Red flags in financial statement analysis pdf

Issues:

1. Compute key ratios and other financial measures for Crazy Eddie during the period 1984-1987. Identify and briefly explain the red flags in Crazy Eddie’s financial statements that suggested the firm possess a higher-than-normal level of audit risk.

2. Identify specific audit procedures that might have led to the detection of the following accounting irregularities perpetrated by Crazy Eddie personnel: (a) the falsification of inventory count sheets, (b) the bogus debit memos for accounts payable, (c) the recording of transshipping transactions as retail sales, and (d) the inclusion of consigned merchandise in year-end inventory.

3. The retail consumer electronics industry was undergoing rapid and dramatic changes during 1980s. Discuss how changes in an audit client’s industry should affect audit planning decisions. Relate this discussion to Crazy Eddie.

4. Explain what is implied by the term lowballing in an audit context. How can this practice potentially affect the quality of independent audit services?

5. Assume that you were a member of Crazy Eddie audit team in 1986. You were assigned to test the client’s year year-end inventory cutoff procedures. You selected 30 invoices entered in the accounting records near year-end: 15 in the few days prior to the client’s fiscal year-end and 15 in the first few days of the New Year. Assume that client personnel were unable to locate 10 of these invoices. How should you and your superiors have responded to this situation? Explain.

6. Should companies be allowed to hire individuals who formerly served as their independent auditors? Discuss the pros and cons of this practice.

Facts:

Mr. Eddie Antar opened his first retail consumer electronics store in 1969 near Coney Island in New York City. By 1987, Antar's firm, Crazy Eddie, Inc., was a public company with annual sales exceeding $350 million. The rapid growth of the company's revenues and profits after it went public in 1984 caused Crazy Eddie's stock to be labeled as an opportunity investment by prominent Wall Street financial analysts. Unfortunately, the story of Eddie Antar unraveled in the late 1980s following a hostile takeover of Crazy Eddie, Inc. After assuming control of the company, the new owners discovered a massive overstatement of inventory that wiped out the cumulative profits reported by the company since it went public in 1984. Subsequent investigations by various regulatory authorities, including the SEC, resulted in numerous civil lawsuits and criminal indictments being filed against Antar and his former associates.

Following the collapse of Crazy Eddie, Inc., in the late 1980s, regulatory authorities and the business press criticized the company's auditors for failing to discover that the company's financial statements had been grossly misstated. This case focuses on the accounting frauds perpetrated by Antar and his associates and the related auditing issues. Among the topics addressed by this case are the need for auditors to have a thorough understanding of their client's industry and the importance of auditors maintaining a high level of skepticism when dealing with a client whose management has an aggressive, growth-oriented philosophy. This case also clearly demonstrates the need for auditors to consider weaknesses in a client's internal controls when planning the nature and timing of year-end substantive tests.

Some of the most important key facts about Crazy Eddie, Inc. are for example that most of Crazy Eddie’s top executives were relatives or close friends of Eddie who lacked the appropriate qualifications for their positions. The consumer electronics industry realized a dramatic increase in sales from 1981 through 1984, which prompted Eddie into the conversion of Crazy Eddie's stores into consumer electronics supermarkets. In 1984, Mr. Eddie took Crazy Eddie public to raise capital needed to finance his company's aggressive expansion program. In order to help market Crazy Eddie's stock, Eddie dismissed the company's small accounting firm and retained Main Hurdman, which later merged with Peat Marwick. Mr. Antar ordered his subordinates to inflate inventory and understate accounts payable after the company went public in 1984 to enhance Crazy Eddie's operating results and maintain the company's stock price at a high level. Some of the several of Crazy Eddie's top accounting officials cooperated with Antar’s fraudulent schemes. By 1986, the boom days for the consumer electronics industry had ended, creating financial problems for Crazy Eddie. Because of the following a 1987 hostile takeover of Crazy Eddie, the new owners discovered that the company's inventory was grossly overstated. In 1989, Crazy Eddie filed a bankruptcy petition and then later that year ceased operations and liquidated its assets. Crazy Eddie's auditors allegedly failed to adequately consider several red flags, including pervasive internal control weaknesses, dominance of the company by one individual, the volatility of the consumer electronics industry, and unusual relationships among key account balances.

