ACCT 573 – Case Studies - topwritershelp.com

Bernard Lawrence Madoff was born on April 29, 1938, in New York City. Madoff spent his childhood in a lower middle-class neighborhood in the borough of Queens. After graduating from high school, Madoff enrolled in the University of Alabama but transferred to Hofstra College on Long Island, now known as Hofstra University, at the beginning of his sophomore year. Three years later in 1960, he graduated with a political science degree from Hofstra.

According to a longtime friend, the driving force in Madoff’s life since childhood was becoming wealthy. “Bernie wanted to be rich; he dedicated his life to it.” That compelling force no doubt accounted for Madoff’s lifelong fascination with the stock market. As a teenager, Madoff frequently visited Wall Street and dreamed of becoming a “major player” in the world of high finance. Because he did not have the educational training or personal connections to land a prime job on Wall Street after he graduated from college, Madoff decided that he would set up his own one-man brokerage firm.

While in college, Madoff had accumulated a $5,000 nest egg by installing sprinkler systems during the summer months for wealthy New Yorkers living in the city’s affluent suburbs. In the summer of 1960, Madoff used those funds to establish Bernard L. Madoff Investment Securities LLC, which was typically referred to as Madoff Securities. Madoff operated the new business from office space that was provided to him by his father-in-law, who was a partner in a small accounting firm. For nearly five decades, Madoff served as the senior executive of Madoff Securities. During that time, the shy New Yorker who had an occasional stammer and several nervous tics would accumulate a fortune estimated at more than one billion dollars.

Taking on Wall Street

Madoff’s brokerage firm initially traded only securities of small over-the-counter companies, securities commonly referred to as “penny stocks.” At the time, the securities of most large companies were traded on the New York Stock Exchange (NYSE). The rules of that exchange made it extremely difficult for small brokerage firms such as Madoff’s to compete with the cartel of large brokerage firms that effectively controlled Wall Street. Madoff and many other small brokers insisted that the NYSE’s rules were anticompetitive and inconsistent with a free market economy. Madoff was also convinced that the major brokerage firms kept securities transaction costs artificially high to produce windfall profits for themselves to the detriment of investors, particularly small investors.

Because of Madoff’s resentment of the major Wall Street brokerage firms, he made it his mission to “democratize” the securities markets in the United States while at the same time reducing the transaction costs of trading securities. “Bernie was the king of democratization. He was messianic about this. He pushed to automate the [securities trading] system, listing buyers and sellers on a computer that anyone could access.”

In fact, Madoff Securities was one of the first brokerage firms to utilize computers to expedite the processing of securities transactions. Bernie Madoff is also credited as one of the founders of the NASDAQ stock exchange that was organized in 1971. The NASDAQ was destined to become the world’s largest electronic stock exchange and the largest global stock exchange in terms of trading volume. In the late 1980s and early 1990s, Madoff served three one-year terms as the chairman of the NASDAQ.

Madoff’s leadership role in the development of electronic securities trading contributed significantly to his firm’s impressive growth throughout the latter decades of the twentieth century. By the early years of the twenty-first century, Madoff Securities was the largest “market maker” on the NASDAQ, meaning that the firm accounted for more daily transaction volume on that exchange than any other brokerage. By that time, the firm was also among the largest market makers for the New York Stock Exchange, accounting for as much as 5 percent of its daily transaction volume. This market-making service was lucrative with low risk for Madoff Securities and reportedly earned the firm, which was privately owned throughout its existence, annual profits measured in the tens of millions of dollars.

In 1962, Madoff had expanded his firm to include investment advisory services. For several years, most of the individuals who set up investment accounts with Madoff Securities were referred to him by his father-in-law. Although the firm was a pioneer in electronic trading and made sizable profits from its brokerage operations, investment advisory services would prove to be its most important line of business. By late 2008, the total value of customer accounts managed by Madoff Securities reached $65 billion.

The key factor that accounted for the incredible growth in the amount of money entrusted to Madoff’s firm by investors worldwide was the impressive rates of return that the firm earned annually on the funds that it managed. For decades, those funds earned an average annual rate of return generally ranging from 10 to 15 percent. Although impressive, those rates of return were not spectacular. What was spectacular was the consistency of the returns. In 2001, Barron’s reported that some of the Madoff firm’s largest investment funds had never experienced a losing year despite significant stock market declines in several individual years. Even when the stock market collapsed in late 2008, individual Madoff funds continued to report net gains for the year-to-date period.

Although Madoff would eventually serve as an investment advisor to dozens of celebrities, professional athletes, and other wealthy individuals, most of the money he managed came from so-called “feeder firms,” which were large hedge funds, banks, and other investment companies. The individuals who had committed their funds to these feeder firms were typically unaware that those funds had been turned over to Madoff.

The reclusive Madoff and his subordinates disclosed as little as possible about the investment strategy responsible for their firm’s success in the stock market. On one occasion, Madoff told an executive of a feeder firm, “It’s no one’s business what goes on here.” The Wall Street Journal reported that Madoff commonly “brushed off” skeptics who questioned his firm’s investment results by pointing out that those results had been audited and by insisting that his investment strategy “was too complicated for outsiders to understand.”

The only substantive information Madoff Securities provided regarding its investment policies was that it employed a “split-strike conversion” investment model. In simple terms, this strategy involved purchasing several dozen blue-chip stocks and then simultaneously selling both put options and call options on those securities. Supposedly, this strategy ensured a positive rate of return on those investments whether the stock market went up or went down.

Competitors, financial analysts, and academics repeatedly attempted to replicate the success of Madoff Securities’ investment strategy. None of those attempts were successful, which only added to Bernie Madoff’s stature and mystique on Wall Street. As one industry insider noted in 2001, “Even knowledgeable people can’t really tell you what he’s doing.” A CNN reporter observed that by the turn of the century Madoff was widely regarded as a stock market wizard and that “everyone” on Wall Street, including his closest competitors, was “in awe of him.”

The Bubble Bursts

On December 10, 2008, Bernie Madoff asked his two sons, Andrew and Mark, who worked at Madoff Securities, to meet him at his apartment that evening. In this meeting, Madoff told his sons that the impressive returns earned for clients of his firm’s investment advisory division over the previous several decades had been fraudulent. Those returns had been produced by an elaborate Ponzi scheme engineered and overseen by Madoff without the knowledge of any of his employees or family members. The following day, an attorney representing Madoff’s sons notified the SEC of their father’s confession. That evening, FBI agents came to Madoff’s apartment. One of the agents asked Madoff “if there was an innocent explanation” for the information relayed to the SEC from his sons. Madoff replied, “There is no innocent explanation.” The agents then placed Madoff under arrest and within hours filed securities fraud charges against him.

The public announcement of Madoff’s fraudulent scheme in December 2008 stunned investors worldwide. That announcement further undercut the stability of global stock markets that were already reeling from the subprime mortgage crisis in the United States, which had “frozen” the world’s credit markets, caused stock prices to drop precipitously, and threatened to plunge the global economy into a deep depression. Politicians, journalists, and everyday citizens were shocked to learn that a massive investment fraud, apparently the largest in history, could go undetected for decades within the capital markets of the world’s largest economic power. Even more disconcerting was the fact that the Madoff fraud went undetected for several years after the implementation of the far-reaching regulatory reforms mandated by the U.S. Congress in the wake of the Enron and WorldCom debacles.

News of the Madoff fraud caused a wide range of parties to angrily demand that the federal government and law enforcement authorities determine why the nation’s “watchdog” system for the capital markets had failed once again. The accounting profession was among the first targets of the public’s anger. On the day that Madoff’s fraud was publicly reported, Floyd Norris, a New York Times reporter acquainted with Madoff, asked a simple question that was on the minds of many people, namely, “Who were the auditors?”

“Rubber-Stamped” Financial Statements

Business journalists quickly determined that the auditor of Madoff Securities was Friehling & Horowitz, an accounting firm located in the small New York City suburb of New City. Friehling & Horowitz had issued unqualified opinions on the financial statements of Madoff Securities since at least the early 1990s, audits for which the small firm was paid as much as $200,000.

Further investigation revealed that Friehling & Horowitz had only one active accountant, one nonprofessional employee (a secretary), and operated from a tiny office occupying approximately two hundred square feet. The active accountant was David Friehling who had performed the annual audits of Madoff’s firm and signed off on the firm’s unqualified audit opinions. Accounting and auditing experts interviewed by the Associated Press insisted that it was “preposterous” to conceive that any one individual could complete an audit of a company the size of Madoff Securities by himself.

Friehling and his firm were members of the American Institute of Certified Public Accountants (AICPA). A spokesperson for that organization revealed that Friehling had reported to the AICPA each year that he did not perform any audits. As a result, Friehling’s firm was not required to submit to the AICPA’s peer review program for CPA firms. Friehling’s firm was also not required to have a periodic peer review at the state level. At the time, New York was one of six states that did not have a mandatory peer review program for accounting firms.

