(INTERNAL AUDITING)

Cash Embezzlement Over 12 Years

Hugh Grove, DBA, MBA

University of Denver

LEARNING OBJECTIVES

After completing and discussing this case, you should be able to

Recognize the lack of internal controls.

Describe methods used to steal $34 million in cash.

Spot various false journal entries.

Recommend internal control to stop embezzlement of cash.

John Moss is recognized for creating the stereo headphone industry in 1958 with his first stereo headphone. Moss Corp. (MOSS) was incorporated in 1971 in Green Bay, Wisconsin and manufactures stereo headphones, speaker-phones, computer headsets, telecom headsets, noise reducing headsets, and wireless headsets. Moss Corp. went public in 1965 at $5 per share. Over the last eleven years, its stock price has ranged from $8 in July 2002, to its peak at $15 in July 2006 to its low at $4 in July 2010. It currently trades at approximately $5.50 per share. Accordingly, its market capitalization has ranged from $3.4 million to $12.8 million to its current level of $5.1 million. Thus, it was below the $75 million market value cutoff for a full implementation level of the Sarbanes-Oxley Act (SOX) and, accordingly, did not have an audit of its internal controls over its financial reporting. The Chief Executive Officer (CEO), Michael Moss, the founders son, and his family directly or indirectly own in excess of 70 percent of the companys 851,000 shares. A $34 million embezzlement of cash from the Moss Corp. occurred and went undetected over a 12 year period from 1997 through December 2009 even though unqualified audit reports were issued every year by a Big Five audit firm.

ACCOUNTING AND AUDITING ENFORCEMENT RELEASE (AAER)

NO. 3340, 10/ 24/12

SEC v. Moss Corporation and Michael Moss, Civil Case No. 2:41-cv-01991

Excerpts

On October 24, 2012, the SEC filed a Complaint (this AAER) against, and proposed settlement with, MOSS and Michael Moss (MM), its CEO and former CFO, based on MOSSs preparation of materially inaccurate financial statements, books and records, and lack of adequate internal controls from fiscal years 2005 through 2009. During this period, Sue Smith, MOSSs former Principal Accounting Officer, Secretary, and Vice-President of Finance, and Julie Jones, MOSSs former Senior Accountant, engaged in a wide-ranging accounting fraud to cover up Smiths embezzlement of $34 million from MOSS. The SEC Complaint alleges that:

The yearly amounts stolen were significant to MOSSs 2005-2009 financial statements. For example, during the fiscal year ending June 30, 2009, Smith stole approximately $8.5 million, while MOSS reported total sales of $38.2 million, net income of $2.0 million, cash of $1.7 million, total assets of $28.5 million, total equity of $23.6 million including retained earnings of $21.6 million, basic/diluted earnings per share of $0.54, and dividends per share of $0.52.

MOSSs financial records were misleading in part because MOSS and MM did not adequately maintain internal controls to reasonably assure the accuracy and reliability of financial reporting. The $34 million embezzlement started in 1997 and ran until December 2009.

While MOSSs internal controls policy required MM to approve invoices of $5,000 or more for payment, its controls did not prevent Smith and Jones from stealing $34 million from MOSS to pay for Smiths personal purchases (lavish shopping sprees at Neiman Marcus among others) without seeking or obtaining MMs approval.

MM knew that MOSSs computerized accounting system was almost 30 years old and he twice deferred proposals for a new system. Access to the accounting systems could not be locked at the end of the day or month and there was no audit trail. Smith and Jones were thus able to make undetected post-closing changes (false journal entries) to the books and bypass an internal control requiring Michael Moss to authorize those changes.

MOSS did not regularly change the password to access the computers and accounting terminals were not locked when unattended. MOSS did not have information technology (IT) security policies and controls to log and monitor network and application security violations or to report incidents to management.

Due to the limited number of people working in MOSSs accounting department, many critical duties were combined and given to a few employees. Based upon the fraudulent accounting books and records prepared by Smith and Jones, MOSS prepared, and MM certified, materially inaccurate audited financial statements and materially inaccurate current, quarterly and annual reports for the fiscal years 2005 through 2009.

Epilogue

When the embezzlement accusations were made public on December 21, 2010, the Nasdaq stock exchange halted trading in Moss shares at the companys request. Moss shares had then traded at $5.51, down from an adjusted 52-week high of $7.89 in April 2010. MM testified that Smiths thefts had threatened the companys stability and that MOSS was forced to cut profit sharing and pay for employees. After resuming trading, by March 2013 over two years later, the shares were trading at $5.33 per share. Sue Smith was arrested in December 2010 after the results of an internal investigation were turned over to authorities. She is in her mid-40s and was paid $173,734 by MOSS in total compensation in fiscal 2009 and $206,462 in fiscal 2008. Her embezzlement ran in spurts. There was a flurry of check-writing over three days in August 2007 totaling $478,735. On August 1, $154,021 was paid to Valentina Inc., an exclusive clothing store. On August 2, $181,000 was paid to Neiman Marcus and $10,120 to Saks Fifth Avenue. On August 3, $296,494 was paid to American Express on her personal credit card. Over a five-year period, Smith spent more than $5 million at the Valentina boutique whose owner said the figure seemed high. Concerning more spending spurts, on February 3, 2007, checks were written to American Express for $204,287 and from July 11 to 17, 2003, $20,182 was spent at Marshall Fields, $26,420 at Saks Fifth Avenue, and $104,738 went to American Express. Smith used the money from MOSS to buy personal items, including womens clothing, furs, purses, shoes, jewelry, a 2007 Mercedes Benz and other automobiles, china, statues, household furnishings, and a vacation ownership interest in Kauai, Hawaii resort property. She also paid for hotels, airline tickets and other personal travel expense for herself and others, renovations and improvements to her home, and personal services for her and her family. She never even took the tags off of many of the items and rented two storage spaces because she couldnt fit it all in her house. Investigators seized more than 22,000 items she may have bought with company money. Prosecutors did not dispute her lawyers defense that Smith likely suffered from bipolar disorder and compulsive shopping but they said that it was an explanation, but not an excuse, for her behavior. In the U.S. District Court on November 17, 2011, Smith pleaded guilty to six counts of fraud, was ordered to pay $34 million in restitution (would selling all of her 22,000 purchases be sufficient?!), and was sentenced to 11 years in prison.

1) Prepare a detailed table analyzing the three elements of the fraud triangle pressure, rationalization, and opportunity.

List three examples of each element

For each example, provide a description of the condition, list the parties involved or impacted by the condition, and list how the condition could be minimized or managed.