Switch Watches & Clock Fraud Case

Sheldon Cooper was a strange character, perhaps more comfortable in a university setting than a boardroom meeting. Starting out as an 18-year-old high school graduate, he worked his way up from the assembly floor of Switch Industries, a manufacturer of watches and clocks. Sheldon's job was to ensure that the company's name and the product registration number were affixed to the bottom of each assembled timepiece. He took great pride in his role at Switch but yearned for the day when he could assume a management position.

Sheldon realized that if he wanted to be successful, he would need a college education, so he enrolled in a local university. After Sheldon received his bachelor's degree in accounting, he informed Switch administration and asked to be considered for the management training program. Shortly thereafter, a position opened in the Purchasing Department for an accounts payable clerk. Sheldon jumped at the opportunity, and his ascension began.

Rising through the ranks, he took on roles with increasing responsibility. Sheldon worked in nearly all areas of the Accounting Department, including payroll, receivables, cash management, and financial reporting. He also had a leadership role in the development and implementation of the new computer systems for inventory management and accounting.

By the time Sheldon was promoted to chief executive officer (CEO), his tenure with the company exceeded 25 years. He knew virtually every detail about Switch Industries. But his meteoric rise left him with few allies. When Sheldon walked into a room, conversation ceased. Employees scattered to avoid confrontations with him, mainly because he believed in management by intimidation. He frequently made unreasonable demands and set unattainable goals.

Sheldon's entire existence and self-worth hinged on the successes and failures at Switch. He never married and routinely worked 15-hour days. The employees joked that he secretly lived at the corporate office. No matter how early they arrived or how late they left, Sheldon Cooper was there. In the few hours he was not at work, he managed to cultivate expensive hobbies and tastes. It was also important to him to demonstrate his success with flashy vehicles, homes, and artwork. He lived in the most exclusive neighbourhood in Toronto and drove a candy-apple-red Ferrari. In fact, Sheldon frequently sped off to Caesars Casino to gamble with customers. He was known as a high roller.

Switch began in 1922 in a Toronto basement workshop of a Swiss immigrant, Howard Wolowitz. Howard worked full time during the day as a butcher but came home each night to tinker with his collection of clocks. Word spread regarding Howard's fascination with clocks and his skill in their repair. Eventually he had so many people requesting his services that he decided to quit his job and open Switch Watches & Clock. The choice of name was similar to a famous watch brand in Switzerland. But in the 1950s, he and his son, Stuart, decided to expand the company. They became Switch Watches & Clock Industries. To keep up with the ever-increasing demand, they built a state-of-the-art facility to assemble and package their timepieces. After Howard retired, Stuart, an energetic 28-year-old, took over the helm.

Stuart was less of a craftsman than his father but had a keen sense for business. He decided to bolster the company's employee time clock business. This strategy paid off with the burgeoning industrial economy and increased focus on mechanization. Sales at Switch Industries grew to record levels. After being in the business for years, Stuart took note of an ambitious employee named Sheldon Cooper who had distinguished himself in the factory and was working toward becoming a manager. Stuart developed a mentoring relationship with Sheldon, knowing that someday, he would be the leader of Switch Industries.

Switch experienced many highly profitable years, and Stuart became very wealthy and decided to retire. Sheldon received a 20% interest in Switch when the company went public and became the new CEO. Stuart appointed several of his close friends and business associates to the board of directors, regardless of their business acumen and leadership skills. A seat on the board, as Stuart saw it, was his method of repayment for their support and loyalty throughout the years.

By the time Sheldon took over, technology had gradually outpaced the products Switch offered. For a while, the company did not realize this because the demand for replacement parts and clocks was still heavy. Sheldon felt it was important to portray a prosperous image, exemplified by the newest addition: a swanky corporate office adjacent to the factory. Before long, the company experienced a decline in both sales and margins.

When Switch hired a new chief financial officer (CFO), Leonard Hofstadter his first directive was to handle the financial statement audit for the current year. Leonard believed this task would be a piece of cake given his 20 years of experience with an international accounting and auditing firm. There he was the engagement partner on two prominent accounts in the timepiece industry. Over the course of Leonard's first few weeks at Switch, he met with supervisors in all areas of the company to obtain an understanding of the operations.

During this time, he began the formal process of documenting the system of internal control. He created flowcharts of the key processes, such as accounts receivable/cash receipts, accounts payable/cash disbursements, inventory management and control, and purchasing and payroll. Leonard was astounded by the lack of documentation and cross functional knowledge of the employees. He was even more alarmed when rumours of financial shenanigans surfaced in nearly all of his interviews with the managers. But everyone feared the wrath of Cooper.

