Crazy Eddie Auditing Case

Brad  Farber   Professor  Dignam   May  2nd  2013   Case  1.8  Crazy  Eddie     1) During  the  years  of  1984  thru  1987,  Crazy  Eddies  financial  statements  showed  a  handful  of   red  flags  which  should  have  led  to  auditors  raising  questions  to  the  companies  numbers  that   were  be  inflated  by  Crazy  Eddie  and  the  rest  of  his  executive  board  (which  was  mostly  his   family).       KEY  RATIOS   March  1st  1987   March  2nd  1986   March  3rd  1985   May  31  1984     Current   Ratio  

 

2.40%    

1.35%    

1.56%    

0.01%  

  Quick   Ratio  

 

1.40%    

0.59%    

0.76%    

0.14%  

 Account  Rec.   Turnover  

 

  Inventory   Turnover  

 

4.98    

3.55    

1.89    

1.95  

  Debt   to  Assets  

 

0.68%    

0.66%    

0.63%    

0.82%  

32  

 

116  

 

49  

 

52  

    Debt   to  Equity   2.00%     1.97%     1.74%     4.97%     One  of  the  first  things  that  pops  out  to  me  when  evaluating  the  ratios  is  the  drastic  change  in  the   Accounts  Receivables  Turnover  from  1986-­‐1987.    It  is  just  an  outlier  from  the  other  3  years  and  does   not  make  much  sense  due  to  the  disintegrating  market  conditions.        The  inventory  turnover   differential  also  might  have  drawn  a  red  flag.    Just  if  the  auditors  would  have  looked  at  these  figures   this  might  have  led  them  to  realize  that  Crazy  Eddy  overstated  inventory  by  $2M  and  $9M  one  year   later.    This  was  a  domino  effect  because  accounts  payable  was  understated  and  profits  and  gross   profit  majorly  overstated  to  meet  investors  expectations.    Over  the  4  years,  the  cash,  inventory   accounts  were  constantly  changing  drastically  year  to  year  which  was  in  large  part  due  to  the  “crazy”   accounting  practices  that  were  used  by  Eddie  and  his  family.         2)  Below  is  a  list  of  specific  audit  procedures  that  might  have  led  to  the  detection  of  some  of  the  fraud   that  occurred  in  Crazy  Eddies  books.    The  code  section  that  refers  to  proper  testing  is  AU  318.         a)  The  falsification  of  inventory  counts  sheets   Audit  Procedures:    If  the  auditors  were  ever  skeptical  of  what  was  going  on  they  could  have   physically  come  onto  the  Crazy  Eddy  premises  and  done  physical  inventory  counts  periodically   without  giving  the  store  any  warning/time  to  allow  them  to  conceal  wrong  an  wrong  doings.        

