R E S P O N S I B I L I T I E S & L E A D E R S H I Pf r a u d

The Case of Phar-Mor Inc.Could SOX Have Prevented the Fraud?

By S. Lansing Williams

The Sarbanes-Oxley Act of 2002 (SOX) was an effort toincrease the confidence of investors after a number ofhigh-profile corporate failures due to malfeasance on thepart of corporate officers and poor internal controls. Afterthe failures of Enron. WorldCom, and other large companies—which resulted in huge losses to investors—Senator Paul Sarbanes(D-Md.) and Representative Michael Oxley (R-Ohio) coau-thored a bill that resulted in public companies improving the accu-racy of their financial reports. The law contains 11 major sec-tions, including (Title I) Public Company Accounting OversightBoard, (Title II) Auditor Independence, (Title III) Corporate

Responsibility. (Title FV) Enhanced Financial Disclosures. (TitleV) Analy.st Conflicts of Interest, and (Title VI) CommissionResources and Authority. Titles VII, VIII, IX, X, and XI dealwith sUidies and reports, corporate and criminal fraud account-ability and white-collar crime penalties, corporate tax retums, andcorporate fraud and accountability.

While SOX came about as a direct result of the Enron melt-down in 2001, followed by the WoridCom bankruptcy in 2002,these two companies were not the only failures that led to itspassage. The 1992 bankruptcy of Phar-Mor Inc. cost itsinvestors $500 million. Although the bankruptcy occurred 10 years

58 SEPTEMBER 2011 / THE CPA JOURNAL

prior to the enactment of SOX, this articleattempts, with hindsight, to determine ifthe bankniptcy might have been prevent-ed if the provisions of SOX bad been ineffect and applied to Phar-Mor Inc.

BackgroundPhar-Mor Inc., a deep discount drugstore

chain, came into existence in 1982 as anaffiliate of family-owned grocery chainGiant Eagle, which also owned a distribu-tion company. Tánico Distributors Co. Thedeep discount concept consisted of using"pt)wer buying," or purchasing the largestpossible amount of product at tbe bestterms, then selling at discounts of up to25%-40% off retail prices.

The then vice-president of Tamco,Michael J. "Mickey" Monus. was namedpresident of the new company. Phar-Morhad grown to 70 stores by 1987 and sawfurther expansion, reaching 200 stores in1990; by 1992, it reachetl 310 outlets with25,000 employees in 34 states (www.I undinguni verse.com/company-histories/PhaiMor-Inc-Coinpany-History.html).

The first indication of financial prob-lems came to light in 1988, when inves-tigation of lower-than-expected profit mar-gins revealed that Phar-Mor was beingbilled for inventory it had not receivedIrom its sister company, Tamco, a prima-ry supplier. Because Phar-Mor did notmaintain receiving records of its purchas-es from Tamco, it was impossible to sub-stantiate products received. At the sametime, Tamco's records were equallypcx)r. A formal analysis of the shortage bya Phar-Mor accountant indicated that tbeinventory shortage/overbilling was around$4 million; bowever, the two subsidiariesof Giant Eagle settled on $7 million, giv-ing Phar-Mor a $2 million profit for theyear. It is interesting to note that the set-tlement resulted in a nearly identical grossmargin as the prior year (David M. Cottrelland Steven M. Glover, "Finding AuditorsLiable for Fraud," The CPA Journal,July 1997).

While not on the radar for several years,another source of problems for Phar-Morbegan with the formation of the WorldBasketball League (WBL) in 1987. Monusowned at least 60% of each of the 10 teiuiisand was respwasible for that portion of eachteam's losses, which a fellow investor inthe WBL told a Cleveland Plain Dealer

reponer averaged $13,000 per game, or$7,800 for Monus's share (www.fundinguniverse.com). It was estimated that Monusembezzled about $15 million from Phar-Mor in support of WBL activit ies(Gabriella Stern, "One Messy Store:Chicanery at Pbar-Mor Ran Deep, CloseLook at Discounter Shows," Wall StreetJournal, January 20, 1994).

