Chapter 7 Internet Cases

Internet Case 7.1

The following exhibit summarizes three well-known fraud cases.

Exhibit: Some noted cases of “cooking the books”

Case 1—MiniScribe Corp.In the mid-1980s, much of the personal-computer industry was slumping. MiniScribe Corp., a disk-drive maker headquartered in Colorado, was no exception. In 1985, a venture-capital firm pumped $20 million into MiniScribe and installed a new CEO, Q. T. Wiles, a man with a proven track record of reviving ailing companies. Indeed, MiniScribe did revive, reporting phenomenal increases in sales and earnings over 13 successive quarters, and quintupling its stock price in just two years. However, in the fall of 1988 its suppliers, Wall Street analysts, and the company’s board of directors began to sense trouble. When 1988 results showed a fourth quarter loss of $14.6 million and a decline in net income of $5.3 million from 1987, Wiles resigned and a committee of outside directors was created to conduct an internal investigation. The six-month investigation concluded that senior management apparently “perpetrated a massive fraud on the company, its directors, its outside auditors, and the investing public.” Evidently, Wiles set unrealistic sales targets and had an abusive management style. Over time, managers were evaluated (and bonuses awarded) solely on their ability to meet sales and income objectives. These factors encouraged managers to falsify sales (by shipping disk drives that customers had not ordered and recording sales prior to passing title to the goods), understate loss reserves (for sales returns and bad debts), include defective disk drives in inventory, and even to break into locked trunks of auditors’ workpapers to alter/inflate inventory values.The outcome: MiniScribe filed for bankruptcy court protection in January 1990, and began liquidating the company in April 1991. Several lawsuits ensued, brought by former bondholders and investors. In one of those cases, a Texas jury awarded $530 million in punitive damages and $20 million in actual damages to former bondholders in their suit against Mr. Wiles, MiniScribe’s auditing firm (Coopers & Lybrand), and its investment banker. The claim against Coopers & Lybrand reportedly was later settled for $45 to $50 million.

Case 2—ZZZZ Best Carpet CleaningIn 1982, at age 16, Barry Minkow started the ZZZZ Best Carpet Cleaning business in his basement. Four years later, the company’s assets totaled a reported $240 million. One year after that, Barry was in prison, serving a 25-year sentence for perpetrating a $100 million fraud on the firm’s investors. So bold and audacious was this fraud that it spawned a book, Faking It in America. ZZZZ Best, Barry’s legitimate carpet cleaning business, never made a profit and borrowed constantly. To support the loan requests, Barry created a fictitious business, purportedly engaged in restoring buildings damaged by fire and flood. The company also went public; and in short order, its stock price rose from 5 cents to $18 per share. Ultimately, the restoration “business” accounted for 80% of ZZZZ Best’s reported earnings; the only catch is that its revenues came from recorded receivables that were entirely fictitious! Barry and his two accomplices pulled off the fraud primarily by concocting fake sales invoices and customer remittance checks. The phony documents were skillfully produced using photocopying equipment and were accepted by the company’s auditors as evidence that sales/receivables transactions actually had occurred. The scam also involved payments to fictitious vendors and kiting checks back and forth among three banks. The fraud was uncovered in a curious way. Barry’s greed also prompted him to overbill carpet cleaning customers on their credit cards; he made refunds only if a customer complained. When a Los Angeles housewife did not receive a prompt refund, she went to the local newspaper with her story. The newspaper published an exposé, and the rest is history. Incidentally, the $240 million in ZZZZ Best “assets” were sold for less than $50,000!

Case 3—Lesley Fay Cos.In January 1993, Lesley Fay Cos., a New York apparel maker, disclosed that its corporate

controller, Donald Kenia, and other key employees had doctored the company books to inflate profits. The

company’s independent directors initiated an internal investigation. In April 1993, Lesley Fay sought Chapter 11 bankruptcy-court protection from its creditors. When the fraud investigation was completed in September 1993, the company restated its pre-tax accounting earnings for 1990-1992 to reverse some $81 million in accounting irregularities uncovered in the investigation. One person who read the investigation report stated that “there wasn’t an entry on the cost side” of the company’s books during 1991/1992 that wasn’t subject to some kind of manipulation. Apparently, the fraudulent accounting involved overstating inventory, understating cost of goods sold, understating or omitting markdown allowances to retailers, failing to record supplier invoices as costs, and inflating revenues and profits by recording such entries for several days after a quarter had ended. The fraud was disclosed when Mr. Kenia admitted to it during the year-end audit for 1992. What motivated Kenia and his associates is unclear; but, at Lesley Fay, as at MiniScribe, top officers’ compensation was tied to each year’s profit performance.

Sources:Andy Zipser, “Cooking the Books: How Pressure to Raise Sales Led MiniScribe to Falsify Numbers,” The Wall Street Journal (September 11, 1989): 1, 8; Andy Zipser, “MiniScribe’s Investigators Determine That ‘Massive Fraud’ Was Perpetrated,” The Wall Street Journal (September 12, 1989): 1; Christi Harlan, “Jury Awards $550 Million in Damages to Ex-Bondholders in MiniScribe Case,” The Wall Street Journal (February 5, 1992): A1; and Christi Harlan, “Coopers & Lybrand Agrees to Payment of $95 Million in the MiniScribe Case,” The Wall Street Journal (October 30, 1992): A1.Videotape, Cooking the Books: What Every Accountant Should Know About Fraud (Austin, TX: National Association of Certified Fraud Examiners, 1991).Teri Agins, “Report Is Said to Show Pervasive Fraud at Leslie Fay,” The Wall Street Journal (September 27, 1993): B4; and Teri Agins, “Leslie Fay Cos.’ Profits Restated for Past 3 Years,” The Wall Street Journal (September 30, 1993): A3, A4.

Required:

Listed below are 11 specific fraud examples taken from those cases. For each fraud example, indicate which information process control goal was initially violated—validity, completeness, or accuracy. Some examples might involve more than one violation. For each example, include in your answer a brief explanation of how that particular fraud relates to the control goal(s) you selected. The explanations supporting your conclusions are as important as the conclusions themselves.

NOTE: When we say initially, we mean what control goal failure led to this example, not what is the present condition. For example, stored data might contain information that is invalid, but it might have been an inaccurate or incomplete input that initially caused the stored data to be invalid.

Fraud Examples1. MiniScribe: Sales were inflated by shipping disk drives that were not ordered by customers.2. MiniScribe: Sales of goods were recorded prior to the passing of title.3. MiniScribe: Some sales returns were never recorded.4. MiniScribe: Defective disk drives were included in inventory.5. MiniScribe: Auditors’ workpapers were altered to inflate inventory values.6. ZZZZ Best Carpet Cleaning: Phony receivable/sales documents were created to overstate sales.7. ZZZZ Best Carpet Cleaning: Payments were recorded to fictitious vendors.8. Lesley Fay: Inventory was overstated, thereby understating cost of goods sold.9. Lesley Fay: Markdown allowances to retailers were understated or omitted.10. Lesley Fay: Suppliers’ invoices were not recorded.11. Lesley Fay: Revenues and profits were inflated by recording sales entries for several days after a quarter had ended.