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Something Went Sour at Parmalat PROBLEM 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, Parmalat's management had fal. sified accounts and created assets to hide losses of S10 billion from Parmalat's Latin American operations. Other allegations charged that Parmalat's management had lied about repurchasing 53.6 billion in bonds, which they had never done. By hiding losses and increasing assets on its bal- ance 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, how- ever. Parmalat was forced to change auditors periodically and chose the Italian branch of Deloitte Touche Tohmatsu (Deloitte & Touche SpA) to be the company's new auditor in 2000. Grant Thom ton, however, continued to audit Parmalat's 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 Parmalat's headquarters. Nevertheless, the $4.9 billion was listed on the subsidiary's balance sheet as of December 31, 2002, and was consoli- dated into Parmalat's 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 (see Parmalat Exhibit 1), 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 num ber in the transmitting fax machine. A mailed confirmation, however, passes through the fed eral mail system and is postmarked with the originating zip code. Also, this particular fax was smudged, raising more suspicions. Forgers routinely "age" their originals" by repeatedly photo- copying 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 company's balance sheet (in this case, 38 percent of Parmalat's assets were in the subsidiary's bank account), auditors should take additional care to obtain further corroboration. All told, the combination of a large SpA with sufficient warning to dig deeper. DISCOVERY bank account and a questionable form of confirmation should have provided Deloitte & Touche 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 management's 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 were missing or nonexistent. Parmalat and its subsidiaries filed for bankruptcy protection in Vially Initial investigation revealed that massive amounts (estimates as high as S19 billion) of assets on December 27, 2003 MAT DOBITI Something Wert Sour Parma 21 2003 16101 FRB OF APERIR 2215743595 To 5457974472 Bankof America Thomien Spa Larpe Auguri, 3072 MILANO, ITALY VE 2541 Rating Cart SANTREN BANYO De Duram 1863-1925 need your love for und Drummer 21.22. We canine reserweh hering en blandt andere se of business en 2012. gada Bing Corporation BAND TUO SUCH Aco. L-5 the dece of business on December 2012 carica in Bern Concours Acrounde TECH 26. Se Det Contato e core but ass on December 2012. Powing relate Lever DAN NA Then it for you! CONFIDENTA e distinto your inquiry Nepal by Bank of Atenes er is eers to the ty teens the forma na made to my other relationship the subject may have with her Barcel Amartesores there Agnes Begrave I Met YITY During the ongoing investigation, a Parmalat employee who had disobeyed order to destroy company documents turned over a number of incriminating computer disks to investigators with evidence mounting. Parmalat's founder and CEO Calisto Tanzi admitted to prosecutors that he was aware of the fraud. He also adimined to misappropriating Parmalat assets (more than $1 billion. prosecutors believe) to cover losses in other family-owned companies. It is unlikely that inves tigators 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 ocher Parme lat executives, including members of Tanzi's family, and the company's former CFO, former board members, and even lawyers, were indicted on charges including frond, embezzlement, false false accounting, and misleading investors. On June 28, 2005, a judge accepted plea bargains from 11 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. DISCUSSION QUESTIONS 1. What steps does an auditor ordinarily take when confirming cash balances held on deposits with financial institutions? 2. What additional steps should the auditors have taken when they received the smudged fax copy printed on Bank of America letterhead? 3. What red flags did the auditors miss? 4. What steps should Deloitte & Touche SpA have taken with respect to Grant Thornton's audit of the Cayman Island subsidiaries? Something Went Sour at Parmalat PROBLEM 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, Parmalat's management had fal. sified accounts and created assets to hide losses of S10 billion from Parmalat's Latin American operations. Other allegations charged that Parmalat's management had lied about repurchasing 53.6 billion in bonds, which they had never done. By hiding losses and increasing assets on its bal- ance 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, how- ever. Parmalat was forced to change auditors periodically and chose the Italian branch of Deloitte Touche Tohmatsu (Deloitte & Touche SpA) to be the company's new auditor in 2000. Grant Thom ton, however, continued to audit Parmalat's 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 Parmalat's headquarters. Nevertheless, the $4.9 billion was listed on the subsidiary's balance sheet as of December 31, 2002, and was consoli- dated into Parmalat's 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 (see Parmalat Exhibit 1), 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 num ber in the transmitting fax machine. A mailed confirmation, however, passes through the fed eral mail system and is postmarked with the originating zip code. Also, this particular fax was smudged, raising more suspicions. Forgers routinely "age" their originals" by repeatedly photo- copying 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 company's balance sheet (in this case, 38 percent of Parmalat's assets were in the subsidiary's bank account), auditors should take additional care to obtain further corroboration. All told, the combination of a large SpA with sufficient warning to dig deeper. DISCOVERY bank account and a questionable form of confirmation should have provided Deloitte & Touche 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 management's 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 were missing or nonexistent. Parmalat and its subsidiaries filed for bankruptcy protection in Vially Initial investigation revealed that massive amounts (estimates as high as S19 billion) of assets on December 27, 2003 MAT DOBITI Something Wert Sour Parma 21 2003 16101 FRB OF APERIR 2215743595 To 5457974472 Bankof America Thomien Spa Larpe Auguri, 3072 MILANO, ITALY VE 2541 Rating Cart SANTREN BANYO De Duram 1863-1925 need your love for und Drummer 21.22. We canine reserweh hering en blandt andere se of business en 2012. gada Bing Corporation BAND TUO SUCH Aco. L-5 the dece of business on December 2012 carica in Bern Concours Acrounde TECH 26. Se Det Contato e core but ass on December 2012. Powing relate Lever DAN NA Then it for you! CONFIDENTA e distinto your inquiry Nepal by Bank of Atenes er is eers to the ty teens the forma na made to my other relationship the subject may have with her Barcel Amartesores there Agnes Begrave I Met YITY During the ongoing investigation, a Parmalat employee who had disobeyed order to destroy company documents turned over a number of incriminating computer disks to investigators with evidence mounting. Parmalat's founder and CEO Calisto Tanzi admitted to prosecutors that he was aware of the fraud. He also adimined to misappropriating Parmalat assets (more than $1 billion. prosecutors believe) to cover losses in other family-owned companies. It is unlikely that inves tigators 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 ocher Parme lat executives, including members of Tanzi's family, and the company's former CFO, former board members, and even lawyers, were indicted on charges including frond, embezzlement, false false accounting, and misleading investors. On June 28, 2005, a judge accepted plea bargains from 11 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. DISCUSSION QUESTIONS 1. What steps does an auditor ordinarily take when confirming cash balances held on deposits with financial institutions? 2. What additional steps should the auditors have taken when they received the smudged fax copy printed on Bank of America letterhead? 3. What red flags did the auditors miss? 4. What steps should Deloitte & Touche SpA have taken with respect to Grant Thornton's audit of the Cayman Island subsidiaries