The Crazy Eddie 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.
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 from cash 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.
Phase 3: Crazy Eddie goes public, stock prices soar
On September 13, 1984, Crazy Eddie had its initial public offering (IPO) and investors quickly gobbled up 1.7 million newly-issued company shares at $8 per share.
The Antars did not unload any of their stock in the IPO. However, in the following three years, family members unloaded most of their shares and pocketed over $90 million in proceeds from unsuspecting investors as Crazy Eddie’s stock skyrocketed.
Keeping the auditors at bay
As a public company committing fraud, we needed to keep our auditors on a short leash during the year-end audit. (They did not review our quarterly financial reports). The less time that Peat Marwick Main or PMM (today known as KPMG) had available to audit our books and records, the easier it was for us to dupe them into issuing clean audit opinions on our falsified reports. I made sure PMM did not have enough time to properly complete its audit field work and appropriately examine Crazy Eddie’s books and records.
Crazy Eddie’s year-end audits were expected to last about eight weeks, and PMM planned to complete its field work in regular increments during that period. By the sixth week (of eight), PMM expected to have about 75% of its field work completed. I made sure this didn’t happen by contriving various stalling techniques aimed at slowing PMM down. My goal was that PMM would only have 25% of its work completed by week six, with 75% left to go. To get the work done and satisfy Crazy Eddie’s management, PMM would have to skimp on certain key procedures. This plan worked every year.
Taking advantage of the auditor’s human frailties
As a general practice, most large accounting firms use relatively inexperienced kids right out of college to do basic audit leg work. They are supervised by slightly more experienced senior auditors who unfortunately depend on feedback from these inexperienced kids in making informed decisions. During the 1980s, both these kids and their supervisors were mostly young single males between the ages of 22 and 29.
As a 28 year old CPA myself, I understood that audits are very boring and tedious for these young single male auditors. It was difficult for them to pay close attention to their work. It was relatively easy to distract them without ever being blamed for obstructing their work. Rather than overtly interfering, I engaged in a calculated plan to subtly distract them with cute Crazy Eddie employees reporting to me. I encouraged my female employees to flirt and get friendly with their young male PMM counterparts and discuss audit issues with them over lunch and dinner on Crazy Eddie’s tab. Meanwhile, I took certain higher level PMM auditors to pick-up bars and other establishments frequented by good-looking women.
Our auditors wasted valuable time getting chummy with our management and female employees rather than paying attention to their jobs. As the scheduled completion of the audit neared, our auditors rushed to complete their field work and failed to undertake key audit procedures which enabled us to easily inflate our reported earnings.
That chumminess also helped us become more likable to our auditors and corrode their professional skepticism. They did not want to believe we were crooks. They believed whatever we told them without verifying the truth. You can steal more with a smile!
The “Panama Pump”
Prior to going public, our main fraud at Crazy Eddie was tax evasion through skimming funds from the company and not reporting those revenues and profits. Now, we planned to launder some of those monies back into Crazy Eddie to inflate profits. We wanted to raise new capital to fund the opening of new stores while keeping the stock price high.
During the first ten months of Crazy Eddie’s 1986 fiscal year which ended on March 2, 1986, our comparable store sales increased by approximately 20% over the previous fiscal year. Comparable store sales is a key indicator of the underlying profitability of retailers. It factors out sales increases from opening additional retail units and provides a baseline comparison of revenues from existing stores during two reporting periods.
In December 1985 (first month of the last quarter), we reported a comparable store sales increase of 17%. However, during the last two months of the fiscal year (January and February 1986) our comparable store sales growth slowed to a mere 4% increase over the previous year (January and February 1985). Wall Street analysts were expecting a 10% increase in comparable store sales.
Note: Crazy Eddie did not report monthly sales figures, but instead reported quarterly sales right after the end of each quarter but before it reported its profits. However, the company customarily reported December sales separately, to give early indications of holiday sales. In the first week of March, Crazy Eddie reported its final quarter’s sales results. It was easy for Wall Street analysts to figure out January and February’s sales results, by subtracting December’s sales from the final quarter’s sales report.