Legal Analysis and Authority:

1. Compute key ratios and other financial measures for Crazy Eddie during the period 1984-1987. Identify and briefly explain the red flags in Crazy Eddie’s financial statements that suggested the firm possess a higher-than-normal level of audit risk

Crazy Eddie, Inc.

Common Size Balance Sheets

March 1, 1987 March 1, 1986 March 1, 1985 May 31, 1984

Cash 3.17% 10.47% 33.99% 3.76%

Short-term investments 41.36% 21.14% 0.00% 0.00%

Receivables 3.68% 1.77% 4.18% 7.12%

Merchandise inventories 36.99% 47.16% 40.51% 63.83%

Prepaid expenses 3.61% 1.86% 0.98% 1.41%

Total current assets 88.81% 82.40% 79.66% 76.12%

Restricted cash 0.00% 2.64% 10.77% 0.00%

Due from affiliates 0.00% 0.00% 0.00% 15.69%

Property, plant and equip 8.95% 5.65% 5.64% 5.05%

Construction in process 0.00% 4.93% 1.76% 0.00%

Other assets 2.24% 4.38% 2.17% 3.14%

Total assets 100.00% 100.00% 100.00% 100.00%

Crazy Eddie, Inc.

Common Size Income Statements

Year ended Year Ended Nine Months Year Ended

March 1,1987 March 2,1986 March 3, 1985 May 31,1984

Net Sales 100.00% 100.00% 100.00% 100.00%

Cost of Goods sold 77.23% 74.11% 75.87% 77.89%

Gross profit 22.77% 25.89% 24.13% 22.11%

Selling, Gen, Admin Exp 17.68% 16.39% 15.04% 16.43%

Interest and other income 2.10% 1.22% 0.89% 0.51%

Interest expense 1.48% 0.31% 0.32% 0.38%

Income before taxes 5.70% 10.41% 9.66% 5.81%

Pension contribution 0.14% 0.31% 0.44% 0.00%

Income taxes 2.84% 5.06% 4.94% 3.06%

Net income 2.72% 5.05% 4.28% 2.75%

Net income per share 0.000096% 0.000183% 0.000176% 0.000131%

Crazy Eddie, Inc.

Financial Key Ratios

1987 1986 1985 1984

Liquidity Ratios:

Current Ratio 2.4062 1.3985 1.5626 0.9287

Quick Ratio 1.4044 0.5982 0.7680 0.1499

Solvency Ratios:

Debt to Assets Ratio 0.6837 0.6643 0.6359 0.8298

Times Interest Earned 3.6169 30.3927 28.2877 14.9253

Long-Term Debt to Equity 2.1617 1.9786 1.7462 4.8755

Activity Ratios:

Inventory Turnover 3.2320 4.3811 5.1358 5.8812

Accounts Rec Turnover 32.5026 116.7711 49.7515 52.7208 Collect of A/R in Days 33 117 50 53

Profitability Ratios:

Gross Margin 0.2277 0.2589 0.2413 0.2211

Net Income Margin 3.0058 5.0498 4.2760 2.7483

Return on Total Assets 0.0359 0.1043 0.890 0.0758

Return on Equity 0.1136 0.3107 0.2443 0.6062

Based analysis of Crazy Eddie’s ratios and financial statements there was several red flags that suggested the firm posed a higher than normal level of audit risk, also is shown during the analysis of the financial statements. The first red flag was the swing in the balance of the cash and short-term investment accounts. During 1985 cash represented 33.99% of total assets and in 1986 cash represented only 10.47% of total assets. This shift in the cash balance is most attributable to the shift in short-term investments, which were 0% and 21.14% respectively. The decline in cash shows that Crazy Eddie was beginning to experience financial disputes and liquidating their cash; despite they continued to expand in this toughening market, which additionally liquidated cash. Another red flag is the drop in value of the merchandise inventory account, in 1984 the value of the inventory was 63.83% and in 1987 had dropped to 36.99%, which shows that they were liquidating their inventory and replacing it with short-term investments. The retail industry is composed largely of merchandise inventory and this downward trend should have been a huge red flag. These many red flags show a company who is losing market share because of the expansion of the electronics market in the late 1980. Although computing some key ratios I notice that the trend of red flags for an auditor, the first ratio that looks a bit suspicious to me is the current ratio that increased from 0.93 in 1984 to 2.41 in 1987. A current ratio over 1 generally suggest that if all of the current liabilities came due at one then the company would be able to pay the debt but in this situation for it to increase 150% over a 4 year span. The next red flag concerning ratios is the long-term debt to equity ratio, which decreased from 4.88 to 2.16. The ratio shows how aggressive Crazy Eddie was in financing their debt. The major red flag that I see with the ratios is the collection of accounts receivables in days, which well below industry average. During the year of 1984 Crazy Eddie was able to collect on account in 53 days and this number rise steeply to 117 in 1986. This show the inability for the company to collect the debt owed to them, which is also reflected in the sinking trend of cash. The extremely high accounts receivable turnover rates are an indicator of credit and collection policies that are too restrictive. The fact that the Antar family had absolute control over the operations was a red flag as well because the company controlled by family members that they would remain loyal but be able to manipulate all aspects of the company and that is not a good thing because an authoritarian management always have bad consequences. The falsification of inventory count sheets could have been prevented if the auditor would have verified the information that was on the sheets but the executives were excellent at staying one step ahead of the auditor because they knew in advance which stores the auditors would visit, then they would ship merchandise to those specific stores.