By 1989 Phar-Mor's losses were mount-ing. In addition to funding of WBL activi-ties, Monus had diverted over $2(X),000 forimprovements to his personal residence andmeals at a country club (Stem 1994), andprofit maiçias continued to deteriorate. Whenthe chief financial officer, Patrick Finn, firstreponed losses to Monus, the presidentcrossed off the loss and wrote in a profit (Jim

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Gilmore, Paul Judge, and Paul Solman,"How to Steal $5(X) Million," Frontline,November 8, 1994). The losses were chargedto what the senior staff involved in the fraudcalled a "bucket account," in which cover-up activities were recorded, and which wasreallocated to the inventory of the existing.stores. It was known that the auditor. Coopers& Lybrand, did not audit accounts with azero balance; thus, the activity in the buck-et accounts that was reallocated was notreviewed (Steven M. Mintz and Roselyn E.Morris, Ethical Obligations and DecisionMaking in Accotmting, McGraw-Hill/Irwin,2008, pp. 132-133).

It was also known that Coopers did notobserve inventory in all stores, but insteadonly used four stores for testing, some timebefore the June 30 year-end, and rolled theinventory value forward from the testcounts (Mintz and Morris 2008).Furthermore, Coopers told Phar-Mor inadvance which stores would be tested,allowing Phar-Mor to ensure that a good"representative count" was taken at thosestores, which then allowed the allocationof the bucket account balances as phantominventory to the other, uncounted stores(Mintz and Morris 2008). Thus, allocatinga loss of $ 12 million, for example, to 125

THE FATE OF PHAR-MOR

The financial cover-up began to unravel when a travel agent was paid$80,000 for a delinquent World Basketball League (WBL) travel expenseon a Phar-Mor check. Curious about the source, she asked a friend, anoutside Phar-Mor shareholder, who asked Phar-Mor's outside counsel, the broth-

er of Chief Executive Officer David Shapira, who asked questions.

With the disclosure of what became a $500 million accounting fraud, Phar-Mor

filed for Chapter 11 bankruptcy, closed 167 of 310 stores, and laid off 15,000

employees (vvvvw.fundinguniverse.com).

Phar-Mor President Michael Monus was indicted on 129 counts of fraud by a feder-

al grand jury in 1993. A hung jury resulted in a mistrial, after which a second grand

jury brought more than 100 new charges against him. He was found guilty of embez-

zling more than $10 million and sentenced to 19 years, seven months in prison.

Vice President of Finance Jeffrey Walley cooperated with authorities, pleaded

guilty to four counts of fraud, and was sentenced to six months house arrest.

Chief Financial Officer Patrick Finn was sentenced to 33 months in federal prison

and fined $7,000 after pleading guilty and cooperating with authorities.

Auditors Coopers & Lybrand were sued $1 billion for fraud, settling for an undis-closed amount

Sources:

Mark S. Beasley, Frank A. Buckless, Steven M. Glover, and Douglas Prawitt,

"Phar-Mor, Inc.: Accounting Fraud, Litigation, and Auditor Liability," Auditing

Cases: An Interactive Learning Approach, Prentice Hall PTR, 2006.

Zabihollah Rezaee and Richard Riley, Financial Statement Fraud, Prevention and

Detection, \N\\e\/, 2010, pp. 121-125.

Gabriella Stern, "One Messy Store: Chicanery at Phar-Mor Ran Deep, Close Look

at Discounter Shows," Wall Street Journal, January 20,1994.

www.fundinguniverse.com/company-histories/PharMor-lnc-Company-History.html

"Report Sheds Light on Evolution of Phar-Mor Scandal" Chain Drug Review,

February 14,1994.

stores resulted in an inventory increase of$96,000 per store, which was explainedto Coopers as building the inventory up forthe July 4 holiday, which had a heavy salesdemand. The drop-off of inventory rightafter the June 30 year-end was alsoexplained by the high volume of July 4sales (Cottrell and Glover 1997).

