R E S P O N S I B I L I T I E S & L E A D E R S H I P fraud The Case of Phar-Mor Inc. Could SOX Have Prevented the Fraud? By S. Lansing Williams T he Sarbanes-Oxley Act of 2002 (SOX) was an effort to increase the confidence of investors after a number of high-profile corporate failures due to malfeasance on the part of corporate officers and poor internal controls. After the failures of Enron. WorldCom, and other large companies— which resulted in huge losses to investors—Senator Paul Sarbanes (D-Md.) and Representative Michael Oxley (R-Ohio) coauthored a bill that resulted in public companies improving the accuracy of their financial reports. The law contains 11 major sections, including (Title I) Public Company Accounting Oversight Board, (Title II) Auditor Independence, (Title III) Corporate 58 Responsibility. (Title FV) Enhanced Financial Disclosures. (Title V) Analy.st Conflicts of Interest, and (Title VI) Commission Resources and Authority. Titles VII, VIII, IX, X, and XI deal with sUidies and reports, corporate and criminal fraud accountability and white-collar crime penalties, corporate tax retums, and corporate fraud and accountability. While SOX came about as a direct result of the Enron meltdown in 2001, followed by the WoridCom bankruptcy in 2002, these two companies were not the only failures that led to its passage. The 1992 bankruptcy of Phar-Mor Inc. cost its investors $500 million. Although the bankruptcy occurred 10 years SEPTEMBER 2011 / THE CPA JOURNAL prior to the enactment of SOX, this article attempts, with hindsight, to determine if the bankniptcy might have been prevented if the provisions of SOX bad been in effect and applied to Phar-Mor Inc. Background Phar-Mor Inc., a deep discount drugstore chain, came into existence in 1982 as an affiliate of family-owned grocery chain Giant Eagle, which also owned a distribution company. Tánico Distributors Co. The deep discount concept consisted of using "pt)wer buying," or purchasing the largest possible amount of product at tbe best terms, then selling at discounts of up to 25%-40% off retail prices. The then vice-president of Tamco, Michael J. "Mickey" Monus. was named president of the new company. Phar-Mor had grown to 70 stores by 1987 and saw further expansion, reaching 200 stores in 1990; by 1992, it reachetl 310 outlets with 25,000 employees in 34 states (www. I undinguni verse.com/company-histories/ PhaiMor-Inc-Coinpany-History.html). The first indication of financial problems came to light in 1988, when investigation of lower-than-expected profit margins revealed that Phar-Mor was being billed for inventory it had not received Irom its sister company, Tamco, a primary supplier. Because Phar-Mor did not maintain receiving records of its purchases from Tamco, it was impossible to substantiate products received. At the same time, Tamco's records were equally pcx)r. A formal analysis of the shortage by a Phar-Mor accountant indicated that tbe inventory shortage/overbilling was around $4 million; bowever, the two subsidiaries of Giant Eagle settled on $7 million, giving Phar-Mor a $2 million profit for the year. It is interesting to note that the settlement resulted in a nearly identical gross margin as the prior year (David M. Cottrell and Steven M. Glover, "Finding Auditors Liable for Fraud," The CPA Journal, July 1997). While not on the radar for several years, another source of problems for Phar-Mor began with the formation of the World Basketball League (WBL) in 1987. Monus owned at least 60% of each of the 10 teiuiis and wasrespwasiblefor that portion of each team's losses, which a fellow investor in the WBL told a Cleveland Plain Dealer SEPTEMBER 2011 / THE CPA JOURNAL reponer averaged $13,000 per game, or $7,800 for Monus's share (www.funding universe.com). It was estimated that Monus embezzled about $15 million from PharMor in support of WBL activities (Gabriella Stern, "One Messy Store: Chicanery at Pbar-Mor Ran Deep, Close Look at Discounter Shows," Wall Street Journal, January 20, 1994). By 1989 Phar-Mor's losses were mounting. In addition to funding of WBL activities, Monus had diverted over $2(X),000 for improvements to his personal residence and meals at a country club (Stem 1994), and profit maiçias continued to deteriorate. When the chief financial officer, Patrick Finn, first reponed losses to Monus, the president crossed off the loss and wrote in a profit (Jim 0 n f e r e n ce Wednesday, September 21,2011 FAE Conference Center New York City 9:00 a.m.-5:00 p.m. Also Available Via Live Webcast Choose In-Person or Live Webcast 1. 