In the zzzz best case, barry minkow was charged with:

Practice: Week 3 Discussion Question 1 (Due Wednesday 3/14)

Review case 4-5, The New CEO.

Respond to the following:

Situate yourself as an experienced CPA in your assigned Accounting Firm. Your firm is consulting for Texarkoma Products. Using the relevant elements of a defined, stated, and cited ethical decision-making model discussed in Ch. 2, explain what Boreing should do. Be sure to engage and integrate your assigned Accounting firm's mission, value, principles, and publications.

Analytical Requirements: Introduce the situation. Introduce and define or situate on the theme from the textbook (cite and reference). Step through the elements using facts, logical reasoning, and appropriate responses as a CPA and member of the AICPA. Conclude on the theme.

Scope: Your original response should be 350-500 words in length and meet the APA and writing standards as shown in the CWE for Masters Level II. Follow up responses should be 150 words in length (graded under participation).

Professional references (no third party): Required: Content from the textbook, AICPA Code of Professional Conduct, a professional Accountancy journal from the United States of America, Accounting technical guidance for any factual assertions. Recommended: Peer reviewed ethical websites (not professor in courses websites), Journal of Business Ethics, and related literature.

For assigned Accounting firm questions, specifically used and linked resources from the firm's website.

Case 4-5: The New CEO

Liza Perky was recently selected to be the CEO of a small company in Oklahoma City

on October 11, 2010. The company is owned by venture capitalists and it plans to go

public in 2011, after five years of growth in sales from $200,000 to $1,500,000.

Texarkoma Products manufactures fax and copy machines and other office machines

and sells them primarily to customers in the Oklahoma, Texas, and Arkansas tristate

area. Increased competition from Kanecola, a startup company in the Kansas,

Colorado, and Nebraska tristate area, forced Texarkoma to cut prices and the losses

started to mount. In 2008 the company lost $500,000 and in 2009 it lost $700,000. For

the first nine months of 2010, the company lost an additional $600,000. That’s when it

fired the former CEO and hired Perky, a turn-around artist who had seemingly saved

dozens of companies by eliminating unprofitable product lines.

Perky believes that the company will soon turn things around because Kanecola was

recently taken over by Clips, Inc., a national company that is located in 40 states.

Texarkoma now has a competitive advantage in the local tristate area since small

businesses in the Southwest tend to be loyal to local and regional distributors because

of the personal service and long-standing ties to the community.

During the last three months of 2010, the company reported a preliminary loss of

$250,000, a total projected loss of $850,000 for the year. On January 8, 2011, Perky

took a look at the results and seemed disappointed. She summoned her chief

accounting officer, Joe Boreing, who is a CPA in Oklahoma. The following dialogue took

place:

Perky: Joe, I’ve been looking over the results for the last three months and the supporting

numbers and I can’t understand how you only put through a $200,000 write-down (40

percent) of the “Gobble” line of commercial copiers.

Boreing: I think we can salvage something from a discount sales drive of the machines.

Perky: How so, Joe? We haven’t sold very many of these machines during the past three

months.

Boreing: We have sold 50 machines.

Perky: And what was our loss?

Boreing: It was 50 percent of the cost of each machine.

Perky: And your numbers indicate there are still 500 machines in stock.

Boreing: That’s right.

Perky: Well, you’re the math wiz but I figure that means a potential loss of at least $250,000.

Boreing: That’s right but I cut it to $200,000 because I have a potential buyer. It’s the Texas

School District. The superintendent wants to buy the copiers for all K–12 schools and

she doesn’t care that it’s not the latest model with all the bells and whistles.

Perky: Do you have a signed contract?

Boreing: No. I expect that to happen by the end of January.

Perky: Well, aren’t you always preaching conservatism to me in terms of the numbers?

Boreing: Not always but in general; the accounting rules require that we provide for all potential

losses immediately.

Perky: Right. So I want you to do that with the Gobble copiers.

Boreing: Okay. I’ll add $50,000 to the write-down.

Perky: That’s not enough. I want you to double the amount.

Boreing: You want me to increase the write-down to $300,000?

Perky: No. I want you to record a total write-off of the Gobble inventory.

Boreing: You want me to write off all $500,000?

Perky: That’s what I said.

Boreing started to resist, but after 10 more minutes of discussion he knew it was no use.

Perky cut him off and told him it was a direct order and she expected him to comply, or

else.

