When the Music Stops: Crazy Eddies Background In the 1980s, Crazy Eddie was a fast-growing electronics retailer business specializing in stereos, televisions, VCRs, and computer gaming systems. Founded by Eddie Antar, Crazy Eddie was well known for its outlandish commercials (see www.youtube.com/watch?v=fO9XC3tAbkQ). Most of the key business positions were filled by members of the Antar family, including CFO Sam Antar, Eddies cousin, and a CPA. While the stores were successful, to avoid paying taxes, the family skimmed large amounts of cash from the business. According to Sam Antar, cash received from each days business was brought to a family members house, where a decision was made regarding how much cash to skim before the days receipts were deposited in the bank. As much as $50,000 was skimmed from a days sales on any given day. In 1979, which was the height of the skimming operation, approximately $3 million was taken out of the business. In fact, so much money was being skimmed that the Antars had difficulty finding places to keep it. (Remember, you cannot put large amounts of cash into the bank without the bank notifying the IRS.) Eventually, the Antars sent couriers to Israel with large amounts of cash to be deposited in Israeli banks. (Israel has favorable bank secrecy laws.) Unsatisfied with the cash already being taken, Eddie and the Antar family decided that the type of money they desired could only be obtained by taking Crazy Eddie public. Because the family would retain large amounts of stock, a favorable IPO and subsequent increases in the company stock would net them tens of millions of dollars. In order to make Crazy Eddie appear more profitable, the family decided to reduce the skimming operation. With less money going into the Antars pockets and more money being recorded as sales, the companys profits appeared to be increasing each year at an extraordinary rate. Further, the family transferred millions of dollars from the bank in Israel to a bank in Panama and included drafts drawn on the bank in Panama as store sales. This process was known as the Panama Pump. Consecutively numbered drafts for $25,000, $50,000, $75,000, and even $100,000 were included in the sales figures for various stores on various days. This process was repeated several times. In 1985, $1.5 million received via the Panama Pump and another $500,000 in previous skimmed cash (stored in safe deposit boxes in local banks) were included in store sales to make Crazy Eddie appear to meet Wall Streets lofty expectations for a growing business. This process increased Crazy Eddie same-store-sales ratio, an important Wall Street measurement for retail companies success. By the time of the IPO, Crazy Eddie looked like a gem that needed to be owned by savvy investors. In 1987, its first year as a public company, Crazy Eddie had 43 stores with reported sales of $350 million. Crazy Eddie was the new darling of Wall Street, with an IPO price of $8 per share that rose to more than $80 per share at its peak. Between 1988 and 1989, Antar family members sold more than $90 million worth of stock. In 1984, Eddie Antar divorced his wife, and the Crazy Eddie family organization began to fracture. Many family members remained loyal to Eddiewho always relied on a charismatic personality to charm employees, customers, and vendorswhile other members of the family decided to side with Eddies ex-wife. Family turmoil persisted and escalated from 1984 through 1987. Profit increases began to slow as the Panama Pump slowed and the dollars necessary to maintain its expected phenomenal sales growth increased. A private equity firm, believing that the slowing growth was a result of Eddies family problems and not a business problem, purchased Crazy Eddie in a hostile takeover. The new owners dismissed family members who occupied key business positions and immediately implemented a complete inventory count. In a very short time, the new owners found they had acquired a failing business with inflated assets. In June 1989, Crazy Eddie filed for Chapter 11 bankruptcy. Eddie Antar is alleged to have made $75 million during the short public life of Crazy Eddie. Facing multiple charges in connection with the fraud, Eddie fled the country and lived using assumed names and the millions he had stashed in foreign bank accounts in several countries. In 1992, he was caught in Israel and, after a lengthy extradition fight, was brought back to the United States where, in 1997, he was convicted on 17 counts of fraud and sentenced to eight years in prison. His cousin, Sam Antar, was a major witness against him. The Hide and Seek of the Audit The audited financial statements for Crazy Eddie included not only fictitious sales, but inflated inventory, inaccurate accounts payable, deferred billing from vendors, side deals with vendors for Page C41inventory (included in inventory counts but not paid for) and fictitious vendor discounts used to offset accounts payable). Yet, from before its IPO all the way until the takeover in 1987, Crazy Eddie received unqualified opinions from its auditor each year. Inventory was a key issue in the Crazy Eddie fraud, yet the auditors work shows no special attention to the inventory account balanceeven when analytical procedures indicated significant red flags. Inventory more than quadrupled between 1984 and 1987, while inventory turnover slowed and the average age of inventory increased. Further, an increase in inventory logically requires more purchases, which should result in a corresponding