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Live Webcast Member Fee: $285; Nonmember Fee: $385 Can't attend ttie event in persoii' Experience the same great speakers and topics directly trom your computer. To register lor the Live Webcast, please visit www.nysscpa.org/e-cpe. or call 877-880-1335. This is an FAE Paperless Event. Visit www.nysscpa.arg for more information. Save on fhis conference and otfier FAE conferences and seminars with POP 2011! Visit www.nysscpa.org for more Information. FAE 61 health (Gilmore, Judge, and Solman). It takes a great deal of courage to become a whistleblower, which makes one wonder if someone hired without violation of the one-year rule would have reported the situation. such a statement unless compelled to do so under the rules in SOX. Part 4 of Title III, section 302 requires the signing officers to take responsibility for establishing and maintaining intemal Title III, section 302, "Corporate controls. In reality, the signing officers Responsibility for Financial Reports." were responsible for ignoring intemal conThis section states that the principal exec- trol procedures, if any even existed. utive officers and the principal financial Part 5 requires the signing officers to disofficers are required to certify in each annu- close to their auditors and board of direcal or quarterly report that— tors' audit committee all significant defi( 1 ) the signing officer has reviewed the ciencies in intemal controls and further disclose any fraud, material or not, that report; (2) based on the officer's knowledge, the involves management. It seems clear report does not contain any untrue state- from the actions of Monus and Finn that ment of a material fact, or omit to state they would likely have felt little, if any, a material fact necessary in order to discomfort in perjuring themselves by commake the statements made, in light of plying falsely with the Title HI, section 302 the circumstances under which such requirements. statements were made, not misleading; Title IV, section 404, "Management (3) based on such officer's knowledge, Assessment of Internal Controls." the financial statements, and other finan- Subsection (a) of this section requires mancial information included in the report, agement to include in annual reports an interfairly present in all material respects nal control report which shall— the financial condition and results of (1) state the responsibility of manageoperations of the issuer as of, and for, ment for establishing and maintaining an the periods presented in the report; adequate intemal control stmcture and procedures for financial reporting; and (4) the signing officers— (A) are responsible for establishing and (2) contain an assessment, as of the end maintaining intemal controls ... of the most recent fiscal year of the (5) the signing officers have disclosed to issuer, of the effectiveness of the interthe issuer's auditors and the audit comnal control structure and procedures of mittee of the board of directors (or perthe issuer for financial reporting. sons fulfilling the equivalent function)— It would probably be safe to say that (A) all .significant deficiencies in the since the management responsible for makdesign or operation of intemal controls ing, assessing, and asserting the establishwhich could adversely affect the issue's ment and maintenance of adequate interability to record, process, summarize, nal control structure and procedures was and report financial data and have identi- the same management perpetuating the fied for the issuer's auditors any material fraud, such assessments would likely still have been made without hesitation. weaknesses in intemal controls; and (B) any fraud, whether or not material, Additionally, subsection (b) requires that involves management or other that— employees who have a significant role With respect to the intemal control assessin the issuer's intemal controls. ment required by subsection (a), each regThis section would have required the prinistered public accounting firm that precipal executive officer, Monus, and the prinpares or issues the audit report for the cipal financial officer, Finn, to state that issuer shall attest to, and report on, the the financial statements of Phar-Mor did not assessment made by the management of contain any untrue statements of a materithe issuer. al fact and that the financial statements Again, given that Finn testified that he fairly presented in all material respected would have given fraudulent joumal entries the condition and results of operations. to the auditors (Cottell and Glover), he The facts show that both individuals would have provided Coopers with suffiwere deeply involved in the misstatement cient detailed intemal control documentaof Phar-Mor's financial health. It would be tion that would have sufficed for a posihighly doubtful that they would have made tive assessment. 62 Title IV, section 406, "Code of Ethics for Senior Financial Officers. " This section de.scribes requirements for a code of ethics for senior financial officers, stating: The Commission shall issue rules to require each issuer, together with periodic reports required ... to disclose whether or not, and if not, the reason therefor, such issuer has adopted a code of ethics for senior financial officers, applicable to its principal financial officer and comptroller or principal accounting officer, or person performing similar functions. ... Definition.