REFCO: OUTWITTING THE AUDITORS Joe Defraud finished his breakfast. Joe had been with Grant Thornton for 15 years and was the lead auditor on the Refco engagement.. He had just talked to Grant Thorntons legal counsel and had learned that a class action suit had been filed against the CPA firm regarding its involvement with Refco. Concerned about the repercussions to his career, he nervously opened the newspaper. While wondering if the audit team had missed red flags pointing to the fraud, he read the feature article in the financial section. From IPO to Bankruptcy in Nine Weeks On October 10, 2005 Refco, Inc. announced that an entity controlled by its Chief Executive Officer, Phillip R. Bennett, owed $430 million to Refco. This amount was listed in Refcos financial statements, but was not disclosed as a related party transaction. Refco immediately announced that the public could no longer rely upon its financial statements for 2002 through 2005. Just two months earlier, Bennett, himself, rang the opening bell at the New York Stock Exchange to celebrate Refcos first day of public trading. By the end of this first day, the value of Refcos stock had increased by an impressive 25%. Now the stocks value dropped as rapidly as it had previously grown. Many of Refcos clients immediately liquidated their accounts, further depleting Refcos assets and resulting in the fourth largest bankruptcy filing in the United States. Refcos independent auditor, Grant Thornton, had issued an unqualified opinion on the financial statements filed with the registration statement. While internal control deficiencies were identified, Grant Thornton did not discover undisclosed related party transactions. Where there any risk factors or signs that should have alerted the auditor to a violation of Generally Accepted Accounting Principles(GAAP)? Company Background Refco Inc. (RFX) was incorporated in Delaware with its principal executive offices in New York City. The company provided financial services to customers, primarily brokering commodities, and futures contracts. Founded in 1969 as Ray E. Friedman and Co., Refco eventually expanded to 23 locations in 14 countries, served over 200,000 customer accounts and became the largest broker on the Chicago Mercantile Exchange in 2004. Revenue was earned from transactions with customers and from interest on cash balances in customer accounts. In August 2004 the private equity firm Thomas H. Lee Partners acquired a 57% interest in Refco. Refcos management retained a significant ownership interest. Thomas Lee, a 1965 graduate of Harvard College and founder of Lee Partners, stated that the ultimate goal was to take Refco public. Praising Refcos management team, Lee noted: Were a company that likes to invest in businesses that have strong growth opportunities and outstanding management teams, and this really has both. As Lee had predicted, Refco announced an initial public offering of 26 million shares at $22 per share on August 11, 2005. Because of previous years profit growth, investors eagerly purchased shares and by the end of the first day of trading the company's shares had gained 25%. Participants to the IPO included CS First Boston, Goldman Sachs, and Banc of America Securities, as the principal underwriters, and the accounting firm, Grant Thornton, as the auditor of the financial statements filed with the prospectus and registration statement. Management Ray Friedman and his stepson, Thomas Dittmer founded Ray E. Friedman and Co. (Refco) in 1969. Friedman had grown up in Iowa, where his family was poor and made money by selling chickens and eggs. A few years later, the experience with his familys enterprise led the ambitious Friedman to establish the company American Produce, through which he sold farm products to retailers and the United States Army. Success was short lived, however, and in 1952 Friedman was convicted for falsifying the meat stamps on chickens sent to army troops in Korea. Friedman was paroled in 1955 and shortly thereafter met and married Evelyn Levine, the mother of Thomas Dittmer. As soon as the Chicago Mercantile Exchange began to trade in cattle futures, Dittmer and Friedman, opened Ray Friedman and Company in 1969. The company prospered despite the fact that the two founders did not always play by the rules. Being fined numerous times by the U.S. Commodity Futures Trading Commission (CFTC) for keeping insufficient records and filing false trading reports, Friedmans, Dittmers, and Refcos reputation became more and more tainted. Disagreements on how to reinvest revenues resulted in Dittmer buying out Friedmans share in Refco in 1974. However, Friedman continued trading through the company, and enjoyed a high society life style, while again being cited for CFTC violations. Dittmer and Refco, as well, got in trouble with the CFTC for record keeping violations, eventually causing Dittmers resignation in 1999. In 1981 Bennett was hired by Refco and was immediately hailed as the companys rescuer. The British-born Bennett had graduated from Cambridge University with a degree in geology, and had spent eleven years working in the commodity and commercial lending departments of Chase Manhattan Corporation. Immediately, Bennett set out to improve Refcos financial position and reputation, working long hours, rarely socializing and continuously monitoring the markets. His hard work paid off when he was named Refcos Chief Executive Officer in 1998. Through 2004 Refcos revenue grew by over 24% a year. Ultimately, Bennett became one of the wealthiest of Britain, owning a Penthouse on Park Avenue and a horse farm in New Jersey near Jacqueline Kennedys estate. The Auditors Grant Thornton, LLP replaced Arthur Andersen as Refcos auditor in 2003. Grant Thornton LLP was one of the largest accounting firms after the big four, with over 50 offices in the United States. The company issued unqualified auditors reports to be included in the registration statement filed with the SEC. While Grant Thornton issued unqualified audit reports, the auditors warned Refcos management