, he owned a majority of the stock to maintain control of the company. Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, CPAs, and attorneys all working for him-the now 19 -year-old kid from Reseda, California, who had turned a mom-and-pop operation into a publicly owned corporation. Barry Goes Public Pressured to get a big-time CPA firm to do his audit by the underwriting firm selling his stock, Minkow hired Ernst \& Whinney to perform the April 30, 1987, fiscal year-end audit. Minkow continued to be one step abead of the auditors-that is, until the Ernst \& Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business-all the revenoe-that Minkow had said was coming in to ZZZZ Best was real. The engagement partner drove to an area in Sacramento, California, where Minkow did a lot of work-supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn't clear, but he identified a building that seemed to be the kind that would be a restoration job in progress. Earlier in the week, Minkow had sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it. Minkow's associate picked out the same site as had the partner later on. Minkow's cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they. could show the building to some potential tenants over the weekend. Minkow's helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time, but it looked as if some restoration work was going on at the site. Minkow was able to pull it off in part due to luck and in part because the Ernst \& Whinney auditors did not want to lose the 27ZZBestaccount.Ithadbecomealargerevenueproduceforthefirm,andMinkowseemeddestinedforgreater and grgater achievements. Minkow was smart and used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they hecame too curious about the insurance restoration jobs. He woutd even threaten to take his business from Ernst \& Whiney gnd give it to other auditors. To get on their good side, he would wine and dine the auditors and even invito then to his house Minkow also took a precaution with the site ysit He haid the fudisons sign a confidentiatity agrcement ibat they would not make any follow up calls to any contractors insuranee companies, the building owner, or other individuals involved in the restoration work. This prevented the puditors fhom corroborating the insiurance restotation contracts with independent third parties The Fraud Starts to Unravel It was a Los Angeles housewife who started the problems for ZZZZ Best that would eventually lead to the company's demise. Because Minkow was a well-known figure and flamboyant character, the Los Angeles Times did a story about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by incrensing the amount of the credit card charge for its carpet cleaning services. Minkow had gambled that most people don't check their monthly statements, so he could get away with the petty fraud. However, the housewife did notice the overcharge and complained to Minkow, and eventually he returned the overpayment. She couldn't understand why Minkow would have had to resort to such low levels back then if he was as 268 CHAPTER S: Frand is Financial Statemenh and Auditor Respoesibitities successful as the Times article made him out to be, So she called the ceporter to find out more, and that ultimately led to the investigation of 2ZZZZ Best and future stories that weren't so flattering. Because Minkow continued to spend lavishly on himself and his possessions. he always ucemed to need more and more money. It got so bad over time that he was close to defaulting on loins and had to make up stories to keep the creditors at bay, and he couldn't pay his suppliers. The complaints kept coming in, and eventually the house of cards that was ZZZZ Best came crashing down. During the time that the fraud was unraveling, Exnst \& Whinney decided to resign from the ZZZZ Best audit. It had started to doubt the veracity of Minkow and his busioess at 2722 Best Of course. by then it matrered little because the firm had been a party to the coverup for some time Legal Liability Issues The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst \& Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report issued by Ernst \& Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report because Ernst \& Whinney had expressly disclaimed issuing any opinion on the statements. The firm lucked out in that the judge understood that a review engagement only provides limited assurance rather than the reasonable assurance of the audit. Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years. Questions 1. Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best, where top management goes to great lengths to fool the auditors? Explain. 2. Discuss the red flags that existed in the ZZZZ Best case and evaluate Ernst \& Whinney's efforts with respect to fraud risk assessment. 3. These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986. What calculations or analyses would you make with these numbers that might help you assess whether the financial relationships are "reasonable"? 4. Analyze Minkow's behavior from the perspective of being a "Dark-Triad Personatity" Does he fit one or more of the personality types? Explain