b)  Bogus  debit  memos  for  accounts  payable   Audit  Procedures:    Substantive  testing  should  have  been  performed.  The  auditors  should  have  sent   out  for  confirmations  to  confirm  with  the  supplier/client  the  validity  of  the  phony  accounts.    They   should  have  tested  and  traced  the  payable  statements  to  the  financials  and  see  if  the  checks  were   actually  written.    Internal  controls  should  have  also  been  looked  at.    The  internal  auditor  for  crazy   Eddie  was  not  only  doing  the  internal  audit  work  but  was  also  acting  as  the  controller,  and  director   of  accounts  payable.           c)  The  recording  of  transshipping  transactions  as  retail  sales   Audit  Procedures:    Eddie  used  this  tactic  to  overstate  inventory.    The  use  of  analytics  could  have   been  applied  to  helping  the  auditors  discover  this  fraud.    Peat  Marwick  and  Hurdman  could  have   done  a  better  job  observing  the  gross  profit  figures,  sales,  and  inventory.    All  of  which  were  heavily   inflated  and  affected  by  the  transshipping  transactions.    Cash  and  receipts  should  have  also  been   looked  over  with  a  closer  eye.               d)  Inclusion  of  consigned  merchandise  at  year  end   Audit  Procedures:  The  auditors  should  have  looked  more  closely  at  year  end  inventory  physical   counts  and  asked  to  see  documentation  to  where  this  inventory  came  from.    If  they  would  have   looked  into  the  proper  documentation  they  would  have  found  the  evidence  that  would  show  that   the  inventory  that  they  were  recording  did  not  in  fact  belong  to  them,  but  to  the  consignor.    This   could  have  been  done  my  matching/tracing  the  vendor  receipts  to  the  financial  statements  and   realizing  that  they  items  were  never  paid  for  but  merely  on  consignment  and  should  not  have  been   recorded  as  inventory.         3)  A  good  audit  team  well  looks  at  internal  and  external  market  factors  during  the  stages  of  planning   the  audit  (Auditing  Standard  9).    During  the  later  part  of  the  1980s  the  boom  days  for  the  electronic   industries  were  in  the  past.    The  bubble  on  the  industry  had  burst,  NYC  had  become  a  saturated   market,  and  increased  competition  had  made  things  much  harder  for  those  retail  stores  that  were   still  in  business.    The  auditors  should  have  been  aware  of  the  market  situation,  and  realized  that  in   times  like  these,  a  company  which  is  showing  record  amounts  of  profit  ,  should  be  looked  at  with  a   closer  eye  of  professional  skepticism.    The  audit  risk  should  have  been  raised  when  that  type  of   market  condition  existed.     4)  The  term  “lowballing”  relates  to  an  independent  audit  firm  giving  a  potential  new  audit  client  a   ridiculously  low  price  on  the  audit  work.    The  motivation  behind  this  is  retain  a  audit  client  and   charge  them  little  for  the  audit  services  in  hopes  to  them  hiring  you  to  do  the  consulting  work  for   the  firm  as  well.    This  is  done  with  the  hopes  that  they  can  overcharge  the  firm  for  consulting  fees   and  bring  in  not  only  audit  revenues  to  the  practice,  but  consulting  as  well.    By  a  firm  doing  both  the   audit  and  consulting  work  for  a  business,  it  can  potentially  affect  the  quality  of  the  work  and  most   definitely  the  independence  of  the  audit.    When  a  company  does  the  audit  work  and  consulting  work   it  definitely  creates  a  conflict  of  interest  and  affects  the  integrity  and  objectivity  of  the  audit.    As  we   saw  in  the  case  of  Enron,  this  can  lead  to  huge  problems  and  can  affect  the  independent  auditor  have   an  objective  viewpoint.        

    5)  If  I  were  unable  to  find  10  out  of  60  randomly  selected  I  would  immediately  reach  out  to  my   supervisor  and  let  him  know  about  the  dilemma  that  I  was  in.      If  I  could  not  find  the  invoices,  but   did  see  the  sales  order  or  the  money  going  out,  it  could  be  possible  that  they  were  misplaced  and   therefore  I  would  not  automatically  assume  fraud  had  occurred.    Besides  reaching  out  to  my   supervisor,  I  might  also  reach  out  to  the  member  of  the  client  that  I  was  in  touch  with  and  have  him   look  into  the  situation.    If  after  doing  further  research,  an  I  was  to  found  out  that  the  invoices  were   non-­‐existent  and  there  was  a  potential  for  fraud,  the  partner  on  the  engagement  would  be  notified   as  well  as  the  firms  management  group.             6)  I  personally  do  not  feel  that  companies  should  be  allowed  to  hire  individuals  who  had  served  as   their  independent  auditors  in  the  past.    One  of  the  biggest  disadvantages  to  this  practice  is  that  the   person  that  is  hired  already  has  an  advantage  if  they  were  to  try  to  commit  fraud  and  conceal  it.       After  the  Enron  debacle  and  Sarbanes  Oxley,  tighter  standards  have  been  set  into  place  regarding   this  situation.    I  think  that  it  is  important  for  people  in  public  accounting  to  make  the  transition  into   the  private  sector,  I  am  do  not  think  it  would  be  in  anyone  best  interest  for  the  that  person  to  make   the  switch  to  go  work  for  a  former  client.    This  situation  might  create  a  conflict  and  the  cons  out   weighs  the  pros.