Practice: Week 3 Discussion Question 2 (Due Friday 3/16)

Review Case 5-2 ZZZZ Best

Respond to the following:

Yellow Group Question

Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best where top management goes to great lengths to fool the auditors? Why or why not? Examine Ernst & Whinney's record and provide expert support for your finding and or not finding fraud.

The AICPA Code obligates CPAs to follow specific standards of conduct in carrying out audits. Answer the following questions with respect to those standards and the related ethical expectations.

Blue Group Question

Why is it important to exercise sensitive moral judgments when conducting an audit? Did Ernst & Whinney meet its obligations in this regard? If not, provide authoritative support for and describe why it failed to meet its obligations.

Orange Group Question

What are the criteria for audit independence according to expert sources from AICPA and or from the professional journals? With that stated, now use that to analyze and comment on the independence of Ernst & Whinney in conducting its audit of ZZZZ Best.

Green Group Question

Auditors are expected to exercise due care in the performance of professional services. Explain the purpose of the due care standard according to appropriate expert sources. Based on the facts of the case, do you think Ernst & Whinney met its due care obligations? Why or why not using your support again to maintain and bolster your aguments.

Note that the textbook is not authoritative or expert support for CPA standards as required in the question prompts.

Analytical Requirements: Introduce the situation. Introduce and define or situate on the theme from the textbook (cite and reference). Step through the elements using facts, logical reasoning, and appropriate responses as a CPA and member of the AICPA. Conclude on the theme.

Scope: Your original response should be 350-500 words in length and meet the APA and writing standards as shown in the CWE for Masters Level II. Follow up responses should be 150 words in length (graded under participation).

Professional references (no third party): Required: Content from the textbook, AICPA Code of Professional Conduct, a professional Accountancy journal from the United States of America, Accounting technical guidance for any factual assertions. Recommended: Peer reviewed ethical websites (not professor in courses websites), Journal of Business Ethics, and related literature. For assigned Accounting firm questions, specifically used and linked resources from the firm's website.

Case 5-2 ZZZZ Best

The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year-old boy from Reseda, California, who was driven to be successful, regardless of the costs. His name is Barry Minkow. Although this case dates back over 30 years, it does serve as an example of what can happen when auditors do not look too hard to find fraud.

Minkow had high hopes to make it big—to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets, but that he could in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Because the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done, and perhaps not be all that concerned with how much it would cost. The only problem with Minkow’s insurance restoration idea was that it was all a fiction. Allegedly, over 80 percent of his revenue was from this work. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst & Whinney (now EY), into thinking the insurance restoration business was real. The auditors never caught on until it was too late.

How Barry Became a Fraudster

Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback, 2 that provides some insights into the mind of a 15-year-old kid who was called a “wonder boy” on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in his garage-office, Minkow called Channel 4 in Los Angeles. He disguised his voice so he wouldn’t sound like a teenager and told a producer that he had just had his carpets cleaned by the 16-year-old owner of ZZZZ Best. He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business. The producer bought it lock, stock, and carpet cleaner. Minkow gave the producer the phone number of ZZZZ Best and waited. It took less than five minutes for the call to come in. Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said, “Who may I say is calling?” Within days, a film crew was in his garage shooting ZZZZ Best at work. The story aired that night, and it was followed by more calls from radio stations and other television shows wanting to do interviews. The calls flooded in with customers demanding that Barry Minkow personally clean their carpets.

As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking account. He managed to find a banker that was so moved by his story that the banker agreed to allow an underage customer to open a checking account. Minkow used the money to buy cleaning supplies and other necessities. Even though his business was growing, Minkow ran into trouble paying back loans and interest when due.

Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage—where all his great ideas first began—and looked at his bank account statement, which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers, so they didn’t yet show up on the bank statement. Voilá! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best account and deposit it into another. Because it might take a few days for the check written on Bank #1 to clear that bank’s records (back then, checks weren’t always processed in real time the way they are today), Minkow could pay some bills out of the second account and Bank #1 would not know—at least for a few days—that Minkow had written a check on his account when, in reality, he had a negative balance. The bank didn’t know it because some of the checks that Minkow had written before the visit to Bank #2 had not cleared his account in Bank #1.

It wasn’t long thereafter that Minkow realized he could kite checks big time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in Bank #1 and carry it onto the balance sheet. Because Minkow did not count the check written on his account in Bank #1 as an outstanding check, he was able to double-count.