Crazy Eddie’s high stock price was based on large increases in same store sales growth. We believed that a failure to meet analysts’ projections would have substantially dropped the price of our stock.
As we worried about missing analyst’s projections, we wanted to raise about $35 million in new capital by selling 1.3 million shares to investors in early March. Eddie Antar and Sam M. Antar (Eddie’s father) also wanted to dump 800,000 shares of stock (worth about $20 million). The difference between a 4% increase in sales and the 10% increase in same store sales expected by Wall Street analysts was about $2.2 million. To meet analysts’ expectations, we conceived of a plan called the “Panama Pump”.
Most of the $2.2 million needed to meet our sales targets came from secret bank accounts in Israel ($1.5 million) and safe deposit boxes in the USA ($500,000 cash) which contained previously skimmed funds. The balance of the needed comparable store sales came from a $200,000 sale of merchandise to another retailer.
The funds in Israel were wired to Panama (both countries were bank secrecy jurisdictions). After the funds were transferred to Panama, a family member withdrew those funds from Bank Leumi in the form of bank drafts or non-negotiable instruments, to avoid violating disclosure laws on the movement of funds into the country. Eventually those funds were deposited in Crazy’s Eddie’s bank accounts and reported as sales.
While the auditors knew we had poor internal controls, they believed we had at least a minimal level of controls to insure that store bank deposits came from customer revenues and no other source. They trusted we had sufficient procedures in place to insure that all store deposits were backed by documentation from authentic sales invoices to customers.
The auditors should have performed tests of internal control procedures by tracing funds deposited in our store bank accounts back to the source, which was supposed to be actual customer invoices, to determine if adequate controls were in place to insure accurate reporting of sales.
Obviously, we had no invoices backing up the $1.5 million funds transferred from Panama and the $500,000 in cash deposited into store bank accounts reported as “revenue.” Furthermore, the Panama drafts were issued in $25,000, $50,000, $75,000, and $100,000 amounts, whereas Crazy Eddie’s average sales were about $300 per customer.
The auditors did not examine our bank deposits for unusual transactions in large dollar amounts, and these unusual transactions weren’t even backed up by false invoices.
The funds from Panama and safe deposit boxes were deposited into store bank accounts a day after the fiscal year ended, on a Monday. Saturday and Sunday’s checks from customers were regularly deposited on Mondays too. Therefore, it appeared we had an increase of over 90% in comparable store sales in the last two days of the fiscal year. That, by itself, should have been a red-flag for the auditors.
Auditors normally perform what is known as “sales cut-off tests” at year-end to insure that revenues in the current year are not improperly shifted to the next year and revenues from the next year are not improperly shifted to the current year. For example, unusually large amounts of funds from sales claimed in the days before the end of the fiscal year, but not deposited into company bank accounts until after the fiscal year ended, may indicate an early recognition of revenues by shifting sales from the following year to the current year.
By design, our auditors did not have time to perform that key audit procedure. My female employees had distracted them from their tasks, and they were then rushing to complete their audits. In this manner, we avoided detection and reported a 10% increase in our January-February 1986 comparable store sales.
Demand for Crazy Eddie shares was so high that we were able to sell 1.495 million shares or 195,000 more than anticipated at $26.375 per share and raise $39.431 million in fresh capital. Eddie and his father Sam M. Antar sold 920,000 shares or 120,000 shares more than anticipated and pocketed $24.3 million in proceeds.
Stock prices usually drop as companies raise new capital because it dilutes existing shareholder interests. Similarly, when insiders unload huge amounts of shares, prices tend to suffer. But because the market liked our inflated comparable store revenue, our share prices held up.
By putting back $2 million dollars of previously skimmed funds back into the company, Crazy Eddie raised at least an extra $5.143 million by selling 195,000 additional shares. Eddie and his father pocketed an extra $3.2 million in stock sales. Since Crazy Eddie’s stock was trading at a P/E multiple of 25 times earnings, the Panama Pump scheme inflated the market capitalization of the company by approximately $40 million, after considering the extra corporation income taxes we paid on the inflated earnings. Not bad for a $2 million “reinvestment.”