By the time Phar-Mor opened its 310thstore in 1992, the fraudulent activities beingcovered up included—• fictitious inventory on the books tocover up operating losses;• Monus's personal expenses chargedto the bucket accounts; and• World Basketball League expensespaid by Phar-Mor, also charged to thebucket accounts.

The cover-up of all this fraudulent activ-ity required a great deal of coordinationamong the senior staff. The group that audi-tors referred to as the "fraud team" con-sisted of—• Monus, president;• Patrick Finn, chief financial officer, aformer Ccxjpers & Lybrand auditor;• Jeffrey Walley, vice president of finance,a former Coopers & Lybrand auditor;• Stanley Cherelstein, controller, a for-mer Coopers & Lybrand auditor; and• John Anderson, accounting manager,hired right out of Youngstown StateUniversity.

In order to cany out a fraud involvingfictitious inventory, the embezzlement offunds covering WBL expenses, and per-sonal embezzlement, there had to be a greatdeal of understanding of audit proceduresand how to circumvent them. With threeof the four key financial executives havingbeen previously employed by the audi-tors, this was accomplished. "The perpe-trators lied, forged dcx;uments, and care-fully 'scrubbed' everything the auditorssaw to hide any indications of malfeasance"(Cottrell and Glover 1997). They knew thatCoopers traditionally did not review zero-balance accounts, so by parking erro-neous amounts in the bucket accounts, thenallocating the balances of those accountsto inventory at year end, they were suc-cessful. In fact, Finn, the CFO, stated in avideo clip of a deposition that if Coopershad asked for the backup to any one of thefraudulent joumal entries, the firaud "wouldhave been all over." Finn also testified thatif Coopers had asked for the closing jour-

60 SEPTEMBER 2011 /THE CPA JOURNAL

nal entries, he would have removed theentries that emptied the fraud bucket beforegiving them to the auditors (Cottell andGlover 1997).

Potential Effects of SOXThere are five specific sections of SOX

that address aspects of the Iraudulent activ-ities of Phar-Mor management. A reviewof these sections and how they couldhave impacted Phar-Mor follows.

Title II, section 203, "Audit PartnerRotation." This provides that a registeredpublic accounting firm may not provide anaudit if the lead audit partner or the review-ing audit partner has performed audit ser-vices for that issuer in each of the five pre-vious fiscal years of the issuer. Referencesto the audit partner only relate to hisdefen.se of audit procedures and allegationsthat he had previously been criticized forexceeding audit budgets and was underpressure to carefully control audit costs(Cottrell and Glover 1997).

If one assumes that the audit partner wason the job at the initiation of the fraud in1989, it is likely that he would have beenrotated off and a new partner would havetaken over during the four-year period inwhich the fraud was carried out. The ques-tion would then become: Would the newaudil partner u.se the same procedures ashis predecessor, and be under the samepressures as the partner?

Title II, section 206, "Conflicts ofInterest." This section makes it unlawful"for a regi.stered public accounting firm toperfomi for an issuer any audit service ...if a chief executive officer, controller, chieffinancial officer, chief accounting officer... was employed by that registered inde-pendent public accounting fimi and par-ticipated in any capacity in the audit of thatissuer during the 1-year pericxl precedingthe date of the initiation of the audit."

As .stated above, three of the members ofthe fraud team at Phar-Mor—Walley, Finn,and ChereLstein—were former Coopers &Lybrand auditors. Whue the author has notbeen able to determine the hire dateof Walley, in Frontline's "How to Steal$500 Million," he leamed that Finn was CFOfrom 1988 to 1992, and that when thefraud was initiated (1989), he had beenwith the company for several years. One canthus conclude that because he was hiredmore than a year prior to the audit, he was

probably not subject to the one-year mle.Regardless of the timing of his hire, he knewand admitted that what he did to cover upthe misstatement was illegal.

Cherelstein, the controller, is quoted in"How to Steal $500 Million" as saying thathe joined Phar-Mor in 1990 and did notbecome aware of the fraud until he becamecontroller and Accounting Manager John

Anderson showed him a subledger sched-ule showing that the June 1991 financialstatements were misstated by approxi-mately $150 million.