Time to Expand the Fraud

Over time, Minkow moved on to bigger and bigger frauds, like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs. Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best. He had cash remittance forms made up from nonexistent customers with whatever sales amount he wanted to appear on the document. He even had a co-conspirator write on the bogus remittance form, “Job well done.” Minkow could then show a lot more revenue than he was really making.

Minkow’s phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets. However, Minkow’s personal tastes had become increasingly more expensive, including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000-square-foot home. So, the question was: How do you solve a perpetual cash flow problem? You go public! That’s right, Minkow made a public offering of stock in ZZZZ Best. Of course, he owned a majority of the stock to maintain control of the company.

Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, CPAs, and attorneys all working for him—the now 19-year-old kid from Reseda, California, who had turned a mom-and-pop operation into a publicly owned corporation.

Barry Goes Public

Pressured to get a big-time CPA firm to do his audit by the underwriting firm selling his stock, Minkow hired Ernst & Whinney to perform the April 30, 1987, fiscal year-end audit. Minkow continued to be one step ahead of the auditors—that is, until the Ernst & Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business—all the revenue—that Minkow had said was coming in to ZZZZ Best was real.

The engagement partner drove to an area in Sacramento, California, where Minkow did a lot of work—supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn’t clear, but he identified a building that seemed to be the kind that would be a restoration job in progress.

Earlier in the week, Minkow had sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it, Minkow’s associate picked out the same site as had the partner later on. Minkow’s cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend. Minkow’s helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time, but it looked as if some restoration work was going on at the site.

Minkow was able to pull it off in part due to luck and in part because the Ernst & Whinney auditors did not want to lose the ZZZZ Best account. It had become a large revenue producer for the firm, and Minkow seemed destined for greater and greater achievements. Minkow was smart and used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they became too curious about the insurance restoration jobs. He would even threaten to take his business from Ernst & Whinney and give it to other auditors. To get on their good side, he would wine and dine the auditors and even invite them to his house.

Minkow also took a precaution with the site visit. He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work. This prevented the auditors from corroborating the insurance restoration contracts with independent third parties.

The Fraud Starts to Unravel

It was a Los Angeles housewife who started the problems for ZZZZ Best that would eventually lead to the company’s demise. Because Minkow was a well-known figure and flamboyant character, the Los Angeles Times did a story about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for its carpet cleaning services.

Minkow had gambled that most people don’t check their monthly statements, so he could get away with the petty fraud. However, the housewife did notice the overcharge and complained to Minkow, and eventually he returned the overpayment. She couldn’t understand why Minkow would have had to resort to such low levels back then if he was as successful as the Times article made him out to be. So she called the reporter to find out more, and that ultimately led to the investigation of ZZZZ Best and future stories that weren’t so flattering.

Because Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money. It got so bad over time that he was close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn’t pay his suppliers. The complaints kept coming in, and eventually the house of cards that was ZZZZ Best came crashing down.

During the time that the fraud was unraveling, Ernst & Whinney decided to resign from the ZZZZ Best audit. It had started to doubt the veracity of Minkow and his business at ZZZZ Best. Of course, by then it mattered little because the firm had been a party to the cover-up for some time.

Legal Liability Issues

The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst & Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report issued by Ernst & Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report because Ernst & Whinney had expressly disclaimed issuing any opinion on the statements. The firm lucked out in that the judge understood that a review engagement only provides limited assurance rather than the reasonable assurance of the audit.

Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years.

Questions

1. Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best, where top management goes to great lengths to fool the auditors? Explain.

2. Discuss the red flags that existed in the ZZZZ Best case and evaluate Ernst & Whinney’s efforts with respect to fraud risk assessment. Criticize the firm’s approach to the audit from a professional judgment perspective.

3. These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986:

1985 1986

Sales $1,240,524 $4,845,347

Cost of goods sold 576,694 2,050,779

Accounts receivable 0 693,773

Cash 30,321 87,014

Current liabilities 2,930 1,768,435

Notes payable—current 0 780,507

1.

a. What is the purpose of performing analytical review procedures in an audit performed under GAAS? What calculations or analyses would you make with these numbers that might help you assess whether the financial relationships are “reasonable”?

b. Given the facts of the case, what inquiries might you make of management based on your analysis?

