CASE STUDYSomething Went Sour at Parmalat! There was much confusion when Italian dairy food giant Parmalat defaulted on a $187 million bond payment in mid-November 2002. Default on a bond payment seemed difficult to believe considering that a Parmalat subsidiary in the Cayman Islands had a $4.9 billion cash balance in a Bank of America account. The problem was that the cash account did not exist. Subsequent investigation revealed that, over a 15-year period, Parmalats management had falsified accounts and created assets to hide losses of $10 billion from Parmalats Latin American operations. Other allegations charged that Parmalats management had lied about repurchasing $3.6 billion in bonds, which they had never done. By hiding losses and increasing assets on its balance sheet, Parmalat was able to continue to borrow enough money from investors and creditors to conceal and perpetuate the massive fraud. AUDIT APPROACH From 1990 to 1999, the Italian branch of Grant Thornton audited Parmalat. Under Italian law, however, Parmalat was forced to change auditors periodically and chose the Italian branch of Deloitte Touche Tohmatsu (Deloitte & Touche SpA) to be the companys new auditor in 2000. Grant Thornton, however, continued to audit Parmalats offshore subsidiaries located in the Cayman Islands. The new auditors first inquired about the Cayman Islands account in December 2002 and received a letter on Bank of America letterhead in March 2003, confirming the existence of the account. The letter, however, was a forgery, created in Parmalats headquarters. Nevertheless, the $4.9 billion was listed on the subsidiarys balance sheet as of December 31, 2002, and was consolidated into Parmalats balance sheets dated December 31, 2002, and June 30, 2003. The auditors missed several red flags. First, the size of the account, on its own, should have been a red flag. It is very unusual for a large company to have so much cash in a single bank account. In addition, between January 2000 and September 2003, Parmalat raised more than $5 billion in debt offerings. With so much cash available in the Cayman Islands, why was Parmalat continuing to borrow money? Second, the communication received from the Bank of America was in the form of a fax, which raises two issues. First, a fax transmission is not subject to the same level of control as returning an original confirmation. Essentially, a fax can be sent from almost anywhere, and the originating phone number can be falsified by simply changing the phone number in the transmitting fax machine. A mailed confirmation, however, passes through the federal mail system and is postmarked with the originating zip code. Also, this fax was smudged, raising more suspicions. Forgers routinely age their originals by repeatedly photocopying them to obscure any telltale photocopying lines. Given these circumstances, the auditors should have followed up directly with the bank. Third, when such large balances represent a significant portion of a companys balance sheet (in this case, 38 percent of Parmalats assets were in the subsidiarys bank account), auditors should take additional care to obtain further corroboration. All told, the combination of a large bank account and a questionable form of confirmation should have provided Deloitte & Touche SpA with sufficient warning to dig deeper. DISCOVERY Parmalat management also told Deloitte & Touche SpA that the company had a $617 million investment in an open-ended mutual fund that it could access at any time. The company, however, was unsuccessful in its attempts to retrieve the funds. Because no evidence was available to support managements claims, Deloitte & Touche SpA included a qualification in its audit review report highlighting the lack of evidence and alerted regulators of suspicions of a larger fraud. Initial investigation revealed that massive amounts (estimates as high as $19 billion) of assets were missing or nonexistent. Parmalat and its subsidiaries filed for bankruptcy protection in Italy on December 27, 2003. During the ongoing investigation, a Parmalat employee who had disobeyed orders to destroy company documents turned over several incriminating computer disks to investigators. With evidence mounting, Parmalats founder and CEO Calisto Tanzi admitted to prosecutors that he was aware of the fraud. He also admitted to misappropriating Parmalat assets (more than $1 billion, prosecutors believe) to cover losses in other family-owned companies. It is unlikely that investigators will ever know for certain what happened to the missing funds (whether they were used to cover operating losses, pay creditors, or illegally enrich management). Twenty other Parmalat executives, including members of Tanzis family, and the companys former CFO, former board members, and even lawyers, were indicted on charges including fraud, embezzlement, false accounting, and misleading investors. On June 28, 2005, a judge accepted plea bargains from of those charged and sentenced them to prison ranging from 10 months to 2.5 years. In his January 2008 trial, Calisto Tanzi was found guilty of securities laws violations and was sentenced to 10 years in prison for his role in the fraud. More than two years later, in December 2010, Tanzi was also found guilty of fraudulent bankruptcy and criminal association and sentenced to an additional 18 years in jail. After he unsuccessfully appealed that verdict in 2011, the court added another nine years to his sentence. He should be about 105 years old when he is finally released. C. What red flags did the auditors miss in the Parmalat case?