Rite Aid & Accounts Payable

When auditing payables and other liabilities, the auditor is not as concerned with existence as they are with completeness. This is because an understatement of liabilities can be used to exaggerate the financial strength of a company just as easily as an overstatement of assets can. It can be much more difficult though to find amounts that are not recorded than to verify the existence of an amount that is recorded. The omission of an entry is much more difficult to detect. Consider the following case that involved the drug store chain, Rite Aid.

The SEC found that Rite Aid overstated its income in every quarter from May 1997 to May 1999, by massive amounts. When the wrongdoing was ultimately discovered, Rite Aid was forced to restate its pre-tax income by $2.3 billion and net income by $1.6 billion, the largest restatement ever recorded. Rite Aid perpetrated the fraud through a number of fraudulent transactions including the following:

Reversals of Actual Expense - In certain quarters, Frank Bergonzi, CFO for Rite Aid, directed that Rite Aid's accounting staff reverse amounts that had been recorded for various expenses incurred and already paid. These reversals were completely unjustified and, in each instance, were put back on the books in the subsequent quarter, thus moving the expenses to a period other than that in which they had actually been paid. The effect was to overstate Rite Aid's income during the period in which the expenses were actually incurred. For example, Bergonzi directed entries of this nature which caused Rite Aid's pre-tax income for the second quarter of FY 1998 to be overstated by $9 million.

"Gross Profit" Entries -- Bergonzi directed Rite Aid's accounting staff to make improper adjusting entries to reduce cost of goods sold and accounts payable in every quarter from the first quarter of FY 1997 through the first quarter of FY 2000 (but not at year end, when the financial statements would be audited). These entries had no substantiation, and were intended purely to manipulate Rite Aid's reported earnings. For example, as a result of these entries alone, Rite Aid overstated pre-tax income by $100 million in the second quarter of FY 1999.

Vendor Rebates -- On the last day of FY 1999, Bergonzi directed that Rite Aid record entries to reduce accounts payable and cost of goods sold by $42 million, to reflect rebates purportedly due from two vendors. On March 11, 1999 -- nearly two weeks after the close of the fiscal year -- Bergonzi directed that the books be reopened to record an additional $33 million in credits. All of these entries were improper, as Rite Aid had not earned the credits at the time they were recorded and had no legal right to receive them. Moreover, due to Rite Aid's pass-through obligations in agreements with its own customers, Rite Aid would have been obligated to pass $42 million out of the $75 million through to third parties. The $75 million in inflated income resulting from these false entries represented 37% of Rite Aid's reported pre-tax income for FY 1999.

Using the accounts payable audit procedures describe how the fraud perpetrated by Rite-Aid might have been uncovered. It was discovered during the investigation that Rite-Aid employees who complained about the fraud were given money to keep quiet. Do you think that paying off employees would have caused the fraud to be less likely to be detected by the auditors? Were internal controls likely to have prevented the Rite-Aid fraud?