How do I cheat thee, let me count the ways
In fiscal year 1986, we had already artificially inflated our earnings by $2,000,000 from fictitious sales resulting from the Panama Pump scheme ($1,500,000 million from the Panama bank drafts and $500,000 in currency from safe deposit boxes). The $200,000 sale to another retailer inflated comparable store sales but did not inflate our reported profits, since the merchandise was sold at cost. We inflated our profits by overstating our reported inventory and understating our accounts payable (amounts owed to vendors). Fraudulently increasing the value of inventories and fraudulently decreasing liabilities such as accounts payable inflates reported income or understates reported losses.
Cozying up with a major vendor
Crazy Eddie had a very cozy relationship with a vendor known as Wren Distributors (Wren). We were Wren’s largest customer, accounting for 35% of its revenues. We purchased over 10% of our merchandise from Wren. In order to inflate our inventory without adding to our accounts payable, I asked Wren to ship us $3 million to $4 million in merchandise before year-end, but to hold off billing until after the auditors completed the year-end audit. Because the merchandise was included in the year-end inventory count without recording the corresponding accounts payable to Wren, we were able to inflate income by $3 million to $4 million.
Inadequate audit procedures equals inflated inventories
Peat Marwick Main’s (PMM) lax audit procedures facilitated our crimes. At year-end in fiscal years 1985 to 1987, PMM only observed the inventory counts in roughly half our stores, leaving us virtually free to inflate inventory counts in other stores. Because the auditors only took random sample test counts of inventories in the stores they observed, we were able to inflate counts in those stores as well.
Our auditors did not have a clue as to the accurate level of inventory. When boxes were stacked high and stored several layers deep, our employees would climb the boxes, count the inventory, and shout out the inflated inventory numbers. Our auditors would duly record the inflated test counts.
We were extremely courteous to our auditors. During breaks, we bought them coffee and ran small errands for them. Our employees would volunteer to make copies of their audit test counts. Enjoying the favors and feeling good about us, they failed to take copies of the entire store inventory counts with them after leaving the store premises. They only took copies of their “test count” samples. Therefore, we knew exactly which inventory counts to inflate since we knew which sample test counts the auditors had taken. These lax audit procedures allowed us to overstate our inventories by $10 to $12 million.
Too much fraud
Ultimately, our various schemes had the potential of inflating profits by $15 to $18 million: $1.5 million in laundered funds received through Panama, $500,000 in currency received from Antar safe deposit boxes, $10 million to $12 million in inflated inventory amounts, and $3 million to $4 million from understating amounts owed to Wren. We had already reported the first three quarters’ financial results. Therefore, the inflation of income had to be applied to fourth quarter earnings.
If we inflated our profits as initially planned, our fourth quarter revenue would have increased $2 million from $97.6 million to $99.6 million due to the Panama Pump and the safe deposit box schemes. We would have reported gross profits of approximately $34.6 million to $37.6 million on revenues of $99.6 million and a whopping gross profit margin of 35%, far in excess of our historical margins.
We were so successful in overstating inventory and understating accounts payable that our auditors believed that we had substantially understated profits during the first three quarters of fiscal year 1986. Eddie and I had discussions with the auditors regarding our dilemma. The issue of accounting fraud never came up.
The auditors believed that we were just being overly cautious in reporting our numbers. An audit partner called our perceived conservatism “accountant’s liability insurance” because “no public company got sued for underreporting earnings.” He advised us to establish $8 million in excessive reserves to reduce the value of our reported inventory and reduce our excessive profits. He called that excessive reserve a “rainy day fund” to be used as needed to create income in future accounting periods. Therefore, our auditors unwittingly helped us reduce the level of our inflated earnings by $8 million, so we inflated our 1986 income by $7 to $10 million, instead of $15 to $18 million.
We rewarded our auditors very handsomely after that 1986 audit. We gave them extra consulting work on our computer system implementation and employee benefit compliance which provided them an extra $1 million in fees. The annual audit fee was only approximately $150,000.
In fiscal year 1987, we devised a new scheme to continue inflating comparable store sales by selling or trans-shipping merchandise to other retailers and wholesalers who were not end-users but re-sellers. While no specific accounting guidance existed for the computation of comparable store sales, it was widely assumed that such sales were made in stores open during both the current and previous year’s reporting period and were made to end-user customers – not trans-shipped to other retailers or wholesalers. In any case, those trans-shipping sales originated from the main office and not at the store level.