2. Identify specific audit procedures that might have led to the detection of the following accounting irregularities perpetrated by Crazy Eddie personnel: (a) the falsification of inventory count sheets, (b) the bogus debit memos for accounts payable, (c) the recording of transshipping transactions as retail sales, and (d) the inclusion of consigned merchandise in year-end inventory.

a. The falsification of inventory count sheets: 1/ The copy all inventory count or compilation sheets following completion of the physical inventory. If this procedure is not practicable because of the number of inventory count sheets, then the auditor may record the numerical sequence of the count sheets used during the physical inventory. Also to minimize the probability that the client will add additional items to partially full count sheets, auditors may draw a reduce through the unused portion of each count sheet or impair the unused portion in some other fashion. 2/ To reduce the probability of clients' recording bogus inventory items, auditors must also determine that sufficient control has been established over inventory tags on which inventory sums are typically recorded before being transferred to calculate or set sheets. Recording the numerical sequence of the tags used during the counting process is one of several relevant audit procedures.

b. Recording of bogus debit memos for accounts payable: 1/ The mailing of accounts payable confirmations on selected accounts and follow up on all reported differences. 2/ The randomly selection of a sample of debit memos charged to accounts payable and investigate supporting documentation to determine whether the charges appear reasonable. 3/ The review of subsequent payments of accounts payable to determine whether amounts deducted from year-end payable balances via client-prepared debit memos were later paid by the client.

c. Recording transshipping transactions as retail sales: 1/ The review the documentation for large volume retail sales transactions, particularly those recorded near year-end, to determine that the sales are valid and properly recorded, for instance, match sales invoices with shipping documentation for these transactions. 2/ The review the client's procedures for recording wholesale transactions to ensure that proper controls exist for these transactions. Perform tests of controls to assess the operating effectiveness of these controls.

d. Inclusion of consigned merchandise in year-end inventory: 1/ When a client has merchandise in its retail outlets that is owned by third parties, the client should have a procedure to ensure that the consigned merchandise is not included in the year-end inventory. Crazy Eddie’s auditors should have reviewed this procedure, assuming that it existed, and taken steps to determine whether client personnel implemented it properly. For example, the auditors could have reviewed inventory count sheets to determine whether consigned merchandise had been included on those sheets.

3. The retail consumer electronics industry was undergoing rapid and dramatic changes during 1980s. Discuss how changes in an audit client’s industry should affect audit-planning decisions. Relate this discussion to Crazy Eddie.

As states, in the AU Section 311, “Planning and Supervision,” notes that auditors should obtain “an understanding of the entity and its environment” (311.02). Evidently, an audit client’s environment includes its industry and major changes that industry is undergoing. The overall health of a client's industry has important implications for the financial health of that company. Likewise, the changes that an industry is undergoing have implications for the future of each company within that industry for these reasons, auditors must be cognizant of, and explicitly consider, industry-related factors in planning audits. By the late 1980s, the retail consumer electronics industry was experiencing problems, including easing demand for its products and intense competition among companies within the industry.