Leonard took the rumors very seriously. Utilizing the scant details, he began an investigation unbeknownst to Sheldon. He discovered many irregularities that required further analysis. To complicate matters, the year-end audit was scheduled to begin the very next Monday. Leonard did not want the auditors to be aware of the potential restatement of previously issued financials unless he established concrete evidence of fraudulent activity. He and the corporate legal counsel, Will Wheaton, scheduled a special telephone conference meeting of the board of directors to inform them of the allegations. It was clear to Leonard and Will that the board was out of touch with Switchthey appeared to be merely puppets for Sheldon Cooper. Sheldon tried to downplay the comments from the various managers and said that he did not think an internal investigation was merited.

Leonard and Will convinced the majority of the board members to authorize the retention of forensic accountants. Leonard called the accountants recommended by Will, the firm of Fowler, Ranch, Gilbert, & Associates. Leonard provided Amy Fowler, with a detailed description of what he had discovered. Fowler told Leonard she would put an investigative team together and scheduled a meeting at Switch for the next morning. The team consisted of four professionals: two junior staff accountants, who would be relied on for data entry and obtaining source documents; an accountant to supervise the staff and investigate the more complex questionable financial transactions; and Bernadette, the senior manager, to participate in the employee interviews with Will and to assist Fowler with the preparation of a written report documenting the findings and recommendations.

Leonard and Will met with Fowler and Bernadette the next morning. Leonard explained the four areas requiring investigation:

1. Manipulation of physical inventory quantities and unit costs
2. Exaggerated revenue recognition
3. Questionable fixed asset capitalization
4. Cash disbursement

Bernadette also began scheduling the questioning of current and former officers, which were to be conducted offsite to ensure privacy. Two of the former (CFO) had moved out of Toronto, so arrangements were made for Will and Bernadette to travel and meet with them. Fowler utilized transcript-style notes that Bernadette prepared, documenting each interview, to establish the time periods and areas for the personnel who might have knowledge about the transactions in question. The consensus from all the former employees was consistent with that of the current staff: Everyone was afraid of Sheldon Cooper.

They stated that he ruled by intimidation and micromanaged every aspect of the business, including significant customers, the banking relationship, the audit, and the annual physical inventory. He frequently undermined the authority of senior management. As a result, there was constant turnover in key positions.

An investigation of the inventory commenced shortly after the interviews. Allegedly, the quantities on numerous tags had been altered after the stock was counted, apparently to reflect higher quantities than those originally counted. The team located the tags for the years in question and put them in number order. The plan was to compare them to those saved and stored by the inventory manager in a locked cabinet in the warehouse. A three-part form existed: one stayed on the inventory, one was pulled after the count and sent to accounting, and the third was saved in a locked cabinet in the inventory manager's warehouse office. But Sheldon Cooper was unaware of the third copy.

The process of organizing and comparing the tags was tedious and time consuming. After several hours, the team identified many where the quantity listed on the copy from the inventory manager's office did not agree with that on the tag attached to the inventory. In fact, the manipulation was quite obvious. For example, where it originally had indicated a quantity of 20, the tag had been changed to read 220. The handwriting and the colour of the ink were clearly different; there was no attempt to hide it. Once the team completed matching the tags to the form from the locked cabinet, they then compared the tags with discrepancies to the final inventory report.

They found, without exception, that the higher quantity had been recorded on the final inventory report. Next, they prepared a schedule of the differences, both quantity and extended cost, to determine the amount of the misstatement by year for the manipulated tags.

The investigators had been told that the values had also been fudged by increasing unit costs. In his interview, a former CFO recalled a time when the physical inventory had been entered for one year, and he did a screen print to get the total value just before the end of the workday. It was $780,000. The former CFO had seen Sheldon Cooper lurking around, and he was grumbling loudly that the inventory value had better be closer to $1,000,000 than $750,000 or the year end numbers were not going to be good. One of the clerks performing the data entry was a longtime company employee and was very close to Sheldon. The next morning the former CFO checked, and the value had jumped to $1,025,000. The former CFO confronted Sheldon and was told to mind his own business.

The investigators obtained vendor price lists and began comparing them to the final inventory report. There were numerous instances of dramatically higher prices over a three-year period. For example, a unit cost of $125 became $1,250. They documented all of the exceptions and quantified them. Meanwhile, Fowler and Bernadette began investigating certain transactions identified by the former sales manager that were handled directly by Sheldon, who had forbidden anyone else to have contact with this client because it was ''his account.''

Bernadette found that the sales to this particular customer, who was also an inventory supplier to Switch, were always made near quarter-end and were for significant amounts but were never actually paid. More digging revealed that the inventory purchased by Switch was the same inventory it was selling to the supplier, but the supplier was buying it back for the inflated sales price. Bernadette had Leonard, run reports from the previous four years for this customer so he could analyze all of the transactions to determine their propriety.

Further, financial statements reflected significant increases in fixed assets during a two-year period, but the details were scant. In fact, Fowler and Bernadette found that the additions were payments to a company owned by Sheldon Cooper. Allegedly, these expenses were for the retooling of certain machines on the assembly floor, but according to the foreman, this work had not been performed in at least three years.