We sold one such wholesaler, known as Zazy International, over $20 million in merchandise. About $10 million of such sales were improperly reported as originating from comparable stores. Zazy issued a series of checks in small denominations for their purchases of merchandise from Crazy Eddie instead of issuing one large check per order. We deposited the small checks (usually in denominations of $10,000 – $20,000) into the bank accounts of the individual stores to make it appear that those sales originated at the store level and not in our main office.
In certain quarters, Crazy Eddie prematurely recognized sales to Zazy International and other distributors. The company invoiced the distributors for merchandise and it simultaneously received checks that were dated before the end of the accounting period. Therefore, sales, comparable store sales, inventory, and cash on hand was inflated in our financial reports. The company shipped the merchandise to the distributors and cashed the checks in the subsequent accounting period.
Desperate times, desperate measures
From the early 1970’s to 1984, Crazy Eddie was a profitable private company. Our frauds were focused primarily on skimming cash to avoid paying income and sales taxes. As a public company from 1984 to 1986, our frauds concentrated on inflating profits or overstating income. However, by Q3 1987, we started losing money for the first time in almost two decades because of increased competition and a steep decline in consumer electronic prices which reduced our revenues. We became desperate to report profits instead of losses.
A fraud made easy by auditor trust
Our auditors’ work papers were left behind in locked boxes on our premises during the audits. We gained access to these papers after learning that the audit manager routinely left his keys in a small 2″ paper clip box hidden in an unsecured desk. Knowing exactly what our auditors were doing, it was relatively easy for us to falsify inventory and accounts payable numbers in excessive amounts.
Massive inventory inflation
We continued to take advantage of our relationship with Wren Distributors. I pressured Wren to ship us about $5 million to $7 million in merchandise before year-end. The merchandise was included in the year-end inventory count without being included in the amount owed to the vendor.
1987 was our year of desperation. We inflated store level inventories by $15 to $20 million. In stores that existed during both 1986 and 1987 inventory levels increased 94% from $31.5 million to around $61.0 million mainly as a result of inflating inventories. (See Crazy Eddie’s Two Sets of Books.)
On April 26, 1987, the audit partner questioned me about the unusual increase in store level inventories during a period of dropping prices. I convinced him not to order a re-count of store inventories and to sign off on the audit on April 28 or two days earlier than planned, despite the fact that major audit work was incomplete.
Debit Memo Fraud
The massive inventory inflation and other schemes were not enough to avoid reporting major losses. So we conceived of a plan to generate $20 million in phony debit memos which were supposed to be chargebacks or offsets against amounts we owed to vendors for items such as advertising rebates, volume discounts, and other reimbursements due to Crazy Eddie.
For example, let’s say Crazy Eddie purchased $30 million from Sony during the year and our accounts payable ledger at year-end reflected that we owed Sony $10 million for unpaid purchases. However, our accounts payable ledger did not yet reflect $1 million in volume rebates due from Sony. That volume rebate is considered a “chargeback” to Sony or an “offset” against amounts we owed to Sony. Because the volume rebate reduced the amount of money that Crazy Eddie owed Sony, it is essentially income to Crazy Eddie.
Up to fiscal year 1986, we waited until vendors like Sony issued what is known as a credit memo to acknowledge “chargebacks” or “offsets” to accounts payable for items such as volume rebates. Even if Sony already owed us the volume rebate, Crazy Eddie did not reduce its accounts payable or recognize income from the volume rebate until we actually received a credit memo from Sony.
Our accounting policy for “purchase discounts and trade allowances” as disclosed in the company’s footnotes to the financial statements were:
Purchase discounts and trade allowances are recognized when received.
We could not reduce our accounts payable or amounts owed to vendors (thereby increasing profits) until a credit memo was actually received from a vendor for purchase discounts and allowances.
In 1987, we started issuing debit memos to claim “chargebacks” for items such as volume rebates, instead of waiting to receive credit memos from our vendors. Upon the issuance of a debit memo, our accounts payable immediately reflected lower amounts owed to vendors and therefore increased our income.
