Crazy eddie inventory fraud

The Crazy Eddie and the Panama Pump Fraud

The Crazy Eddie fraud may appear smaller and gentler than the massive billion-dollar frauds exposed in recent times, such as Bernie Madoff’s Ponzi scheme, frauds in the subprime mortgage market, the AIG bailout, and Goldman Sachs’ failure to disclose. However, our 18-year crime spree conducted in the light of day serves as a fascinating case study of the multiple methods of deceit that white collar criminals routinely engage in. The evolution of the Crazy Eddie crime drama illustrates how petty, easily rationalized criminal infractions can escalate into serious and complex frauds and conspiracies, without so much as a thought given to concepts such as morality, ethics and justice. Morality, ethics and justice are for the other guys – the victims.

Requirements:

You are to assume the role of “the Internal Auditor” responsible for assessing the adequacy and failures of internal control systems for the Crazy Eddie electronics business that led to a massive fraud. Remember that fraud is the “intentional” misrepresentation of material events, such as accounting transactions that cause financial statement users to make damaging business decisions.

As such, you are responsible for reporting the findings of your investigation to such regulatory authorities as the Securities and Exchange Commission, the US Internal Revenue Service, and the US Department of Justice. Each “finding” that you identify should include the following elements:

1. The Condition – What is the substance of the failure in internal control that you identified?

2. The Cause – What id the “root” cause of the failure of the internal control that led to the condition that you identified?

3. The Impact – What is the significance of the finding that you identified? In other words, what is the major “business exposure” that led to the demise of Crazy Eddie’s as a going concern?

4. The Recommendation – What is your recommendation for avoiding this failure of internal control? Please note that your recommendation should “loop back to” and address the “Cause” of the internal control failure (the Condition).

You should identify as many findings as possible based on the following information presented in the case study concerning Crazy Eddie’s electronics business.

Three Easy Steps from Skimming Profits to Accounting Fraud, Securities Fraud, and Conspiracy

Our Crazy Eddie crime spree evolved in three phases:

(1) 1969-1979: Skimming and under-reporting income (tax fraud) prior to the big plan to go public.

(2) 1980-1984: Gradually reducing skimming to increase profit growth in preparation for the initial public offering, i.e., committing securities fraud by “going legit”

(3) 1984-1987: As a public company, Crazy Eddie overstated income to help insiders dump stock at inflated prices using a variety of fraudulent tricks:

· The “Panama Pump” Money Laundering Scheme — Cash skimmed from Crazy Eddie before its initial public offering was laundered back into the company after it went public to inflate revenues and reported profits.

· Fraudulent asset valuations — Overstated inventory assets to inflate reported profits.

· Understated Accounts Payable to Inflate Reported Profits (Accounts Payable Cut-off Fraud) — Inventory that was received by Crazy Eddie before the end of the accounting period was invoiced by suppliers and reflected as shipped to the company in the subsequent accounting period.

· Understated Accounts Payable to Inflate Reported Profits (Debit Memo Fraud) — Crazy Eddie claimed fictitious purchase discounts and trade allowances to understate accounts payable and inflate reported profits.

· Inflated Comparable Store Sales — Crazy Eddie reported bulk sales to non-end users (distributors and other retailers) that originated from its main offices as sales to end user consumers in stores that existed in both the current and period year accounting periods (comparable stores).

· Premature Recognition of Sales to Inflate Revenues, Comparable Store Sales, and Earnings — Crazy Eddie invoiced certain distributors for merchandise and it simultaneously received checks dated before the end of the accounting period. The company shipped the merchandise to the distributors and cashed the checks in the subsequent accounting period.

· Covering up crimes — Subtle changes in accounting policies were used by Crazy Eddie to cover-up certain accounting frauds.

Phase 1: Everybody does this, right?

In 1971, at the age of fourteen, I began my employment at Crazy Eddie as a stock boy. From the very beginning, I was involved in cash skimming and overstating insurance loss claims. This was how the company did business, and I never once questioned our methods.

As a private company from 1969 to 1979, Crazy Eddie’s primary frauds were:

· Tax evasion (skimming cash sales from customers to avoid income and sales taxes)

· Evading payroll taxes by paying employees in cash “off the books” rather than reporting income to the Internal Revenue Service, and

· Reporting phony or exaggerated insurance claims to increase profits.

From 1975 to 1980, I attended Bernard M. Baruch College and majored in public accounting. Eddie Antar and other family members believed that my formal college education in public accounting would help them execute more sophisticated financial crimes in the future. Therefore, the Antar family paid my tuition and paid my full-time salary while I attended college. I continued working at Crazy Eddie at nights, weekends, holiday breaks and summer vacation.

In 1980, I graduated Magna Cum Laude and was on the Dean’s List. The Antars were ready to take full advantage of my accounting education by making me Crazy Eddie’s de facto Chief Financial Officer. This position allowed me to execute more sophisticated crimes on behalf of the family.

Phase 2: Building a bigger and better fraudulent enterprise

Around 1980, we decided to go public. We reasoned that with Crazy Eddie as a public company, we could unload our stock at inflated prices on unsuspecting victims. This would be more profitable than skimming cash sales, tax evasion, and paying employees “off the books.” We anticipated getting a “bigger bang for the buck” by inflating earnings as a public company.

When a public company reports a profit, those earnings are divided by each share of common stock outstanding to compute earnings per share. If a company reported a $1 million profit and has 1 million shares outstanding, its earnings per share is $1.00 per share: $1 million profit divided by 1 million shares outstanding.

A public company’s stock is traded at a multiple of earnings known as the “price earnings ratio” or P/E ratio. If the stock in the above example trades at $30 per share, its P/E ratio is 30: $30 price per share/$1 earnings per share = 30 P/E.

If that company’s management inflated its earnings by $1 million or $1 per share, it would report earnings of $2 million or $2 earnings per share. Assuming the P/E ratio remains at 30, if the earnings were now $2 per share, the price per share would increase to $60 (30 P/E x $2 earnings per share = $60 price per share). The company’s market capitalization would increase by $30 million ($30 price per share x one million shares outstanding = $30 million). All things being equal, inflating earnings by only $1 million or $1 per share added $30 million to the company’s market cap. Insiders can then pocket $30 per share of ill-gotten gains.

Before Crazy Eddie went public, all of the shares were owned by the Antar family. If the Antar family still owned one million shares of stock trading at a P/E of 30, and if we artificially inflated earnings by one million dollars or $1 per share, our collective wealth would have increased by $30 million. Thus, this small one-million-dollar deception created $30 million of fictitious wealth! By comparison, skimming one million dollars off of sales would only save about $300,000 of income taxes, assuming a 30% tax rate.

This shows how inflating earnings by one million dollars has a disproportionately large effect on increasing shareholder wealth–$30 million in market capitalization. Furthermore, faster growing companies are rewarded with even higher P/E ratios by the stock market, which translates into even higher stock prices, demonstrating the importance of proper allocation of fraud-tainted funds.

“Securities fraud by going legit”

Before the IPO, all our illegal skimming of cash sales had to stop. As a public company, Crazy Eddie would need to report growing profits so investors would be willing to pay higher prices for Crazy Eddie’s stock, which we were eager to sell. So ironically, to prepare for our infamous future as a public company, we needed to “legitimize” the business, i.e., “go legit.”