Both of these factors had immediate and important implications for the financial health of Crazy Eddie from an auditing standpoint, these factors increased the likelihood that client management might attempt to window dress the company's financial statements to downplay the negative effect the industry's problems were having on the firm's operating results. Likewise, the auditors should have realized that the changes the industry was undergoing would gradually diminish Crazy Eddie's ability to extract precious deals from its suppliers and to supplement its retail sales with wholesale transactions to its competitors. Collectively, these and other related factors had pervasive implications for the financial health of Crazy Eddie and should have been considered by the auditors during the planning phase of each Crazy Eddie audit.

4. Explain what is implied by the term lowballing in an audit context. How can this practice potentially affect the quality of independent audit services?

The lowballing refers to a method used by accounting firms to obtain audit clients, principally in a competitive bidding process for example when an audit firm lowballs, it offers to provide an independent audit to a prospective client at an annual fee that is considerably below what other audit firms would charge to provide that audit. In many cases, audit firms that lowball to obtain an audit client hope to sell consulting services or other professional services to that client to compensate for the minimal revenue earned by providing the audit. However, if the audit firm issues other than an unqualified opinion on the client's financial statements, it faces some risk of being dismissed by the client. If the audit firm is dismissed, it will almost certainly be unable to sell other professional services to the former audit client. As a net result: the audit firm's strategy of compensating for lost revenue on the audit engagements with revenue from the provision of other professional services doesn't pan out. So, an audit firm that lowballs to obtain an audit client may be very reluctant to issue other than an unqualified opinion on the client's financial statements out of fear of losing the client.

5. Assume that you were a member of Crazy Eddie audit team in 1986. You were assigned to test the client’s year year-end inventory cutoff procedures. You selected 30 invoices entered in the accounting records near year-end: 15 in the few days prior to the client’s fiscal year-end and 15 in the first few days of the New Year. Assume that client personnel were unable to locate 10 of these invoices. How should you and your superiors have responded to this situation? Explain.

Many different auditors would respond in different ways to this scenario probably the most common response, and many would argue the most appropriate, would be to significantly expand the year-end substantive tests applied to the client's inventory account. For example, the cutoff test, itself, would likely be expanded significantly the most troubling feature of such a scenario is the possibility that the client is not providing the requested documentation because it wants to conceal the fact that the year-end inventory cutoff was intentionally or unintentionally messed up. The client did not record inventory sales and purchase transactions occurring near year-end in the proper fiscal year.

6. Should companies be allowed to hire individuals who formerly served as their independent auditors? Discuss the pros and cons of this practice.

This is an important issue that the accounting professionals has debated significantly in recent years, so many critics of the profession have suggested that the integrity of an independent audit is undermined when companies hire their former auditors. For example, a former auditor hypothetically, could help his new employer subvert the purpose of the independent audit. Likewise, the quality of audit services in such situations may be adversely affected because of the personal relationships between the former auditor and his or her former colleagues within the given audit firm. For example, on subsequent audits, the auditors may place too much trust in their former colleague and consequently overlook or discount potential problems in the client's financial statements. As stated in section 206 of the Sarbanes-Oxley Act of 2002 prohibits an accounting firm from providing audit services to a company that has recently hired an employee of the firm to serve in certain key positions.

Conclusion:

In summary, Crazy Eddie's 1984-1987 financial statements contain several red flags suggesting that certain key accounts demanded special attention by the firm's auditors. These red flags, when coupled with other factors, such as the company's tremendous growth rate in sales, demonstrate that the Crazy Eddie audits during this time frame likely posed a higher than normal level of overall audit risk. I also notice that Crazy Eddie's inventory increased dramatically over this time period, from $23 million in 1984 to nearly $110 million in 1987. Moreover notice that the company's inventory turnover slowed considerably during 1987 resulting in the average age of inventory leaping from 80 days to more than 111 days. When the age of a company's inventory increases significantly, the risk of obsolescence and related valuation problems must be seriously considered when an auditing is taking place.

References:

http://www.journalofaccountancy.com/Issues/2000/Oct/SoThatSWhyItSCalledAPyramidScheme.htm. So That’s Why It’s Called a Pyramid Scheme. Wells, Joseph T. 2000 http://www.sec.gov/rules/final/33-8183.htm. U.S. Securities and Exchange Commission. 2003

http://www.whitecollarfraud.com/1265851.html. Antar, Sam E. 2010.

Knapp, Michael C. Contemporary Auditing. 11th ed. N.p.: Cengage, n.d. Print. E.