Cherelstein could not have been hireddirectly from Coopers without violating theone-year mle. Cherelstein stated that whenhe was told of the subledger, he did not reportthe fraud due to concems for his personal

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health (Gilmore, Judge, and Solman). It takesa great deal of courage to become a whistle-blower, which makes one wonder if some-one hired without violation of the one-yearrule would have reported the situation.

Title III, section 302, "CorporateResponsibility for Financial Reports."This section states that the principal exec-utive officers and the principal financialofficers are required to certify in each annu-al or quarterly report that—

( 1 ) the signing officer has reviewed thereport;(2) based on the officer's knowledge, thereport does not contain any untrue state-ment of a material fact, or omit to statea material fact necessary in order tomake the statements made, in light ofthe circumstances under which suchstatements were made, not misleading;(3) based on such officer's knowledge,the financial statements, and other finan-cial information included in the report,fairly present in all material respectsthe financial condition and results ofoperations of the issuer as of, and for,the periods presented in the report;(4) the signing officers—(A) are responsible for establishing andmaintaining intemal controls ...(5) the signing officers have disclosed tothe issuer's auditors and the audit com-mittee of the board of directors (or per-sons fulfilling the equivalent function)—(A) all .significant deficiencies in thedesign or operation of intemal controlswhich could adversely affect the issue'sability to record, process, summarize,and report financial data and have identi-fied for the issuer's auditors any materialweaknesses in intemal controls; and(B) any fraud, whether or not material,that involves management or otheremployees who have a significant rolein the issuer's intemal controls.This section would have required the prin-

cipal executive officer, Monus, and the prin-cipal financial officer, Finn, to state thatthe financial statements of Phar-Mor did notcontain any untrue statements of a materi-al fact and that the financial statementsfairly presented in all material respectedthe condition and results of operations.

The facts show that both individualswere deeply involved in the misstatementof Phar-Mor's financial health. It would behighly doubtful that they would have made

such a statement unless compelled to doso under the rules in SOX.

Part 4 of Title III, section 302 requiresthe signing officers to take responsibilityfor establishing and maintaining intemalcontrols. In reality, the signing officerswere responsible for ignoring intemal con-trol procedures, if any even existed.

Part 5 requires the signing officers to dis-close to their auditors and board of direc-tors' audit committee all significant defi-ciencies in intemal controls and further dis-close any fraud, material or not, thatinvolves management. It seems clearfrom the actions of Monus and Finn thatthey would likely have felt little, if any,discomfort in perjuring themselves by com-plying falsely with the Title HI, section 302requirements.

Title IV, section 404, "ManagementAssessment of Internal Controls."Subsection (a) of this section requires man-agement to include in annual reports an inter-nal control report which shall—

(1) state the responsibility of manage-ment for establishing and maintaining anadequate intemal control stmcture andprocedures for financial reporting; and(2) contain an assessment, as of the endof the most recent fiscal year of theissuer, of the effectiveness of the inter-nal control structure and procedures ofthe issuer for financial reporting.It would probably be safe to say that

since the management responsible for mak-ing, assessing, and asserting the establish-ment and maintenance of adequate inter-nal control structure and procedures wasthe same management perpetuating thefraud, such assessments would likely stillhave been made without hesitation.

Additionally, subsection (b) requiresthat—

With respect to the intemal control assess-ment required by subsection (a), each reg-istered public accounting firm that pre-pares or issues the audit report for theissuer shall attest to, and report on, theassessment made by the management ofthe issuer.Again, given that Finn testified that he

would have given fraudulent joumal entriesto the auditors (Cottell and Glover), hewould have provided Coopers with suffi-cient detailed intemal control documenta-tion that would have sufficed for a posi-tive assessment.