—In this section, the term "code of ethics" means such standards as are reasonably necessary to promote— ... (2) full, fair, accurate, timely, and understandable disclosure in the periodic reports required to be filed by the issuer. The senior management of Phar-Mor willingly and knowingly perpetuated a massive fraud and spent considerable energy and resources maintaining the cover-up. There is no reason to believe that a code of ethics would have been adhered to. Would SOX Have Helped? Had the Phar-Mor fraud been perpetrated in a post-SOX environment, the Coopers & Lybrand partner-in-charge would likely have been replaced by application of SOX regulations because he would have been responsible for the audit for more than five years by 1991 and therefore subject to audit partner rotation. There's a question as to whether his successor would have changed audit procedures to any great extent, and perhaps just as importantly, would have found himself under the same cost restraints. The senior management of Phar-Mor deliberately concealed major losses of the company. Additionally, corporate funds were used to pay for both personal expenses of the president and an unrelated organization. The president, vice president of finance, CFO, controller, and accounting manager were all involved in the cover-up. Three members of this fraud team had worked for the auditor and were familiar with the audit steps that would be taken, thus helping them cover up their activities. If SOX had been enacted in the mid1980s, it would have prevented the hire SEPTEMBER 2011 / THE CPA JOURNAL of Phar-Mor Controller Cherelstein. Walley and Finn, who were hired earlier in the company's existence, were the enablers, using their knowledge of Coopers audit procedures. Because the senior management of PharMor were responsible for perpetuating the fraud, it could be assumed that they would have had no compunction in asserting that all intemal control structures and procedures were effective. Inasmuch as the fraud was dependent upon management knowledge of audit procedures used, it would probably be safe to assume that any management as.sessment of intemal controls would have ignored areas that would have uncovered the fraud. It can be argued that the auditor was negligent in the audit of Phar-Mor because it did not take proper action to ensure that documentation given to them was accurate and allowed procedures that enabled the cover-up, such as inventory observations weeks in advance of the audit date, at only four out of 300 stores. This is substantiated by the finding of negligence on the part of Coopers. Heng Hsieu Lin and Frederick H. Wu in "Limitations of Section 404 of the Sarbanes-Oxley Act" (The CPA Joumal, March 2006) correctly point out that "Reliable financial reports rely to a certain extent on effective intemal controls, but effective intemal contn^ls rely to a large extent on a reliable management system coupled with strong corporate govemance." In a situation like Phar-Mor, the management .system was neither reliable, nor did it constitute strong corporate govemance. Consequently, had SOX been enacted prior to 1988 when the company first began to encounter financial problems. Title III, section 302 may not have had much impact on the misdeeds of management, rendering it worthless. Furthermore, it would probably be safe to say that Title IV, .section 406, establishing a code of ethics for .senior financial officers, would have been ignored. Section 207 did call for a study by the comptroller general of the United States to determine the feasibility of a mandatory rotation period for auditors. This study was conducted by the U.S. General Accounting Office (GAO), now the Government Accountability Office. This study, submitted to Congress in November 2(X)3, concluded SEPTEMBER 2011 / THE CPA JOURNAL that mandatory rotation would be more It would seem that the Phar-Mor Inc. harmful than beneficial in improving audit bankruptcy was what could be consideted reliability due to "the additional financial the perfect storm of corporate management costs and the loss of institutional knowl- malfeasance. It was the senior manageedge of the previous auditor of record," an ment—the individuals responsible for peropinion shared by the AICPA and individ- sonal and inappropriate use of corporate ual members of the audit profession (Barbara assets, the individuals who refused to Arel, Richard Brody, and Kurt Pany, "Audit acknowledge operating losses, tho.se responFirm Rotation and Audit Quality," The CPA sible for development and implementation Jourrutl, January 2005). of intemal controls, tho.se responsible for In retrospect, it would also be easy to accurate financial reporting, iuid tho.se attestargue that had a mandatory rotation of audit ing to their auditors and investors—who firms been in place prior to 1985, the Phar- were responsible for the fraud. This case Mor hankruptcy could well have been appears to point out that laws designed to avoided. Much of the reason for the suc- protect the public, which may be extremely cess of the fraud team was due to the costly to implement, may not always re.sult Q knowledge the individuals had of the audit in the desired outcome. practices of Coopers. If a new audit firm had taken over the audit, management would have had to deal with new proce- S. Lansing Williams, CPA, MBA, is an dures, and the new firm may not have assistant professor of business management ignored transactions within zero-balance at Washington College, Chestertown, Md. accounts. lot Yet a Member? Well You're Missina Out! As a member of the New York State Society of CPAs, you can... • Utilize the new CCH TaxAware Center and gain FREE access to dally tax updates, current developments, tax journals and related publications on a single online platform. 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