of internal control issues. The auditors identified several internal control deficiencies, including their opinion that Refcos accounting department was understaffed, which resulted in a severe problem with the timely reporting of financial results. No formalized closing procedures existed and the company was not in compliance with Securites and Exchange Commission (SEC)s reporting guidelines. Refcos management and board of directors acknowledged the identified deficiencies in internal controls and included the following risk assessment statement in the registration statement filed with the SEC: Figure # 1 Our auditors reported to us that, at February 28, 2005, there were two significant deficiencies in our internal controls over financial reporting. In connection with their audit of our most recently audited financial statements, our independent auditors reported to us that we had two significant deficiencies in our internal controls over financial reporting. Under standards established by the Public Company Accounting Oversight Board, a significant deficiency is defined as a deficiency that results in more than a remote likelihood that a misstatement of the financial statements that is more than inconsequential will not be prevented or detected. One significant deficiency was determined to exist based on the need to increase our existing finance department resources to be able to prepare financial statements that are fully compliant with all SEC reporting guidelines on a timely basis. The second significant deficiency was determined to exist based on our lack of formalized procedures for closing our books. Currently we utilize the services of an outside service provider to assist in our financial reporting process. We are in the process of enhancing our financial reporting capability by hiring additional internal audit and finance personnel and developing formalized closing procedures, including through the implementation of software upgrades throughout our operations. Although these measures are designed to address the issues raised by our independent auditors, these and any future measures may not enable us to remedy these significant deficiencies or avoid other significant deficiencies in the future. In addition, these and any other significant deficiencies will need to be addressed as part of the evaluation of our internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and may impair our ability to comply with Section 404. See We will be exposed to risks relating to the evaluation of our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. The Scheme and an Astute Controller In the early 1990s some of Refcos customers suffered sizeable trading losses because of the financial crisis in Asia. As a result, large amounts of receivables became uncollectible. Refco Group Holdings (RGHI), an entity controlled by Bennett, assumed the bad debts of Refco to improve the financial position of the company and to eliminate the need for write offs. Eventually, the accounts receivable from RGHI grew to hundreds of millions of dollars. None of these transactions were disclosed by Refco as related party transactions in its SEC filings or audited financial statements. In February 2000, prior to the end of Refcos fiscal year, Bennett and RGHI devised a scheme to hide the fact that RGHI by that time owed hundreds of millions to Refco. Through a series of short-term loans, RGHI borrowed money from Bank fuer Arbeit und Wirtschaft (BAWAG), a major Austrian bank, making it possible for RGHI to temporarily pay off some of its debt to Refco. A few days after the Refco fiscal year-end, journal entries reversed the transaction, and RGHI again showed the debt owed to Refco. In a similar fashion, a Refco subsidiary lent money to Liberty Corner Capital Strategies, a New Jersey hedge fund, which in turn loaned the money to RGHI. RGHI then ultimately completed the loop and paid the money to Refco. By shifting the uncollectible accounts between Bennetts private company, Liberty Corner, and BAWAG, Bennett was able to hide the $430 million in debt owed to Refco. These intricate transactions between BAWAG, Liberty Corner, Refco, and RGHI allowed Bennett to conceal the true condition of Refcos balance sheet as they were repeated yearly through 2005. Because of the complexity of the transactions, Bennett succeeded in deceiving the companys auditors. Bennett did not anticipate that his covert debt would be discovered by an employee from Refcos accounting department. Refcos newly hired controller, Peter James, became suspicious when he discovered an unusually large interest transaction paid to Refco on an outstanding loan. This transaction caused James to wonder about its origin, and he soon discovered that Bennett and Refco Group Holdings were actually responsible for the payment and related debt. James approached the chief financial officer, Gerald M. Sherer, regarding his findings. Immediately, Refcos audit committee started an internal investigation, and on October 6, 2005 the three-member audit committee, led by Ronald OKelley, CEO of Atlantic Coast Venture Investments Inc. in Naples, Florida, confronted Bennett, then announced the defalcations to the public. On October 12, 2005, Bennett was arrested and charged with securities fraud, a mere two months after its initial public offering (IPO). Subsequently, Refcos stock fell from $29 to 65 cents. As Joe closed the paper, he trembled and wondered how his audit team could have missed the now obvious signs pointing to fraud. He realized that he now faced the auditors nightmare of trying to prove that the audit was performed with due diligence and according to auditing standards.

Question:

1. Key facts and summary of case (not more than to of a page).

2. What was the auditors responsibility with respect to detecting fraud during the Refco audit?

3. Auditing standards refer to fraud risk factors that may increase the likelihood of fraud. Discuss their presence in the Refco case.

4. Explain how internal controls influenced the fraud risk factors.

5. A conclusion.