In March 2009, the New York Times reported that Friehling had maintained dozens of investment accounts with Madoff Securities, according to documents obtained by the court-appointed trustee for that firm. Those same documents indicated that Friehling & Horowitz had another 17 investment accounts with Madoff’s firm. In total, Friehling, his accounting firm, and his family members had nearly $15 million invested in funds managed by Madoff. Federal prosecutors noted that these investments had “flouted” the accounting profession’s auditor independence rules and “disqualified” Friehling from serving as the auditor of Madoff Securities.

David Friehling would be the second person arrested by federal law enforcement authorities investigating Madoff’s fraud. Among other charges, federal prosecutors indicted Friehling for securities fraud, aiding and abetting an investment fraud, and obstructing the IRS. The prosecutors did not allege that Friehling was aware of Madoff’s fraudulent scheme but rather that he had conducted “sham audits” of Madoff Securities that “helped foster the illusion that Mr. Madoff legitimately invested his clients’ money.”

News reports of Friehling’s alleged sham audits caused him to be berated in the business press. A top FBI official observed that Friehling’s “job was not to merely rubber-stamp statements that he didn’t verify” and that Friehling had betrayed his “fiduciary duty to investors and his legal obligation to regulators.” An SEC official maintained that Friehling had “essentially sold his [CPA] license for more than 17 years while Madoff’s Ponzi scheme went undetected.” Many parties found this and other denigrating remarks made by SEC officials concerning Friehling ironic since the federal agency was itself the target of scornful criticism for its role in the Madoff fiasco.

Sir Galahad and the SEC

On at least eight occasions, the SEC investigated alleged violations of securities laws by Madoff Securities during the two decades prior to Bernie Madoff’s startling confession. In each case, however, the investigation concluded without the SEC charging Madoff with any serious infractions of those laws. Most of these investigations resulted from a series of complaints filed with the SEC by one individual, Harry Markopolos.

On the March 1, 2009, edition of the CBS news program 60 Minutes, investigative reporter Steve Croft observed that until a few months earlier Harry Markopolos had been an “obscure financial analyst and mildly eccentric fraud investigator from Boston.” Beginning in 1999, Markopolos had repeatedly told the SEC that Bernie Madoff was operating what he referred to as the “world’s largest Ponzi scheme.” Between May 2000 and April 2008, Markopolos mailed or hand delivered documents and other evidence to the SEC that purportedly proved that assertion. Although SEC officials politely listened to Markopolos’s accusations, they failed to vigorously investigate them.

One lengthy report that Markopolos sent to the SEC in 2005 identified 29 specific “red flags” suggesting that Madoff was perpetrating a massive fraud on his clients. Among these red flags was Madoff’s alleged refusal to allow the Big Four auditor of an investment syndicate to review his financial records. Another red flag was the fact that Madoff Securities was audited by a one-man accounting firm, namely, Friehling & Horowitz. Also suspicious was the fact that Madoff, despite his firm’s leadership role in electronic securities trading, refused to provide his clients with online access to their accounts, providing them instead with monthly account statements by mail.

Among the most credible and impressive evidence Markopolos gave to the SEC were mathematical analyses and simulations allegedly proving that Madoff’s split-strike conversion investment strategy could not consistently produce the investment results that his firm reported. Markopolos noted that if such an investment strategy existed, it would be the “Holy Grail” of investing and eventually be replicated by other Wall Street investment advisors. Even if Madoff had discovered this “Holy Grail” of investing, Markopolos demonstrated there was not sufficient transaction volume in the options market to account for the huge number of options that his investment model would have required him to buy and sell for his customers’ accounts.

In the months following the public disclosure of Madoff’s fraud, Harry Markopolos reached cult hero status within the business press. Markopolos was repeatedly asked to comment on and explain the scope and nature of Madoff’s scheme. Markopolos’s dissection of Madoff’s fraud suggested that three key factors accounted for it continuing unchecked for decades. First, Madoff targeted investors who were unlikely to question his investment strategy. According to Markopolos, a large number of “smart” investors had refused to invest with Madoff despite his sterling record. “Smart investors would stick to their investment discipline and walk away, refusing to invest in a black-box strategy they did not understand. Greedy investors would fall over themselves to hand Madoff money.”

The second factor that allowed Madoff’s fraud to continue for decades was his impeccable credentials. Even if his impressive investment results were ignored, Madoff easily qualified as a Wall Street icon. He was a pioneer of electronic securities trading and throughout his career held numerous leadership positions within the securities industry, including his three stints as NASDAQ chairman. Madoff’s stature on Wall Street was also enhanced by his well-publicized philanthropy. He regularly contributed large sums to several charities.

The final and most important factor that allowed Madoff to sustain his fraudulent scheme was the failure of the regulatory oversight function for the stock market. In testimony before Congress and media interviews, Harry Markopolos insisted that the Madoff debacle could have been avoided or at least mitigated significantly if federal regulators, particularly the SEC, had been more diligent in fulfilling their responsibilities. According to Markopolos, Madoff knew that the SEC’s accountants, attorneys, and stock market specialists were “incapable of understanding a derivatives-based Ponzi scheme” such as the one he masterminded. That knowledge apparently emboldened Madoff and encouraged him to continually expand the scope of his fraud.

Even after Markopolos explained the nature of Madoff’s fraud to SEC officials, they apparently did not understand it. “I gift wrapped and delivered the largest Ponzi scheme in history to them … [but the SEC] did not understand the 29 red flags that I handed them.” The outspoken SEC critic went on to predict that “If the SEC does not improve soon, they risk being merged out of existence in the upcoming rewrite of the nation’s regulatory scheme.”

Markopolos’s pointed criticism of the SEC and additional harsh criticism by several other parties forced the agency’s top officials to respond. An embarrassed SEC Chairman Christopher Cox admitted that he was “gravely concerned” by the SEC’s failure to uncover the fraud.

In an extraordinary admission that the SEC was aware of numerous red flags raised about Bernard L. Madoff Investment Securities LLC, but failed to take them seriously enough, SEC Chairman Christopher Cox ordered a review of the agency’s oversight of the New York securities-trading and investment-management firm.

Epilogue

On March 12, 2009, Bernie Madoff appeared before Judge Denny Chin in a federal court-house in New York City. After Judge Chin read the 11 counts of fraud, money laundering, perjury and theft pending against Madoff, he asked the well-dressed defendant how he pled. “Guilty,” was Madoff’s barely audible one-word reply. Judge Chin then told Madoff to explain what he had done. “Your honor, for many years up until my arrest on December 11, 2008, I operated a Ponzi scheme through the investment advisory side of my business.” Madoff then added, “I knew what I did was wrong, indeed criminal. When I began the Ponzi scheme, I believed it would end shortly and I would be able to extricate myself and my clients … [but] as the years went by I realized this day, and my arrest, would inevitably come.”

Despite allegations his two sons, his brother, and his wife were at least knowledgeable of his fraud and possibly complicit in it, Madoff refused to implicate any of them or any of his other subordinates. Madoff claimed that he alone had been responsible for the fraud and that the brokerage arm of his business, which had been overseen by his brother and his two sons, had not been affected by his Ponzi scheme. On June 29, 2009, Madoff appeared once more in federal court. After reprimanding Madoff for his actions, Judge Chin sentenced him to 150 years in federal prison, meaning the 71-year-old felon would spend the rest of his life incarcerated.

In August 2009, Frank DiPascali, Madoff Securities’ former chief financial officer, pleaded guilty to complicity in Madoff’s fraudulent scheme. During an appearance in federal court, DiPascali testified, “It was all fake; it was all fictitious. It was wrong and I knew it at the time.” As a result of DiPascali’s cooperation with federal law enforcement authorities, more than one dozen other former subordinates or business associates of Bernie Madoff, including his brother Peter, would plead guilty or be convicted of various criminal charges. DiPascali died in May 2015 while awaiting sentencing for his role in Madoff’s fraud.

David Freihling, Madoff’s long-time auditor, pleaded guilty in November 2009 to the nine-count indictment filed against him by federal prosecutors. Freihling’s sentencing hearing was delayed six times while he was cooperating with the ongoing investigations of the Madoff fraud. Finally, in May 2015, a federal judge sentenced Freihling to one year of home detention. The judge justified the lenient sentence by noting Friehling’s extensive cooperation with law enforcement authorities investigating the Madoff fraud. In 2009, the AICPA announced it had expelled Friehling for not cooperating with its investigation of his audits of Madoff Securities; one year later, Friehling was stripped of his CPA license by the state of New York. The controversy over the failure of Friehling’s firm to undergo any peer reviews persuaded the New York state legislature to pass a law in December 2008 requiring most New York accounting firms that provide attest services to be peer reviewed every three years.