The final area examined was the review of cash disbursements. Bernadette asked Leonard to have his IT staff member export the cheque and wire transfer registers into Excel. After this was completed, she sorted and subtotaled the data by payee. Next, she arranged information by total amount disbursed, highest to the lowest. Finally, the team reviewed the paid bill files for the significant payments to ascertain if there was documentation supporting their business purposes.

When Fowler, Ranch, Gilbert, & Associates completed their investigation, they delivered a comprehensive written report to Will and the board of directors. A week later, Fowler and Bernadette were scheduled to make an oral presentation summarizing the findings. They focused on three areas:

1. Switch had misrepresented its financial condition for at least four years. In some cases, it was facilitated by the falsification of certain of the company's books and records, particularly with respect to the inventory.
2. By all indications, there were inappropriate management overrides by the president and CEO, Sheldon Cooper. The roadblocks established there, combined with Cooper's mantra of ''stay in your own lane,'' resulted in a litany of misstatements and misrepresentations.
3. The broad categories of improprieties included:

• Inventory misstatements
• Erroneous revenue recognition
• Questionable fixed asset capitalization policies
• Disbursements and compensation issues

The board of directors was stunned and angered by the report. They fired questions at Fowler and Bernadette. Over the years, the board had relied heavily on Sheldon's word and promises. They felt betrayed by his dishonesty. A strategy had to be developed to minimize the long-term impact to the company and its shareholders. Switch was public, and the Canadian Regulators needed to be notified of the financial misstatements. The board, Leonard, and Switch administration also had to discuss the situation with their current auditors and their lenders, Toronto-Dominion Bank.

When Will contacted the regulators and presented them with a copy of the investigative report, they requested that the company prepare the appropriate filings to rectify the situation. Sheldon Cooper would be dealt with separately. Leonard and Will met with the partner from the auditing firm, an old friend of Sheldon's, to inform her about the forensic investigation and the results. Leonard also wanted to discuss why the auditors had not identified the irregularities during the course of their audits of the financial statements. He had not been able to locate a single letter from them recommending improvements in the system of internal controls. The partner was shocked by the news. The auditors determined it was necessary to conduct their own investigation.

Leonard and Will also arranged a meeting with Switch's loan officer from Toronto-Dominion Bank. Also, an old friend of Sheldon's, he appeared extremely agitated after hearing the news regarding the financial misstatements. The officer informed them that Toronto-Dominion Bank, in addition to providing the company with a line of credit secured by inventory, had loaned a considerable sum to Sheldon individually, and that the loan was secured by Switch's stock.

Leonard and Will were not aware that of this. Now it all began to make sense to Leonard; Sheldon had committed the fraud to maintain the company's value at a price level to keep his loan from being undercollateralized.

If the stock stayed above a certain price, Sheldon could continue to borrow funds to finance his extravagant lifestyle. Toronto-Dominion put Switch on a temporary credit hold and informed Leonard and Will. The bank recognized that anything involving Switch would also adversely affect the loan to Sheldon, so it wanted to move forward cautiously. Toronto-Dominion also decided to send a team of auditors over to Switch to perform its own investigation.

Finally, Sheldon had to be confronted. The board of directors convened a special meeting with Leonard, Will, and Sheldon. He was very quiet when the board chairman reviewed the findings of the forensic investigation and then began to cry hysterically, confessing and confirming that the misstatements were all his doings. In addition, Sheldon admitted that the manipulations had started five years ago. Because the company was underperforming, he had to be more aggressive to maintain positive financial results. He complained that when he stepped in to run the company, their state-of-the-art manufacturing facility was antiquated and needed a significant overhaul.

He also believed Switch's products were on the verge of being obsolete. Sales had been decreasing for years. Newer and better products from competitors required Switch to reduce prices significantly, which greatly diminished profit margins. Sheldon also masked the overhead costs. His salary had been increased to $500,000 per year, and the newly constructed corporate office building was a huge financial burden. Sheldon admitted that he did not want to change his lifestyle or run the risk of tarnishing the company's image, but he just didn't think he had an alternative. He acknowledged that he was manipulating the financial information so that the stock price would not fall in order to keep his entire empire from collapsing.

CASE REQUIREMENTS

1. One factor of the internal control environment when investigating fraud is "integrity and ethical values." In what ways were integrity and ethical values slighted by Sheldon? Support your answer with evidence from the case study in this situation.
2. Describe the investigative techniques used by the forensic team to uncover the fraud. Evaluate the success of these techniques, and outline two additional measures that could have been undertaken.
3. The fraud at Switch is one of many major financial statement frauds that have occurred in recent years. Describe five factor that could explain why the falsifying of financial statements is occurring so frequently.
4. Apply the fraud triangle to this case. Speculate on the motivation/pressures, opportunity, and rationalization of Sheldon.
5. Evaluate and comment on the Board's behaviour. Include in your evaluation the responsibility of the Board with regards to internal controls.