Phar-Mar Inc. Accounting Scandal

Summary

Phar-Mor, Inc. was a deep-discount store that had substantial growth in a short period of time. It started with 15 stores and grew to over 310 stores in thirty two states between 1985 and 1992. At first Phar-Mor was seen as a major prospect in the retail market. With sales of over $3 billion and growing, Phar-Mor's success even worried some of the biggest retail giant, including Wal-mart. The president, founder, and COO of Phar-Mor was Mickey Monus, who became quite extravagant with his money as Phar-Mor grew. The key to the company's success was "power buying" a phrase coined by Mr. Monus, it was a practice of stocking up on products when suppliers where offering rock-bottom prices. After using this "power buying" strategy Phar-Mor then sold the products at deep discounts, beating any competitor's prices. This practice was indeed a key practice that attracted many price conscious consumers and led to the company's rapid success. However, the deep discount prices where so low that eventually Phar-Mor was no longer able to turn up a profit. In fact, it is believed that there were no profits generated after 1987. This is how the problem began, because Monus and other executives did not want the truth about there losses to damage the success and favorable reputation of Phar-Mor, they began to use imaginative accounting practices to hide their losses on the financial statements.

Phar-Mor's cover up and fraud was very extensive and went on for many years without being uncovered. In fact, Phar-Mor was deemed a hot commodity and attracted many large investors. These investors were eager to invest and willingly forked over more then $1.14 billion for further growth. These investors included some big names such as Westinghouse, Sears Roebuck & Co., Edward J. De Bartolo, and Lazard Freres & Co. The fraud was extensive and involved inventory overstatements, misappropriation of assets, and fraudulent financial reporting. The interesting thing was that the scale of collusion by management it was almost unthinkable, because it involved many people in the organization who worked together over many years to carefully cover up the fraud. The members that contributed included the president and COO, CFO, vice president of marketing, director of accounting, the controller, and many other key figures. The fact that these individuals all worked together is why the massive fraud went undetected for so many years.

Eventually, the fraud was uncovered, not by the external auditors or the SEC, but by a travel agent. This unlikely event took place when a travel agent received a Phar-Mor check signed by Mickey Monus for expenses that had nothing to do with Phar-Mor. The agent was suspicious and showed the check to her landlord who happened to be an investor in the Phar-Mor Company. The Landlord called David Shapira Phar-Mor's CEO and told him about his concern. David Shapira made an announcement in mid-1992, disclosing to the public that Phar-Mor was involved in a huge fraud that was instigated mainly by Mickey Monus the prior president and COO.

The outcome of the Phar-Mor fraud was quite substantial. It landed Mickey Monus in prison for over nineteen years, he was convicted of fraudulent accounting that inflated shareholder equity by a half a billion dollars, which ended up causing over one billion dollars in losses and Phar-Mor's bankruptcy. Also, several top managers admitted to their roles in the fraud and where convicted of financial fraud. Two were given prison sentences and the group was communally fined over one million dollars for their involvement. Eventually, lawsuits were filed against Coopers & Lybrand LLP currently known as Price Waterhouse Coopers, who were Phar-Mor's independent audits. The suits were brought by Phar-Mor's creditors, investors, and even some of Phar-Mor's management. The suits alleged that Coopers & Lybrand were reckless in performing their audits, the claims were for over one billion dollars. Although Coopers & Lybrand were never charged with knowingly assisting in the fraud they were ultimately found liable, and settled the claims for an unknown amount.

The Fraud

Phar-Mor, Inc. applied a variety of different fraudulent reporting techniques to "cook the books" and commit one of the biggest corporate frauds in American history. A number of things were done to cover up the massive losses the company was taking including issuing fake invoices for merchandise purchases, making fake journal entries in order to increase inventory and decrease cost of sales, recognizing inventory purchases but then not accruing the corresponding liability, and over-counting merchandise.

Since their prices were way too low, eventually profit margins began to decline very fast, this resulted in millions of losses. Instead of disclosing and recording these losses, President Monus along with the CFO Pat Finn and two other high ranking officials, decided to cross out the correct numbers insert highly inflated numbers, during this a sub ledger with the real numbers was also being kept. After a few months of this practice Pat Finn the CFO took on the responsibility of altering the numbers. By mid 1990 Monus's refusal to raise prices led to even more cover ups and eventually more members of the organization began to get involved in the fake reporting including the manager of accounting and the Controller. By the time the fraud was discovered executives at Phar-Mor had misstated financial statements by over $500 million.

Overstating inventory was a major part of the fraud. Phar-Mor executives hid the losses and made the books balance by significantly overstating inventory. Phar-Mor used the complex retail method to account for inventory. This method records inventory at the retail price and then converts it to GAAP cost by applying a cost complement percentage. When using this method the company ignored the lower of cost or market rule. Inventory was also shared between stores, therefore inventory overstatement was a result of being both incorrectly valued and incorrectly counted. So when problems arose with inventory during audits, Phar-Mor debited a made up "bucket account", which collected all the fake entries. These accounts were given the name accrued inventory, and were very suspicious, but for some reason were never investigated by auditors.

Phar-Mor also misappropriated assets, over ten million dollars was directed from Phar-Mor into Mr. Monus's private venture, the World Basketball League, which was a failing venture that was losing funding, and therefore Monus used Phar-Mor funds to cover growing World Basketball League expenses.