Although none of the Big Four accounting firms were directly linked to Madoff Securities, legal experts speculated those firms would face civil lawsuits in the wake of Madoff’s fraud. That potential liability stemmed from the Big Four’s audits of the large “feeder firms” that entrusted billions of dollars to Madoff. Lynn Turner, a former chief accountant of the SEC, contended that the auditors of the feeder firms had a responsibility to check out Madoff’s auditor. “If they didn’t, then investors will have to hold the auditors [of the feeder firms] accountable.”

In February 2009, KPMG became the first of the Big Four firms to be named as a defendant in a civil lawsuit triggered by the Madoff fraud. A California charity sued the accounting firm to recover the millions of dollars it lost due to Madoff’s scheme. KPMG had served as the independent auditor of a large hedge fund that had hired Madoff to invest the charity’s funds. Among critical risk factors allegedly overlooked by the KPMG auditors was that Madoff’s huge organization was serviced by a tiny accounting firm operating out of a strip mall in a New York City suburb.

In November 2015, Ernst & Young (E&Y) became the first of the Big Four firms to be held civilly liable for losses suffered by investors in a Madoff feeder firm. E&Y was ordered to pay those investors approximately $25 million. PricewaterhouseCoopers settled a similar lawsuit in January 2016 by agreeing to pay $55 million to the investors in another of Madoff’s feeder firms.

In early 2009, President Obama appointed Mary Schapiro to replace Christopher Cox as the chairperson of the SEC. In the aftermath of the Madoff fraud, Schapiro reported her agency would revamp its oversight policies and procedures for investment advisers having physical custody of customer assets. Among the measures ultimately adopted by the SEC were annual surprise audits of such firms to ensure customer funds are being properly safe-guarded. Those investment advisory firms must also have internal control audits by independent accounting firms to determine whether they have “the proper controls in place.” Finally, Schapiro pledged the SEC would implement specific measures to ensure credible whistle-blowing allegations, such as those made by Harry Markopolos regarding Madoff’s firm, would be investigated on a thorough and timely basis.

Bernie Madoff’s victims included a wide range of prominent organizations and individuals. The large asset management firm Fairfield Greenwich Advisers alone had more than one-half of its investment portfolio of $14 billion invested with Madoff. Other companies and organizations that had significant funds in the custody of Madoff Securities included the large Dutch bank Fortis Bank, the large British bank HSBC, the International Olympic Committee, Massachusetts Mutual Life Insurance Company, New York University, Oppenheimer Funds, and Yeshiva University.

One media outlet reported that the list of individuals who had investments with Madoff reads like a lineup from Lifestyles of the Rich and Famous, a popular television program of the 1980s. Those individuals included award-winning actors and actresses, Hollywood directors and screenwriters, media executives, journalists, professional athletes, a Nobel Prize winner, and high-profile politicians. Among these individuals were Kevin Bacon, Zsa Zsa Gabor, Jeffrey Katzenberg, Henry Kaufman, Larry King, Ed Koch, Sandy Koufax, Senator Frank Lautenberg, John Malkovich, Stephen Spielberg, Elie Wiesel, and Mort Zuckerman.

By early 2016, Irving Picard, the court-appointed trustee charged with recovering the billions of dollars stolen or misused by Madoff, had filed more than 1,000 civil lawsuits against a wide range of defendants. To date, he has recouped more than $11 billion of the losses suffered by Madoff investors. Those recoveries, the seizure of assets by law enforcement authorities when Madoff revealed the fraud, and other collected amounts reduce the net estimated losses of Madoff’s victims to somewhere between $10 to $20 billion.

Background

https://www.bing.com/videos/search?q=bernie+madoff&&view=detail&mid=76D4E7D83576AE0B4BCA76D4E7D83576AE0B4BCA&&FORM=VRDGAR&ru=%2Fvideos%2Fsearch%3Fq%3Dbernie%2Bmadoff%26FORM%3DHDRSC3

10 Years Later:

https://www.bing.com/videos/search?q=bernie+madoff&&view=detail&mid=1228FB27A4B9613C371A1228FB27A4B9613C371A&&FORM=VRDGAR&ru=%2Fvideos%2Fsearch%3Fq%3Dbernie%2Bmadoff%26FORM%3DHDRSC3

Questions

Provide a narrated power point or a Kaltura video with answers to these questions:

1. Research recent developments involving this case. Summarize these developments in a bullet format. There are two news summaries in order to get you started

2. Suppose that a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff Securities. What audit procedures should the investment firm’s independent auditors have applied to those assets?

3. Professional auditing standards discuss the three key “conditions” that are typically present when a financial fraud occurs and identify a lengthy list of “fraud risk factors.” Briefly explain the difference between a fraud “condition” and a “fraud risk factor” and provide examples of each. What fraud conditions and fraud risk factors were apparently present in the Madoff case?

4. In addition to the reforms mentioned in this case, recommend other financial reporting and auditing-related reforms that would likely be effective in preventing or detecting frauds similar to that perpetrated by Madoff.

WEEK TWO – Preventing Fraud

See the “The Trolley Dodgers” case for this question.

The Trolley Dodgers

In 1890, the Brooklyn Trolley Dodgers professional baseball team joined the National League. Over the following years, the Dodgers would have considerable difficulty competing with the other baseball teams in the New York City area. Those teams, principal among them the New York Yankees, were much better financed and generally stocked with players of higher caliber.

After nearly seven decades of mostly frustration on and off the baseball field, the Dodgers shocked the sports world by moving to Los Angeles in 1958. Walter O’Malley, the flamboyant owner of the Dodgers, saw an opportunity to introduce professional baseball to the rapidly growing population of the West Coast. More important, O’Malley saw an opportunity to make his team more profitable. As an inducement to the Dodgers, Los Angeles County purchased a goat farm located in Chavez Ravine, an area two miles northwest of downtown Los Angeles, and gave the property to O’Malley for the site of his new baseball stadium.

Since moving to Los Angeles, the Dodgers have been the envy of the baseball world: “In everything from profit to stadium maintenance … the Dodgers are the prototype of how a franchise should be run.” During the 1980s and 1990s, the Dodgers reigned as the most profitable franchise in baseball with a pretax profit margin approaching 25 percent in many years. In late 1997, Peter O’Malley, Walter O’Malley’s son and the Dodgers’ principal owner, sold the franchise for $350 million to media mogul Rupert Murdoch. A spokes-man for Murdoch complimented the O’Malley family for the long-standing success of the Dodgers organization: “The O’Malleys have set a gold standard for franchise ownership.”

During an interview before he sold the Dodgers, Peter O’Malley attributed the success of his organization to the experts he had retained in all functional areas: “I don’t have to be an expert on taxes, split-fingered fastballs, or labor relations with our ushers. That talent is all available.” Edward Campos, a longtime accountant for the Dodgers, was a seemingly perfect example of one of those experts in the Dodgers organization. Campos accepted an entry-level position with the Dodgers as a young man. By 1986, after almost two decades with the club, he had worked his way up the employment hierarchy to become the operations payroll chief.

After taking charge of the Dodgers’ payroll department, Campos designed and implemented a new payroll system, a system that only he fully understood. In fact, Campos controlled the system so completely that he personally filled out the weekly payroll cards for each of the Dodgers’ 400 employees. Campos was known not only for his work ethic but also for his loyalty to the club and its owners: “The Dodgers trusted him, and when he was on vacation, he even came back and did the payroll.”

Unfortunately, the Dodgers’ trust in Campos was misplaced. Over a period of several years, Campos embezzled several hundred thousand dollars from his employer. According to court records, Campos padded the Dodgers’ payroll by adding fictitious employees to various departments in the organization. In addition, Campos routinely inflated the number of hours worked by several employees and then split the resulting overpayments 50-50 with those individuals.

The fraudulent scheme came unraveled when appendicitis struck down Campos, forcing the Dodgers’ controller to temporarily assume his responsibilities. While completing the payroll one week, the controller noticed that several employees, including ushers, security guards, and ticket salespeople, were being paid unusually large amounts. In some cases, employees earning $7 an hour received weekly paychecks approaching $2,000. Following a criminal investigation and the filing of charges against Campos and his cohorts, all the individuals involved in the payroll fraud confessed.

A state court sentenced Campos to eight years in prison and required him to make restitution of approximately $132,000 to the Dodgers. Another of the conspirators also received a prison sentence. The remaining individuals involved in the payroll scheme made restitution and were placed on probation.

Epilogue

The San Francisco Giants are easily the most heated, if not hated, rival of the Dodgers. In March 2012, a federal judge sentenced the Giants’ former payroll manager to 21 months in prison after she pleaded guilty to embezzling $2.2 million from the Giants organization. An attorney for the Giants testified that the payroll manager “wreaked havoc” on the Giants’ players, executives, and employees. The attorney said that the embezzlement “included more than 40 separate illegal transactions, including changing payroll records and stealing employees’ identities and diverting their tax payments.” A federal prosecutor reported that the payroll manager used the embezzled funds to buy a luxury car, to purchase a second home in San Diego, and to travel.

