F&C International, Inc.

Alex Fries emigrated to the United States from Germany in the early nineteenth century. The excitement and opportunities promised by the western frontier fascinated thousands of new Americans, including the young German who followed his dreams and the Ohio River west to Cincinnati. A chemist by training, Fries soon found a job in the booming distillery industry of southern Ohio and northern Kentucky. His background suited him well for an important need of distilleries, namely, developing flavors to make their products more palatable for the public. Alex Fries eventually established his own flavor company. Thanks largely to Fries, Cincinnati became the home of the small but important flavor industry in the United States. By the end of the twentieth century, the flavor industry's annual revenues approached $5 billion.

Alex Fries' success in the flavor industry became a family affair. Two of his grandsons created their own flavor company, Fries & Fries, in the early 1900s. Several decades later, another descendant of Alex Fries, Jon Fries, served as the president and CEO of F&C International, Inc., a flavor company whose common stock traded on the NASDAQ stock exchange. F&C International, also based in Cincinnati, reigned for a time during the 1980s as Ohio's fastest- growing corporation. Sadly, the legacy of the Fries family in the flavor industry came to a distasteful end in the early 1990s.

The Fraud

Jon Fries orchestrated a large-scale financial fraud that led to the downfall of F&C International. At least 10 other F&C executives actively participated in the scam or allowed it to continue unchecked due to their inaction. The methods used by Fries and his cohorts were not unique or even innovative. Fries realized that the most effective strategy for embellishing his company's periodic operating results was to inflate revenues and overstate period-ending inventories. Throughout the early 1990s, F&C systematically overstated sales revenues by backdating valid sales transactions, shipping customers product they had not ordered, and recording bogus sales transactions. To overstate inventory, F&C personnel filled barrels with water and then labeled those barrels as containing high-concentrate flavor products. The company also neglected to write off defective goods and included waste products from manufacturing processes in inventory. Company officials used F&C's misleading financial statements to sell equity securities and to obtain significant bank financing.

As F&C's fraud progressed, Jon Fries and his top subordinates struggled to develop appropriate sales and inventory management strategies since the company's accounting records were unreliable. To help remedy this problem, F&C created an imaginary warehouse, Warehouse Q.

Warehouse Q became the accounting repository for product returned by customers for being below specification, unusable or nonexistent items, and items that could not be found in the actual warehouses.

Another baffling problem that faced Fries and his confederates was concealing the company's fraudulent activities from F&C's independent auditors. The executives continually plotted to divert their auditors' attention from suspicious transactions and circumstances uncovered during the annual audits. Subversive measures taken by the executives included creating false documents, mislabeling inventory counted by the auditors, and undercutting subordinates' attempts to expose the fraud.

The size and complexity of F&C's fraud eventually caused the scheme to unravel. Allegations that the company's financial statements contained material irregularities triggered an investigation by the Securities and Exchange Commission (SEC). The investigation revealed that F&C had overstated its cumulative pretax earnings during the early 1990s by approximately $8 million. The company understated its pretax net loss for fiscal 1992 alone by nearly 140 percent or $3.8 million.

The Division Controller

Catherine Sprauer accepted an accounting position with F&C International in July 1992, shortly after the June 30 close of the company's 1992 fiscal year. Sprauer, a CPA, drafted the Management's Discussion and Analysis (MD&A) section of F&C's 1992 Form 10-K registration statement. In October 1992, the 28-year-old Sprauer became the controller of F&C's Flavor Division. Following that promotion, Sprauer continued to help prepare the MD&A sections of F&C's periodic financial reports submitted to the SEC.

In early January 1993, an F&C employee told Sprauer that he saw company employees filling inventory barrels with water in the final few days of June 1992. This individual also advised Sprauer that he had documentation linking two F&C executives to that incident, which was apparently intended to overstate the company's year-end inventory for fiscal 1992. According to the SEC, Sprauer abruptly ended the conversation with this employee and did not discuss his allegations with anyone.