Barry: The Afterlife

After being released from jail in 1997, Minkow became a preacher and a fraud investigator, and he spoke at schools about ethics. He had established a reputation of trust as a pastor in the Community Bible Church in San Page 318Diego that he had served after being released from prison. However, over time his greedy nature got the better of him. He admitted that he tricked a widower into making a $75,000 donation for a hospital in Sudan to honor his wife after she died of cancer. Only there was no hospital, and Minkow pocketed the money. Minkow also admitted, among others things, that he stole $300,000 from a widowed grandmother who was trying to raise her teenage granddaughter. In addition, Minkow confessed to diverting church member donations for his own benefit and embezzling money intended as church donations. In all, Minkow admitted stealing—and concealing from the IRS—at least $3 million from church parishioners and lenders. As described in court documents, Minkow’s conduct continued for over a decade. On April 28, 2014, he was sentenced to five years in prison for his crimes that will be tacked on to the five-year term in the Lennar scheme, described below.

Soon after his arrival at Community Bible Church, a church member asked him to look into a money management firm in nearby Orange County. Suspecting something was not right, Minkow used his “fraud-sniffing” abilities to alert federal authorities, who discovered the firm was a $300 million pyramid scheme. This was the beginning of the Fraud Discovery Institute, a for-profit investigative firm. Minkow managed to dupe the investment community again; several Wall Street investors liked what they saw and sent him enough money to go after bigger targets. By Minkow’s estimate, he had uncovered $1 billion worth of fraud over the years.

Once again, Barry’s true self got the better of him and in 2009, he issued a report accusing the major homebuilder Lennar of massive fraud. Minkow claimed that irregularities in Lennar’s off-balance-sheet debt accounting were evidence of a massive Ponzi scheme. He accused Lennar of not disclosing enough information about this to its shareholders, and also claimed that a Lennar executive took out a fraudulent personal loan. Minkow denounced Lennar as “a financial crime in progress” and “a corporate bully.” From January 9, 2009 (when Minkow first made his accusations), to January 22, 2009, Lennar’s stock tumbled from $11.57 a share to only $6.55. Minkow issued the report after being contacted by Nicholas Marsch, a San Diego developer who had filed two lawsuits against Lennar for fraud. One of Marsch’s suits was summarily thrown out of court, while the other ended with Marsch having to pay Lennar $12 million in counterclaims.

Lennar responded by adding Minkow as a defendant in a libel-and-extortion suit against Marsch. According to court records, Minkow had shorted Lennar stock, buying $20,000 worth of options in a bet that the stock would fall. Minkow also forged documents alleging misconduct on Lennar’s part. He went forward with the report even after a private investigator he had hired for the case could not substantiate Marsch’s claims. (In an unrelated development, it was also revealed that Minkow operated the Fraud Discovery Institute out of the offices of his church and even used church money to fund it—something which could have potentially jeopardized his church’s tax-exempt status.)

On December 27, 2010, Florida circuit court judge Gill Freeman issued terminating actions against Minkow in response to a motion by Lennar. Freeman found that Minkow had repeatedly lied under oath, destroyed or withheld evidence, concealed witnesses, and deliberately tried to “cover up his misconduct.” According to Freeman, Minkow had even lied to his own lawyers about his behavior. Freeman determined that Minkow had perpetuated “a fraud on the court” that was so egregious that letting the case go any further would be a disservice to justice. In her view, “no remedy short of default” was appropriate for Minkow’s lies. She ordered Minkow to reimburse Lennar for the legal expenses it incurred while ferreting out his lies. Lennar estimates that its attorneys and investigators spent hundreds of millions of dollars exposing Minkow’s lies.

On March 16, 2011, Minkow announced through his attorney that he was pleading guilty to one count of insider trading. Prosecutors had charged that Minkow and Marsch conspired to extort money from Lennar by driving down its stock. According to his lawyer, Minkow had bought his Lennar options using “nonpublic information.” The complaint also revealed that Minkow had sent his allegations to the FBI, IRS, and SEC, and that the three agencies found his claims credible enough to open a formal criminal investigation into Lennar’s practices. Minkow then used confidential knowledge of that investigation to short Lennar stock, even though he knew he was barred from doing so. Minkow opted to plead guilty to the conspiracy charge rather than face charges of securities fraud and market manipulation, which could have sent him to prison for life.

Minkow resigned his position as senior pastor, saying in a letter to his flock that because he was no longer “above reproach,” he felt that he was “no longer qualified to be a pastor.”

Questions (continued)

4. Why do you think Minkow was able to pull off the fraud at the church for so long and not be detected?