When initially confronted about her embezzlement scheme, the payroll manager had “denied it completely.” She confessed when she was shown the proof that prosecutors had collected. During her sentencing hearing, the payroll manager pleaded with the federal judge to sentence her to five years probation but no jail term. She told the judge, “I cannot say how sorry that I am that I did this, because it’s not who I am. I have no excuse for it. There is no excuse in the world for taking something that doesn’t belong to you.”

Background

https://www.sfexaminer.com/news/former-giants-payroll-manager-sentenced-to-21-months-in-prison-for-embezzlement/

https://fraudtalk.blogspot.com/2011/08/san-francisco-giants-payroll-manager.html

Questions

Provide a narrated power point or a Kaltura video with answers to these questions:

1. Identify the key audit objectives for a client’s payroll function. Comment on objectives related to tests of controls and substantive audit procedures.

2. What internal control weaknesses were evident in the Dodgers’ payroll system?

3. Identify audit procedures that might have led to the discovery of the fraudulent scheme masterminded by Campos.

Week 4 – Investigating Fraud

See the “Just for FEET, Inc.” case for this question.

Just for FEET, Inc.

Life is so fragile. A single bad choice in a single moment can cause a life to turn irrevocably 180 degrees.

………U.S. District Judge C. Lynwood Smith, Jr.

In 1971, 25-year-old Thomas Shine founded a small sporting goods company, Logo 7, that would eventually become known as Logo Athletic. Shine’s company manufactured and marketed a wide range of shirts, hats, jackets, and other apparel items that boldly displayed the logos of the Miami Dolphins, Minnesota Twins, Montreal Canadiens, and dozens of other professional sports teams. In 2001, Shine sold Logo to Reebok and became that company’s senior vice president of sports and entertainment marketing. In that position, Shine wined and dined major sports stars with the intent of persuading them to sign exclusive endorsement contracts with Reebok.

During his long career, Thomas Shine became one of the most well-known and respected leaders of the sporting goods industry. Shine’s prominence and credibility in that industry took a severe blow in February 2004 when he pleaded guilty to a criminal indictment filed against him by the U.S. Department of Justice. The Justice Department charged that Shine had signed a false audit confirmation sent to him in early 1999 by one of Logo’s largest customers. The confirmation indicated that Logo owed that customer approximately $700,000. Although Shine knew that no such debt existed, he signed the confirmation and returned it to the customer’s independent audit firm, Deloitte & Touche, after being pressured to do so by an executive of the customer. As a result of his guilty plea, Shine faced a possible sentence of five years in federal prison and a fine of up to $250,000.

Out of South Africa

At approximately the same time that Thomas Shine was launching his business career in the retail industry in the United States, Harold Ruttenberg was doing the same in South Africa. Ruttenberg, a native of Johannesburg, paid for his college education by working nights and weekends as a sales clerk in an upscale men’s clothing store. After graduation, he began importing Levi’s jeans from the United States and selling them from his car, his eventual goal being to accumulate sufficient capital to open a retail store. Ruttenberg quickly accomplished that goal. In fact, by the time he was 30, he owned a small chain of men’s apparel stores.

Mounting political and economic troubles in his home country during the early and mid-1970s convinced Ruttenberg to move his family to the United States. South Africa’s strict emigration laws forced Ruttenberg to leave practically all of his net worth behind. When he arrived in California in 1976 with his spouse and three small children, Ruttenberg had less than $30,000. Despite his limited financial resources and unfamiliarity with U.S. business practices, the strong-willed South African was committed to once again establishing himself as a successful entrepreneur in the retailing industry.

Ruttenberg soon realized that the exorbitant rents for commercial retail properties in the major metropolitan areas of California were far beyond his reach. So, he moved his family once more, this time to the more affordable business environment of Birmingham, Alabama. Ruttenberg leased a vacant storefront in a Birmingham mall and a few months later opened Hang Ten Sports World, a retail store that marketed children’s sportswear products. Thanks largely to his work ethic and intense desire to succeed, Ruttenberg’s business prospered over the next decade.

In 1988, Ruttenberg decided to take a gamble on a new business venture. Ruttenberg had come to believe that there was an opportunity to make large profits in the retail shoe business. At the time, the market for high-priced athletic shoes—basketball shoes, in particular—was growing dramatically and becoming an ever-larger segment of the retail shoe industry. The principal retail outlets for the shoes produced by Adidas, Nike, Reebok, and other major athletic shoe manufacturers were relatively small stores located in thousands of suburban malls scattered across the country, meaning that the retail athletic shoe “subindustry” was highly fragmented. The five largest retailers in this market niche accounted for less than 10 percent of the annual sales of athletic shoes.

Ruttenberg realized that the relatively small floor space of retail shoe stores in suburban malls limited a retailer’s ability to display the wide and growing array of products being produced by the major shoe manufacturers. Likewise, the high cost of floor space in malls with heavy traffic served to limit the profitability of shoe retailers. To overcome these problems, Ruttenberg decided that he would build freestanding “Just for FEET” superstores located near malls. To lure consumers away from mall-based shoe stores, Ruttenberg developed a three-pronged business strategy focusing on “selection,” “service,” and “entertainment.”

Ruttenberg’s business plan for his superstores involved a stores-within-a-store concept; that is, he intended to create several mini-stores within his large retail outlets, each of which would be devoted exclusively to the products of individual shoe manufacturers. He believed this store design would appeal to both consumers and vendors. Consumers who were committed to one particular brand would not have to search through store displays that included a wide assortment of branded products. Likewise, his proposed floor design would provide major vendors an opportunity to participate in marketing their products. Ruttenberg hoped that his planned floor design would spur the major vendors to compete with each other in providing so-called vendor allowances to his superstores to make their individual displays more appealing than those of competitors.

Customer service was the second major element of Ruttenberg’s business plan for his shoe superstores. Ruttenberg planned to staff his stores so that there would be an unusually large ratio of sales associates to customers. Sales associates would be required to complete an extensive training course in “footwear technology” so that they would be well equipped to answer any questions posed by customers. When a customer chose to try on a particular shoe product, he or she would have to ask a sales associate to retrieve that item from the “back shop.” Sales associates were trained to interact with customers in such a way that they would earn their trust and thus create a stronger bond with them.

Just for Feet’s 1998 Form 10-K described the third feature of Harold Ruttenberg’s business plan as creating an “Entertainment Shopping Experience.” Rock-and-roll music and brightly colored displays greeted customers when they entered the superstores. When they tired of shopping, customers could play a game of “horse” on an enclosed basketball half-court located near the store’s entrance or sit back and enjoy a multiscreen video bank in the store’s customer lounge. Frequent promotional events included autograph sessions with major sports celebrities such as Bart Starr, the former Green Bay Packers quarterback who was also on the company’s board of directors.

Ruttenberg would eventually include two other key features in the floor plans of his superstores. Although Just for Feet did not target price-conscious customers, Ruttenberg added a “Combat Zone” to each superstore where such customers could rummage through piles of discontinued shoe lines, “seconds,” and other discounted items. For those customers who simply wanted a pair of shoes and did not have a strong preference for a given brand, Ruttenberg incorporated a “Great Wall” into his superstores that contained a wide array of shoes sorted not by brand but rather by function. In this large display, customers could quickly compare and contrast the key features of dozens of different types of running shoes, walking shoes, basketball shoes, and cross-trainers.

Quite a FEET

Just for Feet’s initial superstore in Birmingham proved to be a huge financial success. That success convinced Harold Ruttenberg to open similar retail outlets in several major metropolitan areas in the southern United States and to develop a showcase superstore within the glitzy Caesar’s Forum shopping mall on the Las Vegas Strip. By 1992, Just for Feet owned and operated five superstores and had sold franchise rights for several additional stores. The company’s annual sales were approaching $20 million, but that total accounted for a small fraction of the retail shoe industry’s estimated $15 billion of annual sales.

To become a major force in the shoe industry, Ruttenberg knew that he would have to expand his retail chain nationwide, which would require large amounts of additional capital. To acquire that capital, Ruttenberg decided to take his company public. On March 9, 1994, Just for Feet’s common stock began trading on the NASDAQ exchange under the ticker symbol FEET. The stock, which sold initially for $6.22 per share, would quickly rise over the next two years to more than $37 per share.

Ruttenberg used the funds produced by Just for Feet’s initial public offering (IPO) to pursue an aggressive expansion program. The company opened dozens of new superstores during the mid-1990s and acquired several smaller competitors, including Athletic Attic in March 1997 and Sneaker Stadium in July 1998. For fiscal 1996, which ended January 31, 1997, the company reported a profit of $13.9 million on sales of $250 million. Two years later, the company earned a profit of $26.7 million on sales of nearly $775 million. By the end of 1998, Just for Feet was the second largest athletic shoe retailer in the United States with 300 retail outlets.

