Whatever happened to crazy eddie

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.”

Around 1980, I helped devise a plan to gradually reduce Crazy Eddie’s skimming while artificially increasing the growth of reported profits. This would create the appearance of a thriving, growing company.

That same year, I passed the CPA examination with a 90% average and scored in the top 1% in the country.

Working for Crazy Eddie’s auditors

In 1981, I started working for Penn & Horowitz, the accounting firm that audited Crazy Eddie’s books and records. I continued working at Crazy Eddie to help implement our plan to turn Crazy Eddie into a public company. Since I was not permitted under auditing standards to work for both Crazy Eddie and its auditors, the Antars paid me off the books to conceal my employment.

My work at Penn & Horowitz served two purposes:

(1) To fulfill my auditing experience requirement to obtain my CPA license. (2) To learn how to take advantage of auditors, especially important if Crazy Eddie were to become a public company.

In June 1984, I left Penn & Horowitz and officially began working for Crazy Eddie again. I was no longer compensated by the company in cash.

Around the same time, Crazy Eddie replaced Penn & Horowitz with Main Hurdman, a major accounting firm. (Note: In 1986, Main Hurdman merged with Peat Marwick Mitchell to become Peat Marwick Main (PMM). In 1987, that accounting firm became known as KPMG, after another merger). In 1985, I finally obtained my CPA license.

Look, more profits!

From 1980 to 1984, Crazy Eddie gradually reduced its skimming (gross skimming less expenses paid in cash) from approximately $3 million per year in fiscal year 1979 to nearly zero in fiscal year 1984. As a result of the gradual reduction in skimming, Crazy Eddie’s reported pro forma annual profits grew from $1.7 million in fiscal year 1980 to $8.0 million in fiscal year 1984. If we factor in new store openings during the same period, Crazy Eddie’s pro forma profit per store grew from $219,975 per unit in fiscal year 1980 to $617,737 per unit in fiscal year 1984.

Without the reduction in skimming, Crazy Eddie’s pro forma profits only grew from $4.7 million in fiscal year 1980 to $8.0 million in fiscal year 1984. Crazy Eddie’s pro forma profit per store only grew from $606,122 per unit in fiscal year 1980 to $617,737 in fiscal year 1984. Crazy Eddie’s real per unit profitability was hardly growing at all, except in the minds of unsuspecting investors who were unaware that we simply reduced our skimming to enhance our so-called growth. (See Crazy Eddie’s Two Sets of Books.)

As Crazy Eddie gradually reduced its skimming, the company could no longer pay its employees in cash or off the books. Therefore, all employees had to be compensated by check or “on the books” and their entire income had to be reported to the IRS. The company now had to pay its share of payroll taxes, while employees were required to pay both payroll and income taxes.

From 1969 to 1979, Crazy Eddie typically paid its managers a minimal salary by check and the balance in cash. The company did not pay employees exclusively in cash just in case we needed to terminate their employment or they got injured on the job, in which case they could receive unemployment compensation or disability insurance payments.

For example, a department manager was paid $15,000 legitimately by check and another $35,000 in cash. This employee would have received about $48,500 per year in take home pay computed as follows: cash compensation of $35,000, plus check compensation of $15,000, less combined payroll and income taxes of about $1,500. If we had paid the department manager $50,000 entirely by check, he would have less take home pay due to the added tax burden. His net take home pay would have been about $40,000 per year (gross check compensation $50,000 less combined payroll and income taxes of $10,000).

In the transition to a public company, we grossed up our employees’ compensation to keep their net income the same, even though it would now be subject to taxes. For example, we increased the department manager’s salary to $65,000 per year, paid by check, and subject to taxes. As a result, Crazy Eddie’s books and records reflected over 100 employees receiving significant raises in the years prior to taking Crazy Eddie public.

Both external audit firms Penn and Horowitz in 1980-83, and Main Hurdman in 1984, noticed that many employees who were previously paid what seemed to be extremely low wages (considering their positions and responsibilities) had received raises in multiples of 3 to as many as 20 times their previously-reported salaries. The auditors did not know that Crazy Eddie management was “grossing up” their employees’ total check compensation to make up for the loss of “off the books” compensation.

The gullible auditors accepted our silly explanation that our employees had sacrificed many years working at below average wages for the opportunity to be part of what they hoped might become a growing public company.