Later that same day, another F&C employee approached Sprauer and confessed that he was involved in the episode recounted to her earlier in the day. This individual told Sprauer that he had acted under the direct instructions of Jon Fries. The employee then attempted to hand Sprauer a listing of inventory items affected by the fraud. Sprauer refused to accept the list. The persistent employee placed the list in Sprauer's correspondence file. The document detailed approximately $350,000 of nonexistent inventory in F&C's accounting records. Sprauer reportedly never showed the list of bogus inventory to her superiors, to other F&C accountants, or to the company's independent auditors. However, she subsequently warned F&C's chief operating officer (COO), Fletcher Anderson, that the company had "significant inventory problems."

The Chief Operating Officer

Fletcher Anderson became the COO of F&C International in September 1992 and joined the company's board of directors a few days later. On March 23, 1993, Anderson succeeded Jon Fries as F&C's president and CEO. During the fall of 1992, Anderson stumbled across several suspicious transactions in F&C's accounting records.

In late September 1992, Anderson discovered sales shipments made before the given customers had placed purchase orders with F&C. He also learned that other sales shipments had been delivered to F&C warehouses rather than to customers. Finally, in early October 1992, Anderson uncovered a forged bill of lading for a customer shipment. The bill of lading had been altered to change the reported month of shipment from October to September. Each of these errors inflated F&C's reported earnings for the first quarter of fiscal 1993, which ended September 30, 1992.

More direct evidence that F&C's financial data were being systematically distorted came to Anderson's attention during the second quarter of fiscal 1993. In November, a subordinate told Anderson that some of the company's inventory of flavor concentrate was simply water labeled as concentrate. The following month, Anderson learned of Warehouse Q and that at least $1.5 million of the inventory "stored" in that warehouse could not be located or was defective.

Catherine Sprauer submitted her resignation to Fletcher Anderson in late January 1993. Among the reasons Sprauer gave for her resignation were serious doubts regarding the reliability of the company's inventory records. Anderson insisted that Sprauer not tell him why she believed those records were unreliable because he wanted to avoid testifying regarding her concerns in any subsequent litigation.

In February 1993, shortly before Anderson replaced Jon Fries as F&C's top executive, an F&C cost accountant warned him that the company had an inventory problem "in the magnitude of $3-4 million." Anderson later told the SEC that although the cost accountant had access to F&C's inventory records and its actual inventory, he believed the accountant was overstating the severity of the company's inventory problem.

The Chief Financial Officer

Craig Schuster served as the chief financial officer (CFO) of F&C International during the early 1990s. As F&C's CFO, Schuster oversaw the preparation of and signed the company's registration statements filed with the SEC, including the company's Form 10-K reports for fiscal 1991 and 1992. Throughout 1992, Schuster became aware of various problems in F&C's accounting records, most notably the existence of Warehouse Q. In March 1992, Schuster learned that his subordinates could not locate many items listed in F&C's perpetual inventory records. A few months later, Schuster discovered that customer shipments were being backdated in an apparent attempt to recognize sales revenue prematurely. In late 1992,

Schuster determined that approximately $1 million of F&C's work-in-process inventory was classified as finished goods.

On December 17, 1992, a frustrated Schuster prepared and forwarded to Fletcher Anderson a 23-page list of $1.5 million of inventory allegedly stored in Warehouse Q. The memo indicated that the inventory could not be located or was defective. The SEC's enforcement releases focusing on the F&C fraud did not reveal how or whether Anderson responded to Schuster's memo.

Because he supervised the preparation of F&C's financial reports filed with the SEC, Schuster knew that those reports did not comment on the company's inventory problems. On January 1, 1993, Craig Schuster resigned as the CFO of F&C International. The final F&C registration statement Schuster signed was the company's Form 10-Q for the first quarter of fiscal 1993, which ended September 30, 1992.