During the mid-1990s, Just for Feet’s common stock was among the most closely monitored and hyped securities on Wall Street. Analysts and investors tracking the stock marveled at the company’s ability to consistently outperform its major competitors. By the late 1990s, market saturation and declining profit margins were becoming major concerns within the athletic shoe segment of the shoe industry. Despite the lackluster profits and faltering revenues of other athletic shoe retailers, Harold Ruttenberg continued to issue press releases touting his company’s record profits and steadily growing sales. Most impressive was the company’s 21 straight quarterly increases in same-store sales through the fourth quarter of fiscal 1998.

In November 1997, Delphi Investments released a lengthy analytical report focusing on Just for Feet’s future prospects. In that report, which included a strong “buy” recommendation for the company’s common stock, Delphi commented on the “Harold Ruttenberg factor.” The report largely attributed the company’s financial success and rosy future to “the larger-than-life founder and inventor of the Just for Feet concept.”

In frequent interviews with business journalists, Harold Ruttenberg was not modest in discussing the huge challenges that he had personally overcome to establish himself as one of the leading corporate executives in the retail apparel industry. Nor was Ruttenberg reluctant to point out that he had sketched out the general frame-work of Just for Feet’s successful business plan over a three-day vacation in the late 1980s. After being named one of 1996’s Retail Entrepreneurs of the Year, Ruttenberg noted that Just for Feet had succeeded principally because of the unique marketing strategies he had developed for the company. “Customers love our stores because they are so unique. We are not a copycat retailer. Nobody does what we do, the way we do it. The proof is in our performance.” In this same interview, Ruttenberg reported that he had never been tempted to check out a competitor’s stores. “I have nothing to learn from them. I’m certainly not going to copy anything they are doing.” Finally, Ruttenberg did not dispute, or apologize for, his reputation as a domineering, if not imposing, superior. “I can be a very demanding, difficult boss. But I know how to build teams. And I have made a lot of people very rich.”

Ruttenberg realized that one of his primary responsibilities was training a new management team to assume the leadership of the company following his retirement. “As the founder, my job is to put the right people in place for the future. I’m preparing this company for 25 years down the road when I won’t be here.” One of the individuals who Ruttenberg handpicked to lead the company into its future was his son, Don-Allen Ruttenberg, who shared his father’s single-minded determination and tenacious business temperament. In 1997, at the age of 29, Don-Allen Ruttenberg was named Just for Feet’s vice president of new store development. Two years later, the younger Ruttenberg was promoted to the position of executive vice president.

Similar to most successful companies, Just for Feet’s path to success was not without occasional pitfalls. In 1995, Wall Street’s zeal for Just for Feet’s common stock was tempered somewhat by an accounting controversy involving “store opening” costs. Throughout its existence, Just for Feet had accumulated such costs for each new store in an asset account and then amortized the costs over the 12-month period following the store’s grand opening. A more common practice within the retail industry was to expense such costs in the month that a new store opened. Criticism of Just for Feet’s accounting for store opening costs goaded company management to adopt the industry convention, which resulted in the company recording a $2.1 million cumulative effect of a change in accounting principle during fiscal 1996.

In the summer of 1996, Wall Street took notice when Harold Ruttenberg; his wife, Pamela; and their son, Don-Allen, sold large blocks of their Just for Feet common stock in a secondary offering to the general public. Collectively, the three members of the Ruttenberg family received nearly $49.5 million from the sale of those securities. Major investors and financial analysts questioned why the Ruttenbergs would dispose of much of their Just for Feet stock while, at the same time, the senior Ruttenberg was issuing glowing projections regarding the company’s future prospects.

Clay Feet

No one could deny the impressive revenue and profit trends that Just for Feet established during the mid- and late 1990s. Exhibit 1 and Exhibit 2, which present the company’s primary financial statements for the three-year period fiscal 1996 through fiscal 1998, document those trends. However, hidden within the company’s financial data for that three-year period was a red flag. Notice in the statements of cash flows shown in Exhibit 2 that despite the rising profits Just for Feet reported in the late 1990s, the company’s operating cash flows during that period were negative. By early 1999, these negative operating cash flows posed a huge liquidity problem for the company. To address this problem, Just for Feet sold $200 million of high-yield “junk” bonds in April 1999.

Exhibit 1Just for FEET, Inc., 1996–1998 Balance Sheets

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Exhibit 2Just for FEET, Inc., 1996–1998 Income Statements and Statements of Cash Flows

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A few weeks after selling the junk bonds, Just for Feet issued an earnings warning. This press release alerted investors that the company would likely post its first-ever quarterly loss during the second quarter of fiscal 1999. One month later, Just for Feet shocked its investors and creditors when it announced that it might default on its first interest payment on the $200 million of junk bonds. Investors received more disturbing news in July 1999 when Harold Ruttenberg unexpectedly resigned as Just for Feet’s CEO. The company replaced Ruttenberg with a corporate turnaround specialist, Helen Rockey. Upon resigning, Ruttenberg insisted that Just for Feet’s financial problems were only temporary and that the company would likely post a profit during the third quarter of fiscal 1999.

Harold Ruttenberg’s statement did not reassure investors. The company’s stock price went into a freefall during the spring and summer of 1999, slipping to near $4 per share by the end of July. In September, the company announced that it had lost $25.9 million during the second quarter of fiscal 1999, a much larger loss than had been expected by Wall Street. Less than two months later, on November 2, 1999, the company shocked its investors and creditors once more when it filed for Chapter 11 bankruptcy protection in the federal courts.

Just for Feet’s startling collapse over a period of a few months sparked a flurry of lawsuits against the company and its executives. Allegations of financial mismanagement and accounting irregularities triggered investigations of the company’s financial affairs by state and federal law enforcement authorities, including the Alabama Securities Commission, the FBI, the Securities and Exchange Commission (SEC), and the U.S. Department of Justice. In May 2003, the Justice Department announced that a former Just for Feet executive, Adam Gilburne, had pleaded guilty to conspiracy to commit wire and securities fraud. Gilburne, who had served in various executive positions with Just for Feet, revealed that he and other members of the company’s top management had conspired to inflate the company’s reported earnings from 1996 through 1999.

The information [testimony provided by Gilburne] alleges that beginning in about 1996, Just for Feet’s CEO [Harold Ruttenberg] would conduct meetings at the end of every quarter in which he would lay out analysts’ expectations of the company’s earnings, and then draw up a list of “goods”—items which produced or added income— and “bads”—those which reduced income. The information alleges that the CEO directed Just for Feet’s employees to increase the “goods” and decrease the “bads” in order to meet his own earnings expectations and those of Wall Street analysts.

Approximately two years following Gilburne’s guilty plea, the SEC issued a series of enforcement releases that documented the three key facets of the fraudulent scheme perpetrated by Just for Feet’s management team. “Just for Feet falsified its financial statements by

(1) improperly recognizing unearned and fictitious receivables from its vendors,

(2) failing to properly account for excess inventory, and

(3) improperly recording as income the value of display booths provided by its vendors.”

The stores-within-a-store floor plan developed by Harold Ruttenberg provided an opportunity for Just for Feet’s vendors to become directly involved in the marketing of their products within the company’s superstores. Each year, Just for Feet received millions of dollars of “vendor allowances” or “advertising co-op” from its major suppliers. These allowances were intended to subsidize Just for Feet’s advertising expenditures for its superstores.

Despite the large size of the vendor allowances, in most cases there was not a written agreement that documented the conditions under which Just for Feet was entitled to an allowance or the size of a given allowance. After Just for Feet had run a series of advertisements or other promotional announcements for a vendor’s product, copies of the advertising materials would be submitted to the vendor. An account manager for the vendor would then approve an allowance for Just for Feet based upon the amount of the advertised products that the company had purchased.

Generally accepted accounting principles (GAAP) dictate that vendor allowances not be offset against advertising expense until the given advertisements have been run or other promotional efforts have been completed. However, Just for Feet began routinely recording anticipated vendor allowances as receivables and advertising expense offsets well before the related advertising or promotional programs had been completed. Just for Feet’s management team was particularly aggressive in “front-loading” vendor allowances during fiscal 1998. At the end of fiscal 1997, Just for Feet had slightly more than $400,000 of outstanding vendor allowance receivables; 12 months later, at the end of fiscal 1998, that total had soared to almost $29 million.

During fiscal 1998, Just for Feet’s merchandise inventory nearly doubled, rising from $206 million on January 31, 1998, to almost $400 million on January 31, 1999. Although Just for Feet had a large amount of slow-moving inventory, the company’s management team refused to properly apply the lower of cost or market rule in arriving at a year-end valuation reserve for that important asset. As a result, at the end of both fiscal 1997 and fiscal 1998, the company’s allowance for inventory obsolescence stood at a nominal $150,000.

