The Phar-Mor Case

Ashley Paige Hudson May 11, 2014
ACCT525
Week 1 Assignment

The Phar-Mor case relates to a marked accounting fraud and collusion by management officials that finally surfaced in 1992, after several years of falsified inventory records and financial reports. Phar-Mor, Inc. was a private retail company that was growing attention and market share in the mid 1980’s. This chain of discount drugstores grew to 310 stores in in 34 states before investor losses reached $500 million and they declared bankruptcy. In this cover-up scandal management maintained fictitious gross sales and inventory levels that created an illusion of success. The top executives at Phar-Mor that were responsible for this scheme ended up
confessing to financial statement fraud and the company was fined over $1 million. The company’s former president Michael Menus was found guilty on over 100 counts of a federal indictment charges of fraud, embezzlement and tax evasion. The company’s independent audit firm, Coopers & Lybrand LLP, were sued and charged with recklessly issuing an audit opinion. There audits lacked important elements of a random, thorough and reasonable material testing process. There are were numerous gaps in auditing standards and procedures, professional conduct and due diligence. (Williams, 2011).
The Waste Management scandal emerged in 1997and the whistle was blown by the company’s newly hired chief executive officer.
He came in requesting an evaluation of the company’s accounting records and found usual accounting transgressions. This Houston-based public waste management company then faces a historic restatement of earnings from 1992 to 1997 and this led to further investigation of accounting fraud. At this time, this was the largest corporate restatement in history and one of the most conspicuous executive accounting scandals seen by the Securities Exchange Commission (SEC). Management had deliberately inflated earnings to meet target margins and deferred current period expenses such as depreciation expense. There were implications that several of the chief accounting officers were previously employed by Arthur Andersen which poses some questions about this connection and the independence of the audit. Andersen would present the company with “Proposed Adjusting Journal Entries” (PAJEs) needed to correct any overstated earnings and understated expenses, however; management often refused to make the necessary changes. This relationship developed into colluded agreement with Andersen to write off accumulated errors found across the 1990s. Top executives had profited tremendously from this scandal at the expense of the shareholders which led to a $457 million class-action suit and Andersen was fined $7 million by the SEC (Ball,
2009).
In 2002, Enron became one of the most notorious accounting scandals in history.
The criminal justice department and the SEC were conducting their investigations during the same time period as the development of Sarbanes-Oxley Act of 2002 (SOX). In the early 1990s, Enron had become successful for their innovative practices of improve companies financials through structuring Special Purpose Entities (SPE’s). Under these complex transactions, Enron clearly masked their debt liabilities by selling assets between these limited partner shell companies and fabricated profits. It was hardly a coincidence that yet another Houston commodities corporation in connection with Arthur Andersen had misrepresentation and fraudulent reporting. This systematic corporate scheme led shareholders loss of $74 billion and caused employees and investors to lost retirement accounts. Several key management players, along with Andersen, were found guilty of fraud and most of them severed prison time (Willits; Nicholls,
2014).
A common theme in these three cases is a failed integrity of our capitalistic system through corporate malfeasance. These executive-level accounting scandals led regulatory bodies, the investors and the public arena to have some serious concerns about corporate accounting practices and auditing procedures. Public outrage called for something significant to be done to increase investors’ confidence in the transparency of financial reporting. The Sarbanes-Oxley Act in 2002 was an answer from congress aiming to reduce accounting problems that had transpired from these big scandals (Balog, 2012).

The Sarbanes-Oxley Act has created numerous laws to decrease some of the gaps and mitigate future corporate crimes. It is difficult to determine whether SOX could have prevented the Phar-Mor fraud, but it most certainly would have made it more difficult to get away with. The Sarbanes-Oxley Act was a clear response by congress that was developed to enhance financial disclosures, assess internal controls and assign more accountability to management.
Most notably Sections 404, under Title IV of the act, pertains to the assessment of internal controls and require the issuers to publish information in their annual reports concerning the scope and adequacy of internal controls and procedures for financial reporting. Section 409 requires the urgent disclosure of information related to any material change in financial conditions or operations. SOX would have not allowed for the conflicts of interest and self-serving audits that were displayed in all three cases. Both of these section requirements would have been able to hinder some of the fraudulent activity within the Waste Management and Enron scandals. The Public Company Accounting Oversight Board (PCAOB) was established through SOX to oversee the audits of public accounting firms that preform the external audits. This oversight organization development would have greatly reduced the collusion and recklessness presented in all three cases. Other important SOX developments include the protection of whistleblowers, risk guidance, expansion of the SEC’s supervision powers and increased criminal fraud penalties. The Sarbanes-Oxley could have prevented some or all of these sandals if these companies would have complied with the accountability policies, ethical practices, improvement in oversight, development of audit committees and developed security policies required with the implement of the Sarbanes-Oxley Act (Balog, 2012).

References:

Williams, S. (2011). The case of Phar-Mor Inc. CPA Journal, 81(9), 58–63. Available from: Business Source Complete, Ipswich, MA. AN – 66865299

Ball, R. (2009). Market and Political/Regulatory Perspectives on the Recent Accounting Scandals. Journal of Accounting Research, 47 (2), 277-323. Available from: Business Source Complete, Ipswich, MA. AN – 36867648

Balog, I. (2012). Ethics evolution in the era of Sarbanes-Oxley. Pennsylvania CPA Journal, 82(4), 1–2. Available from: Business Source Complete, Ipswich, MA. AN – 69726504

Willits, S., & Nicholls, Curtis. (2014). Is the Sarbanes-Oxley Act Working? CPA Journal, 84(4), 38-43. Available from: Business Source Complete, Ipswich, MA. AN - 95569700