The Rest of the Story

In a September 28, 1994, enforcement release, the SEC criticized Catherine Sprauer, Fletcher Anderson, and Craig Schuster for failing to ensure that F&C's financial reports "filed with the Commission and disseminated to the investing public were accurate."

The federal agency also chastised the three individuals for not disclosing in F&C's financial reports "significant accounting problems of which they were aware." Finally, the SEC scolded Anderson and Schuster for not establishing adequate internal controls to provide for the proper recognition of revenue and the proper valuation of inventory. In an agreement reached with the SEC to settle the allegations pending against them, the three former F&C executives pledged to "permanently cease and desist" from committing or causing violations of federal securities laws.

A second enforcement release issued by the SEC on September 28, 1994, contained a series of allegations directed at Jon Fries and seven other senior F&C executives. The SEC charged that these executives were primarily responsible for F&C's fraudulent earnings scheme. To settle these charges, each executive pledged not to violate federal securities laws in the future. The settlement agreement permanently banned Jon Fries from serving as an officer or director of a public company. Several of the individuals agreed to forfeit proceeds received from earlier sales of F&C securities. Fries relinquished more than $2 million he had realized from the sale of F&C common stock. Finally, the SEC imposed civil fines on four of the executives that ranged from $11,500 to $20,000.

F&C International filed for bankruptcy in April 1993 shortly after the fraud became public. The following year, a competitor purchased F&C's remaining assets. In March 1995, Jon Fries began serving a 15-month sentence in a federal prison for his role in the F&C fraud.

Directions:

You are encouraged to refer to the Code of Ethics for Professional Accountants provided by the HKICPA when applicable and cite relevant standards.

Questions

Jon Fries (CEO), Fletcher Anderson (COO), Craig Schuster (CFO), and Catherine Sprauer (division controller) were the four central figures in this case.

(5pts) 1. Identify the key responsibilities associated with the professional role of Craig Schuster (CFO). Briefly describe the type and extent of interaction Craig Schuster (CFO) likely had with F&C's independent auditors.

(20 pts) 2. Using a [-10, 10] scale, where -10 represents "Highly Unethical" and 10 represents "Highly Ethical", evaluate the conduct of the Craig Schuster (CFO). Support your answer by providing ethical and economic arguments using facts from the case and information discussed in class. Be sure to discuss the ethical dilemma s/he faced, some of the available alternatives, the parties who would be most likely affected by the individual's actions, and how.

(5 pts) 3. Who benefits from the inflation of revenues and overstating of inventory? Who, if anyone, is harmed? Explain.

(10 pts) 4. "Anderson insisted that Sprauer not tell him why she believed those records were unreliable because he wanted to avoid testifying regarding her concerns in any subsequent litigation."

What concept does this action describe? Is this action legal? In your opinion, is it ethical?

(10 pts) 5. Would you as the auditor of F&C regard the scenario, as whole, differently if a regular employee knew of the irregularities instead of one of the key individuals mentioned? Why?

(40pts)6. Suppose you are the auditor for F&C. Consider the following scenarios independently:

a) First, consider that you are successfully fooled by the diversion strategies implemented by different managers and officers, and thus, you are unaware of the potential issues that are surfacing. Do you face a dilemma? Elaborate why or why not. (10 pts)

b) Now, suppose you become aware of the general issues. Namely, the irregularities surrounding "Warehouse Q" and the testimonies of the employees confessing to inventory manipulation. Moreover, you also observe key individuals departing from the company. Discuss the alternatives that you face, the related ethical and real implications, and, in your opinion, your preferred course of action. (20 pts)

c) Lastly, given the same facts as in b), now assume that F&C is your only audit client. How does this change your conclusion from the previous part? (10 pts)

(10 pts) 7. In thinking back to the previous question, a set of particular circumstances may give rise to legal liability from the auditor's perspective. Explain the term scienter, its relation to auditing of financial statements and its role in the legal liability exposure of auditors.