The major athletic shoe vendors erected promotional displays or booths in the Just for Feet superstores. These booths were maintained by sales representatives of the vendors and were the property of those vendors. In early 1998, Don-Allen Ruttenberg concocted a fraudulent scheme to produce millions of dollars of “booth income” for Just for Feet. Without the knowledge of its vendors, Just for Feet began recording in its accounting records monthly booth income amounts allegedly earned from those vendors. The offsets to these revenue amounts for accounting purposes were booked (debited) to a booth assets account. By the end of fiscal 1998, Just for Feet had recorded $9 million of bogus assets and related revenues as a result of this scheme. More than 80 percent of these bogus transactions were recorded during the final two quarters of fiscal 1998, ostensibly to allow Just for Feet to reach its previously announced earnings targets for those two periods.

An important feature of the Just for Feet accounting fraud was Don-Allen Ruttenberg’s close relationship with key executives of the major athletic shoe vendors. Since Just for Feet was among the largest customers of each of those vendors, the company had a significant amount of economic leverage on their executives. The younger Ruttenberg used this leverage to persuade those executives to return false confirmations to Just for Feet’s independent audit firm, Deloitte & Touche. Those confirmations were sent to Just for Feet’s vendors to confirm bogus receivables that were a product of the company’s fraudulent accounting scheme. In most cases, the bogus receivables resulted from inflated or otherwise improper vendor allowances booked by Just for Feet. One of the five vendor executives who capitulated to Don-Allen Ruttenberg’s demands was Thomas Shine, the senior executive of Logo Athletic. Executives of four Just for Feet vendors steadfastly refused to provide false confirmations to Deloitte. Those executives were employed by Asics-Tiger, New Balance, Reebok, and Timberland. Ironically, in 2001, Thomas Shine became an executive of Reebok when that company purchased Logo Athletic.

Footing & Cross-Footing

Deloitte & Touche served as Just for Feet’s independent audit firm from 1992 through early December 1999, one month after the company filed for Chapter 11 bankruptcy. Deloitte issued unqualified audit opinions each year on Just for Feet’s financial statements, including the financial statements in the S-1 registration statement the company filed with the SEC when it went public in 1994.

Steven Barry served as Just for Feet’s engagement partner for the fiscal 1998 audit. Barry was initially an employee of Touche Ross & Co. and was promoted to partner with that firm in 1988. The next year, Barry became a Deloitte & Touche partner following the merger of Touche Ross with Deloitte, Haskins, & Sells. In 1996, Barry was promoted to managing partner of Deloitte’s Birmingham, Alabama, office. Barry’s principal subordinate on the 1998 Just for Feet audit was Karen Baker, who had been assigned to the company’s audit engagement team since 1993. Initially the audit senior on that engagement team, she became the engagement audit manager after being promoted to that rank in 1995.

Deloitte assigned a “greater than normal” level of audit risk to the fiscal 1998 Just for Feet audit during the planning phase of that engagement. To help monitor high-risk audit engagements, Deloitte had established a “National Risk Management Program.” In both 1997 and 1998, Just for Feet was included in that program. Each client involved in this program was assigned a “National Review Partner.” This partner’s duties included “discussing specific risk areas and plans to respond to them … reviewing the audit workpapers concerning risk areas of the engagement, and reviewing the financial statements and Deloitte’s audit reports with an emphasis on the identification of specific risk areas as well as the adequacy of the audit report and disclosures regarding these risk areas.”

The audit workpapers for the fiscal 1997 audit identified several specific audit risk factors. These factors included “management accepts high levels of risk,” “places significant emphasis on earnings,” and “has historically interpreted accounting standards aggressively.” Another 1997 workpaper noted that the company’s management team placed a heavy emphasis on achieving previously released earnings targets, expressed an “excessive” interest in maintaining the company’s stock price at a high level, and engaged in “unique and highly complex” transactions near fiscal year-end. A summary 1997 workpaper entitled “Risk Factors Worksheet” also noted that Harold Ruttenberg exercised “one-man rule (autocrat)” over Just for Feet and that the company practiced “creative accounting.”

For both the 1997 and 1998 audit engagements, Deloitte personnel prepared a “Client Risk Profile.” This workpaper for those two audits identified vendor allowances and inventory valuation as key audit risk areas. In 1996, Deloitte’s headquarters office had issued a firm-wide “Risk Alert” informing practice offices that vendor allowances should be considered a “high-risk area” for retail clients.

During the 1998 audit, the Deloitte engagement team identified several factors that, according to the SEC, should have caused both Barry and Baker to have “height-ened professional skepticism” regarding Just for Feet’s vendor allowances. The most important of these factors was the huge increase in the vendor allowance receivables between the end of fiscal 1997 and fiscal 1998. In the final few weeks of fiscal 1998, Just for Feet recorded $14.4 million of vendor allowances, accounting for almost one-half of the year-end balance of that account. Deloitte was never provided with supporting documentation for $11.3 million of those vendor allowances, although a Just for Feet executive had promised to provide that documentation. Deloitte completed its fieldwork for the fiscal 1998 audit on April 23, 1999, almost three months following the fiscal year-end. As of that date, Just for Feet had not received any payments from its suppliers for the $11.3 million of undocumented vendor allowances.

In March 1999, Deloitte mailed receivables confirmations to 13 of Just for Feet’s suppliers. Collectively, those vendors accounted for $22 million of the $28.9 million of year-end vendor allowances. Again, Don-Allen Ruttenberg persuaded executives of five Just for Feet vendors to sign and return confirmations to Deloitte even though the vendor allowance receivables listed on those confirmations did not exist or were grossly inflated. The confirmations returned by the other eight vendors were generally “nonstandard,” according to the SEC. That is, these confirmations included caveats, disclaimers, or other statements that should have alerted Deloitte to the possibility that the given receivable balances were unreliable. “Five vendors returned nonstandard letters that, instead of unambiguously confirming amounts owed to Just for Feet at the end of the fiscal 1998 year, as requested by the auditors, provided ambiguous information on amounts of co-op [vendor allowances] that the Company had earned, accrued, or had available during the year” [emphasis added by SEC]. Another of the returned confirmations explicitly noted that “no additional funds” were due to Just for Feet.

The eight nonstandard confirmations accounted for approximately $16 million of the $22 million of vendor allowance receivables that Deloitte attempted to confirm at year-end. “Despite these and other flaws, the Respondents [Deloitte, Barry, and Baker] nonetheless accepted these letters as confirming approximately $16 million in receivables claimed by Just for Feet.” The SEC’s investigation of Deloitte’s Just for Feet audits revealed that although Barry and Baker accepted these flawed confirmations, two subordinates assigned to the 1998 engagement team continued to investigate the obvious discrepancies in those confirmations well after the completion of that audit. These two individuals, who were audit seniors, twice contacted a Just for Feet executive in the months following the completion of the 1998 audit in an attempt to obtain plausible explanations for the eight nonstandard and suspicious confirmations. That executive did not respond to the audit seniors and neither Barry, nor Baker, apparently, insisted that he provide appropriate documentation and/or explanations regarding the amounts in question.

Just for Feet’s large increase in inventory during fiscal 1998 raised several important issues that the Deloitte auditors had to address during the 1998 audit, the most important being whether the client’s reserve for inventory obsolescence was sufficient. The primary audit procedure used by Deloitte during the 1998 audit to assess the reasonableness of the client’s inventory valuation reserve was to obtain and test an inventory “reserve analysis” prepared by a company vice president. This latter document was supposed to include the following three classes of inventory items for which company policy required application of the lower of cost or market rule:

(1) shoe styles for which the company had four or fewer pairs,

(2) shoes and other apparel that were selling for less than cost, and

(3) any inventory styles for which no items had been sold during the previous 12 months.

The reserve analysis for 1998, however, excluded those inventory styles for which no sales had been made during the previous 12 months, an oversight that the Deloitte auditors never questioned or investigated. The Deloitte auditors also discovered that a large amount of inventory included in a Just for Feet warehouse had been excluded from the reserve analysis prepared by the company vice president. Again, the auditors chose not to question client personnel regarding this oversight.

After completing their inventory audit procedures, the Deloitte auditors concluded that Just for Feet’s year-end reserve for inventory obsolescence was significantly understated. The SEC noted that this conclusion was reached by the Deloitte auditors despite the obvious deficiencies in audit procedures applied to Just for Feet’s reserve for inventory obsolescence:

Even using the flawed inventory analysis provided by the Vice President and the deficient inventory information that excluded the goods from the New Jersey warehouse, the Respondents concluded that Just for Feet’s obsolescence reserve should have been in the range of $441,000 to over $1 million.