increase in accounts payable, yet accounts payable actually decreased during this period. When observing the physical inventory, the auditor noted that the inventory in the warehouse was stacked and placed in rows. However, the auditors did not ask for inventory to be moved so that items in back of the rows could be verified. In addition, when the auditor noted changes to the inventory counts, they inquired of management but failed to follow up on the issue or include any concerns in the audit documentation. Keeping the fraud from the auditors took hard work and a lot of nerve! In one instance, Crazy Eddie employees opened the auditors records and altered the inventory counts on the auditors sheets. (Remember these were pen-and-paper workpapers back in the 1980s.) Keys to the Audit Trunk (the bag with all the audit workpapers, plans, and information) were left accessible to the client.1 Transfers of inventory were made to intentionally double-count inventory and make an accurate inventory count as difficult as possible for the auditors. Deals were made with vendors to provide merchandise before the year-end but to delay the billing until after year-end. This inventory on hand helped Crazy Eddies close some of the inventory discrepancies between the physical inventory and the recorded inventory. Because auditors assigned to inventory were often young men (in the 1980s, many more males entered the accounting and auditing profession than females), Sam always assigned very attractive young women to assist the auditors in the inventory count. Sam indicated that many of these auditors tended to focus attention on the attractive assistants, thereby placing less focus on the inventory. Further, female employees were encouraged to flirt with young male auditors and even to discuss audit issues over lunch or dinner. Sam even took senior audit team members to bars and clubs that were frequented by attractive young women. While the Panama Pump was working, many stores had $25,000 or $50,000 drafts included in the days sales. This resulted in sale spikes on those days for those stores. Had the auditors investigated these drafts in detail, they may have seen a $50,000 item, which was highly unusual especially in the 1980s. Further, these large cash items had no corresponding customer receipt to indicate what might have been purchased for $50,000. The consecutive numbers on these drafts at different stores, and the fact these were drafts and not checks,2 should have been a glaring red flag for the auditors. But no such investigation was ever made by the auditors. It is alleged that Main Hurdman had underbid the initial audit (1985) and, in an attempt to have a profitable engagement, did not perform adequate procedure. Further, the following year (1986), Main Hurdman merged with Peat Marwick, and new auditors were part of the engagement team. In 1997, following the takeover, Peat Marwick was terminated and Touche Ross was hired. It is certainly possible that the lack of consistency resulting from changing auditors helped Crazy Eddie hide its misconduct. Conclusion Sam Antar is very forthcoming regarding the fraud and his efforts to fool the auditor. In fact, Sam has a website (http://whitecollarfraud.com/) and travels the country speaking to professional groups and university students. A portion of an interview Sam did for the Association of Certified Fraud Examiners can be viewed at www.youtube.com/watch?v=5f6ZpC2bmbs. Eddie and Sam Antar went their separate ways, and Eddie was eventually released from prison. CNBC arranged for Sam and Eddie to meet after years of never seeing or speaking to each other. A summary of the Crazy Eddies case and the Sam and Eddie reunion can be seen at www.youtube.com/watch?v=Y_7ntzgTvhs. Page C42

Questions:

1. At Crazy Eddie, the management team established deceiving the auditors as a primary strategic objective. If management spends considerable time and effort on this goal, is it possible that the auditor can still fulfill his or her mission of ensuring the financial statements are not materially misstated? If so, what steps can an auditor take to overcome these types of situations? 2. How could the auditors have determined that the inventory balance was materially misstated? What changes to the audit plan would have been necessary to validate the existence and valuation of inventory? 3. In Crazy Eddie, the auditors work plan and results were viewed by the client, in part because the security of their workpapers was inadequate. Why is protecting the audit work product so important? In todays audit environment, what should auditors do to protect their work product? What might auditors do in todays audit environment that could expose their work product to individuals not engaged in the audit? 4. What is the primary purpose of analytical procedures performed during the planning stages of the audit? Please identify the warning signs that were revealed about the inventory balance during analytical procedures that were ignored by the auditors. 5. Crazy Eddie focused on making the company look extremely profitable just prior to the IPO. Why was this important? Does this make a client that is in the process of issuing an IPO a higher-risk client? Why or why not? Are there other risks to the auditor when an IPO is included in the engagement? 6. When Touche Ross became the new audit firm in 1997, what additional steps is the new auditor required to complete during the audit process? Are there any other steps that the audit firm should take?