Our new accounting policy for “purchase discounts and trade allowances” as disclosed in the company’s footnotes to the financial statements were:
Purchase discounts and trade allowances are recognized when earned.
In the past, we waited weeks for a credit memo to arrive from our vendors. By changing our accounting policy for purchase discounts and allowances we could recognize the purchase discounts and trade allowances “when earned.” Under Crazy Eddie’s new accounting policy, we did not have to wait until the vendor issued a credit memo to record purchase discounts and trade allowances and reduce our accounts payable. With our new policy, we immediately issued a debit memo claiming that such amounts were owed to us by the vendors.
The debit memos made it easy for us to issue phony charge-backs to vendors, which helped us inflate our income. Fraudulently decreasing liabilities such as accounts payable inflates reported income or understates reported losses.
In 1987, we reduced our reported accounts payable from about $70 million to $50 million, almost 30%, through the issuance of $20 million in phony debit memos. We were desperately trying to cover up massive losses.
Fortunately, the audit staff member who was responsible for leg work on accounts payable had no prior experience in auditing accounts payable and had only started working for PMM six months earlier. He first learned about chargebacks to vendors against amounts purportedly owed to them mostly from me. He did not even begin verifying accounts payable balances until April 28, 1987, the very same day that PMM issued a clean audit opinion. He had spent too much time engaging in small talk with female employees assigned to distract him.
In sworn testimony, he answered the questions below by Stephen Howard, Attorney from Milbank, Tweed, Hadley, & McCloy, who represented the Oppenheimer-Palmieri Fund, L.P., one of the major shareholders who in November 1987 took over Crazy Eddie in a hostile takeover:
Question: There’s a date at the bottom of the page which appears to be 4/28/87. Do you see that?
PMM staffer: Yes, I do.
Question: Is that your handwriting.
PMM staffer: Yes, it is.
Question: What does that signify?
PMM staffer: It was my policy to date my work papers when I began to perform test work.
Question: So that tells us you started this work on the 28th but it doesn’t tell us when you finished it?
PMM staffer: That is correct.
PMM had already signed off on Crazy Eddie’s audit on April 28, 1987 and the young inexperienced auditor started his test work that same day. In his other sworn testimony, he said that he continued his field work for more than one day, but couldn’t recall how many days it took him to complete his work.
Because the audit was officially completed, PMM had no incentive to continue its work. It only examined our accounts payable or amounts we owed to three major vendors out of thousands of vendors. Each of those three vendors reported significant discrepancies in amounts they claimed that Crazy Eddie owed them due to our issuance of phony charge backs to vendors in the form of debit memos. For example, Sony claimed that we owed it about $5 million more than we claimed we owed it because Sony never acknowledged receiving any of our debit memos. The auditors never contacted any of the companies about any of the discrepancies.
On May 22, 1987, or 24 days after PMM issued its clean audit opinion of Crazy Eddie’s books and records, a senior staff member finally conducted an interview of our accounts payable manager (a female co-conspirator). She lied to him about our phony debit memos. However, it was too late for him to check on the accuracy of her representations, since the audit officially concluded on April 28, 1987.
Key audit procedures missed
In previous years, we had generated an accounts payable aging schedule for our auditors to review. That schedule provides detailed information about every invoice owed to vendors, any offsetting chargebacks to vendors such as debit memos, and how long those items have remained outstanding.
However, for fiscal year 1987, we did not generate this analysis. Our auditors were unable to determine how long the phony debit memos were on our books and records and why, after the passage of time, they were not sent to vendors to claim deductions against amounts owed to them.
The sheer volume of phony debit memos caused our books and records to show many vendors owing us money, rather than the other way around! Those negative accounts payable balances were red flags that the auditors never properly scrutinized.
An excerpt from PMM’s work papers said:
… traced all debit memos into A/P status report as of 03/01/87. No further work necessary.
An “A/P status report” simply lists all invoices owed to vendors and offsetting debit memos. Therefore, the debit memos were traced to a report listing the phony debit memos. Our auditors simply traced the phony debit memos to the books and records that reflected them, but did not do any follow up work to confirm their validity.
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