The Deloitte audit team proposed an audit adjustment to increase the reserve for inventory obsolescence by more than $400,000; however, the client rejected that audit adjustment, meaning that the year-end balance of that account remained at a meager $150,000.

Although not specifically identified as a “key audit risk area” during the 1998 audit, the Deloitte auditors focused considerable attention on Just for Feet’s accounting decisions for the approximately $9 million of “booth income” the company recorded during that year. The Deloitte auditors discovered the monthly booth income journal entries recorded by Just for Feet during fiscal 1998 and prepared a workpaper documenting those entries. “An analysis at the end of the workpaper, which Baker reviewed, showed that the net effect of Just for Feet’s booth-related journal entries was to increase assets with a corresponding increase in income. The Respondents [Deloitte, Barry, and Baker] performed no further analysis to determine the basis and propriety of these journal entries.”

Instead of independently investigating these entries, the Deloitte auditors accepted the representation of a Just for Feet executive that the entries had no effect on the company’s net income. According to this executive, the monthly booth income amounts were offset by preexisting “co-op” or advertising credits that had been granted to Just for Feet by its major vendors. In other words, instead of using those advertising credits to reduce reported advertising expenses, Just for Feet was allegedly converting those credits into booth income or revenue amounts.

By the end of 1998, the bogus booth income journal entries had produced $9 million of nonexistent “booth assets” in Just for Feet’s accounting records. Since “neither the Company nor the auditors had internal evidence supporting the recording of $9 million of booth assets,” the Deloitte engagement team decided to corroborate the existence and ownership assertions for those assets by obtaining confirmations from the relevant Just for Feet vendors. These confirmations were prepared with the assistance of certain Just for Feet executives who were aware of the fraudulent nature of the booth income/booth assets amounts. Apparently, these executives contacted the vendor representatives to whom the confirmations were mailed and told them how to respond to the confirmations. The booth assets confirmations returned by the vendors to Deloitte were replete with errors and ambiguous statements. A frustrated audit senior who reviewed the confirmations brought this matter to the attention of both Barry and Baker.

An audit senior reviewed these confirmations and informed Barry and Baker that she was in some cases sending multiple confirmation requests to the vendors because many of their initial requests came back in forms different from that requested. The Respondents failed to discover from these indications that Just for Feet might not actually … [own]the booths as claimed.

Epilogue

In February 2000, after realizing that Just for Feet was no longer salvageable, Helen Rockey began the process of liquidating the company under Chapter 7 of the federal bankruptcy code. Over the next few years, settlements were announced to a number of large lawsuits linked to the Just for Feet accounting fraud and the company’s subsequent bankruptcy. Just for Feet’s former executives and Deloitte were among the principal defendants in those lawsuits. One of those cases, a class-action lawsuit filed by Just for Feet’s former stockholders, was settled for a reported $32.4 million in 2002.

Several of Just for Feet’s former executives pleaded guilty to criminal charges for their roles in the company’s massive accounting fraud. Among these individuals was Don-Allen Ruttenberg. In April 2005, a federal judge sentenced Ruttenberg to 20 months in federal prison and fined him $50,000. At the same time that the younger Ruttenberg’s sentence was announced, a Justice Department official reported that Harold Ruttenberg, who was gravely ill with brain cancer, would not be charged in the case. In January 2006, Harold Ruttenberg died at the age of 63.

Five executives of Just for Feet’s former vendors also pleaded guilty to various criminal charges for providing false confirmations to the company’s auditors. Most of these individuals, including Thomas Shine, received probationary sentences. An exception was Timothy McCool, the former director of apparel sales for Adidas, who received a four-month “noncustodial” sentence. While sentencing McCool, U.S. District Judge C. Lynwood Smith, Jr., noted, “ Life is so fragile. A single bad choice in a single moment can cause a life to turn irrevocably 180 degrees. I think that is where you find yourself.”

Arguably, the party to the Just for Feet scandal that received the most condemnation from the courts and the business press was Deloitte. In April 2005, the SEC berated the prominent accounting firm for the poor quality of its Just for Feet audits in Accounting and Auditing Enforcement Release No. 2238. In that same enforcement release, the SEC fined Deloitte $375,000 and suspended Steven Barry from serving on audit engagements involving SEC registrants for two years; Karen Baker received a one-year suspension.

On the same date that the SEC announced the sanctions that it had imposed on Deloitte for its Just for Feet audits, the federal agency also revealed the sanctions that Deloitte received for its allegedly deficient audits of a large telecommunications company, Adelphia Communications. Similar to Just for Feet, the once high-flying Adelphia had suddenly collapsed in 2002 following revelations that its previously issued financial statements that had been audited by Deloitte were riddled with errors. The SEC stunned the public accounting profession by fining Deloitte $50 million for its role in the huge Adelphia scandal, which was easily the largest fine ever imposed on an accounting firm by the federal agency.

Shortly after the SEC announced the sanctions that it had levied on Deloitte for its Just for Feet and Adelphia Communications audits, James Quigley, Deloitte’s CEO, issued a press release responding to those sanctions. Quigley noted in his press release that, “Among our most significant challenges is the early detection of fraud, particularly when the client, its management and others collude specifically to deceive a company’s auditors.” This statement infuriated SEC officials. An SEC spokesperson responded to Quigley’s press release by stating that, “Deloitte was not deceived in this case. The findings in the order show that the relevant information was right in front of their eyes. Deloitte just didn’t do its job, plain and simple. They didn’t miss red flags. They pulled the flag over their head and claimed they couldn’t see.”

The SEC also suggested that Quigley’s press release violated the terms of the agreement that the agency had reached with Deloitte in settling the Just for Feet and Adelphia cases. Under the terms of that agreement, Deloitte was not required to “admit” to the SEC’s findings, nor was it allowed to “deny” those findings. Deloitte subsequently rescinded Quigley’s press release and issued another that eliminated some, but not all, of the statements that had offended the SEC.

Background

https://www.latimes.com/archives/la-xpm-2003-may-13-fi-feet13-story.html

https://www.wsj.com/articles/SB105278122330015100

https://www.bizjournals.com/birmingham/stories/2000/04/03/focus4.html

Questions

Provide a narrated power point or a Kaltura video with answers to these questions:

1. Prepare common-sized balance sheets and income statements for Just for Feet for the period 1996–1998. Also compute key liquidity, solvency, activity, and profitability ratios for 1997 and 1998. Given these data, comment on what you believe were the high-risk financial statement items for the 1998 Just for Feet audit.

2. Just for Feet operated large, high-volume retail stores. Identify internal control risks common to such businesses. How should these risks affect the audit planning decisions for such a client?

3. Just for Feet operated in an extremely competitive industry, or subindustry. Identify inherent risk factors common to businesses facing such competitive conditions. How should these risks affect the audit planning decisions for such a client?

4. Prepare a comprehensive list, in a bullet format, of the audit risk factors present for the 1998 Just for Feet audit. Identify the five audit risk factors that you believe were most critical to the successful completion of that audit. Rank these risk factors from least to most important and be prepared to defend your rankings. Briefly explain whether or not you believe that the Deloitte auditors responded appropriately to the five critical audit risk factors that you identified.

5. Put yourself in the position of Thomas Shine in this case. How would you have responded when Don-Allen Ruttenberg asked you to send a false confirmation to Deloitte & Touche? Before responding, identify the parties who will be affected by your decision.

Week 8 – Other Types of Fraud

See the “Saks Fifth Avenue” case for this question.

Saks Fifth Avenue

Attracting customers and closing sales are challenges that face all retailers, ranging from a Piggly Wiggly grocery in a small southern town to the Giorgio Armani Boutique nestled among the elegant shops lining Rodeo Drive in Beverly Hills. Besides the never-ending need to produce revenues, retailers wrestle daily with many other challenges and problems that pose serious threats to their operations. Theft of cash and inventory by employees historically ranks as one of the most common threats to retail operations. Increasing numbers of employee lawsuits, lawsuits predicated on sexual harassment, racial discrimination, and related charges, also jeopardize the financial health of many retailers. Strong internal controls can significantly reduce the likelihood of losses from employee theft and from lawsuits filed by employees. Saks Fifth Avenue, an upscale merchandiser based in New York, learned that lesson firsthand in the late 1990s.

Promotions, Pay Raises, and Pilfering

In late 1993, Joseph Fierro accepted a part-time sales position with a Saks Fifth Avenue store in New York City. Fierro was assigned to the Men’s Polo Department of that store, a department supervised by Robert Perley. Fierro’s hard work and ingenuity produced sizable sales and impressed his superior. Within a few months, Perley hired Fierro as a full-time salesperson at an annual salary of $30,000. A few months later, Perley created a new position for Fierro, “Clothing Specialist,” so that he could give his star employee a 20 percent raise. By early 1996, Fierro’s annual salary had risen to $46,000 on the strength of strong performance appraisals consistently given to him by Perley.

In late August 1996, Joseph Fierro purchased a shirt from another department of the Saks store in which he worked. To obtain an employee discount for the shirt, a discount that he was not entitled to receive, Fierro forged two signatures on a document used to authorize employee sales discounts. The signatures he forged were those of Robert Perley and Donna Ruffman, a co-worker. Fierro also entered the transaction in one of his department’s electronic cash registers using Ruffman’s employee identification number. The discount saved Fierro $9.85.

Approximately one week later, two auditors from Saks’ Loss Prevention Department reviewed the August transactions entered in the electronic cash registers of the Men’s Polo Department. The auditors noticed the employee sales transaction entered by Ruffman. After examining the documentation for the transaction, they suspected that someone had forged the authorization signatures for the related discount. The auditors questioned several employees in the department regarding the suspicious sale, including Joseph Fierro. Fierro initially denied that he had entered the transaction in his department’s cash register. When the auditors suggested that they could easily determine who initiated the transaction, Fierro recanted. He admitted originating the transaction and forging the signatures of both Perley and Ruffman. In a written statement, Fierro later apologized for the incident. “I realize it was wrong to do this. I exercised poor judgment and I am truthfully sorry for what I did. I realize that something like this is wrong and it will never happen again.”

After being questioned by the Loss Prevention auditors, Fierro returned to his department and discussed the matter with Perley. Perley told Fierro that he had no influence on the Loss Prevention Department’s decisions but pledged to help him in any way he could. Perley later testified that he telephoned both the Loss Prevention Department and the Human Resources Department and appealed to them not to terminate Fierro.

On September 13, 1996, two representatives of Saks’ Human Resources Department notified Fierro that he was being dismissed for violating company policy. They referred Fierro to Saks’ employee handbook that listed specific examples of prohibited conduct that would lead to the “immediate dismissal” of an employee. Saks charged Fierro with engaging in three such acts including theft of company merchandise, forging a signature, and receiving an unauthorized benefit by entering a transaction in a cash register under another employee’s identification number.

Saks’ Human Resources Department conducted an exit interview with Fierro on the date he was terminated. During this interview, Fierro again apologized for the poor judgment he had exercised. He also expressed disbelief that an “exceptional employee” could be fired for such a “trivial transgression.”

He Called Me Buttafucco!

After losing his job at Saks Fifth Avenue, Fierro searched for employment in the New York City area. Among the jobs he applied for was a position with a financial services company. This company insisted on contacting Fierro’s former employers. Before the prospective employer contacted Saks, Fierro called a Saks employee in the Human Resources Department who had conducted his exit interview. This individual had supposedly told Fierro during that exit interview that the reason he had been dismissed would not be disclosed to prospective employers. However, when Fierro telephoned this individual, she informed him that if asked, she would reveal the circumstances that had led to his dismissal.

Shortly after Fierro’s telephone conversation with the human resources employee, he filed a discrimination lawsuit against Saks Fifth Avenue with the Equal Employment Opportunity Commission (EEOC). Fierro filed the lawsuit pursuant to Title VII of the Civil Rights Act of 1964 and the New York Human Rights Law. In his lawsuit, Fierro claimed that he was subjected to a “hostile work environment” during his employment with Saks. Fierro also claimed that Robert Perley, his supervisor, discriminated against him because of his Italian-American heritage and that Perley fired him in retaliation for his decision to stand up to that discriminatory treatment.

Fierro predicated his charge of discriminatory treatment upon inappropriate remarks allegedly made to him by Perley. He claimed that Perley referred to him on occasion by a term commonly used as a slur against Italian-Americans. Fierro also claimed that Perley occasionally called him “Joey Buttafucco.” Finally, Perley allegedly made an insensitive racial remark alluding to Fierro’s Hispanic wife. After Perley made the latter remark, Fierro told him that the remark was unacceptable. At that point, according to Fierro, Perley “commenced a plan to terminate him.”

Fierro maintained that the discriminatory remarks allegedly made to him by Perley caused him to have low personal esteem and severely damaged his career. Those remarks also reportedly caused him to suffer “permanent psychological damage.” Fierro insisted that he was haunted by images of the three-letter slur that Perley had used in referring to him: “ … every time I look in the mirror I see those three letters above my head and it really hurts.”

District Court Settles Fierro’s Lawsuit

Federal district judge Charles Brieant presided over Fierro’s lawsuit against Saks Fifth Avenue. Judge Brieant quickly rejected Fierro’s claim that Perley discriminated against him. The judge also dismissed the related allegation that Saks fired Fierro for “standing up” to Perley’s discriminatory treatment. Evidence presented by both Fierro and Saks suggested that rather than discriminating against Fierro, Perley considered him a valued employee and gave him glowing job performance appraisals. The evidence reviewed by Judge Brieant also suggested that Perley was not involved in Fierro’s dismissal. That decision apparently was made by the Human Resources Department with considerable input from the Loss Prevention Department. In fact, as noted earlier, Perley made two telephone calls to intercede on Fierro’s behalf.

Judge Brieant concluded that Saks’ dismissal of Fierro was not a discriminatory action but simply a consistent application of the company’s zero tolerance policy for employee theft. The judge admitted that the theft loss Saks suffered was “relatively trivial,” but he went on to note that retailers have a “strong business interest in deterring employee pilfering.” Neither the Civil Rights Act of 1964, nor the New York Human Rights Law, the judge observed, prohibit employers from being “overly rigid or even harsh” in punishing employee theft. Saks’ employment records demonstrated that the company consistently punished employee theft with the harsh measure of termination. For example, Saks immediately dismissed a former co-worker of Fierro who was caught “booking credits to his own account.”

Judge Brieant considered more seriously Fierro’s claim that he was subjected to a hostile work environment. The judge invoked the following definition of a hostile work environment.

“A hostile work environment exists when the workplace is permeated with discriminatory intimidation, ridicule, and insult, that is sufficiently severe or pervasive to alter the conditions of the victim’s employment.”

An employer can assert several defenses in an employee lawsuit alleging a hostile work environment. Among the most credible defenses, Judge Brieant noted, is the existence of an explicit anti-harassment policy. Saks had such a policy during Fierro’s employment. The company also had a related complaint procedure allowing employees to file a grievance against a superior or co-worker for engaging in “hostile” behavior. Judge Brieant noted that Fierro never filed a grievance against Perley or his co-workers during his three years with Saks. When asked why he did not take such action, Fierro testified, “I was afraid of repercussions. If you start to conflict with your manager, before you know it it’s not a very pleasant outcome.” Judge Brieant found Fierro’s inaction unsatisfactory.

“At some point, employees must be required to accept responsibility for alerting their employers to the possibility of harassment. Without such a requirement, it is difficult to see how Title VII’s deterrent purposes are to be served, or how employers can possibly avoid liability in Title VII cases. Put simply, an employer cannot combat harassment of which it is unaware.”

Fierro presented evidence supporting his contention that references to individuals’ racial origin, sexual orientation, and religious affiliation were common in his former department. However, his former co-workers testified that they intended such references to be humorous or self-deprecating. Perley denied participating “in this intended humor” by his subordinates. After reviewing the evidence presented in Fierro’s lawsuit, Judge Brieant observed that Perley’s department “did not adhere to the highest standards of decorum.” Nevertheless, he suggested that the department’s work environment was not hostile but “merely offensive.”

“Conduct that is merely offensive and not severe enough to create an objectively hostile or abusive work environment— an environment that a reasonable person would find hostile or abusive—is beyond Title VII’s purview. Thus for racist comments, slurs, and jokes to constitute a hostile work environment, there must be more than a few isolated incidents of racial enmity, meaning that instead of sporadic racial slurs, there must be a steady barrage of opprobrious racial comments.”

In July 1998, Judge Brieant dismissed Fierro’s allegation that he was subjected to a hostile work environment at Saks Fifth Avenue. The judge noted that Fierro did not make such a claim during his employment with Saks or during his exit interview. Instead, that allegation and the related discrimination charges apparently originated near the time Saks refused to give Fierro a “clean” employment reference. Judge Brieant concluded that the timing of Fierro’s allegations and Saks’ refusal to provide the employment reference was “hardly a coincidence.”

Questions

1. In your opinion, was Saks’ zero tolerance policy for employee theft reasonable? Was the policy likely cost-effective? Defend your answers.

2. Did Saks’ anti-harassment policy and the related complaint procedure qualify as internal controls? Explain.

3. Identify five control activities that you would commonly find in a men’s clothing department of a major department store. Identify the control objective associated with each of these activities.

4. Should a company’s independent auditors be concerned with whether or not a client provides a non-hostile work environment for its employees? If your answer is “yes,” identify the specific audit issues that would be relevant in this context.

The facts and quotations appearing in this case were drawn from the following legal opinion: Fierro v. Saks Fifth Avenue, 13 F.Supp. 2d 481 (1998).

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