Title IV, section 406, "Code of Ethicsfor Senior Financial Officers. " This sec-tion de.scribes requirements for a code ofethics for senior financial officers, stating:

The Commission shall issue rules torequire each issuer, together with peri-odic reports required ... to disclosewhether or not, and if not, the reasontherefor, such issuer has adopted acode of ethics for senior financial offi-cers, applicable to its principal financialofficer and comptroller or principalaccounting officer, or person perform-ing similar functions. ...Definition.—In this section, the term"code of ethics" means such standardsas are reasonably necessary to pro-mote— ...

(2) full, fair, accurate, timely, and under-standable disclosure in the periodicreports required to be filed by the issuer.The senior management of Phar-Mor

willingly and knowingly perpetuated amassive fraud and spent considerable ener-gy and resources maintaining the cover-up.There is no reason to believe that a codeof ethics would have been adhered to.

Would SOX Have Helped?Had the Phar-Mor fraud been perpe-

trated in a post-SOX environment, theCoopers & Lybrand partner-in-chargewould likely have been replaced by appli-cation of SOX regulations because hewould have been responsible for the auditfor more than five years by 1991 and there-fore subject to audit partner rotation.There's a question as to whether his suc-cessor would have changed audit proce-dures to any great extent, and perhaps justas importantly, would have found himselfunder the same cost restraints.

The senior management of Phar-Mordeliberately concealed major losses of thecompany. Additionally, corporate fundswere used to pay for both personalexpenses of the president and an unrelat-ed organization. The president, vicepresident of finance, CFO, controller, andaccounting manager were all involved inthe cover-up. Three members of this fraudteam had worked for the auditor and werefamiliar with the audit steps that wouldbe taken, thus helping them cover up theiractivities.

If SOX had been enacted in the mid-1980s, it would have prevented the hire

62 SEPTEMBER 2011 / THE CPA JOURNAL

of Phar-Mor Controller Cherelstein. Walleyand Finn, who were hired earlier in thecompany's existence, were the enablers,using their knowledge of Coopers auditprocedures.

Because the senior management of Phar-Mor were responsible for perpetuating thefraud, it could be assumed that they wouldhave had no compunction in assertingthat all intemal control structures and pro-cedures were effective. Inasmuch as thefraud was dependent upon managementknowledge of audit procedures used, itwould probably be safe to assume that anymanagement as.sessment of intemal con-trols would have ignored areas that wouldhave uncovered the fraud.

It can be argued that the auditor wasnegligent in the audit of Phar-Mor becauseit did not take proper action to ensure thatdocumentation given to them was accurateand allowed procedures that enabled thecover-up, such as inventory observationsweeks in advance of the audit date, at onlyfour out of 300 stores. This is substantiat-ed by the finding of negligence on the partof Coopers.

Heng Hsieu Lin and Frederick H. Wuin "Limitations of Section 404 of theSarbanes-Oxley Act" (The CPA Joumal,March 2006) correctly point out that"Reliable financial reports rely to a cer-tain extent on effective intemal controls,but effective intemal contn^ls rely to a largeextent on a reliable management systemcoupled with strong corporate govemance."In a situation like Phar-Mor, the manage-ment .system was neither reliable, nor didit constitute strong corporate govemance.Consequently, had SOX been enacted priorto 1988 when the company first began toencounter financial problems. Title III, sec-tion 302 may not have had much impacton the misdeeds of management, render-ing it worthless. Furthermore, it wouldprobably be safe to say that Title IV, .sec-tion 406, establishing a code of ethics for.senior financial officers, would have beenignored.

Section 207 did call for a study by thecomptroller general of the United States todetermine the feasibility of a mandatory rota-tion period for auditors. This study was con-ducted by the U.S. General AccountingOffice (GAO), now the GovernmentAccountability Office. This study, submittedto Congress in November 2(X)3, concluded

that mandatory rotation would be moreharmful than beneficial in improving auditreliability due to "the additional financialcosts and the loss of institutional knowl-edge of the previous auditor of record," anopinion shared by the AICPA and individ-ual members of the audit profession (BarbaraArel, Richard Brody, and Kurt Pany, "AuditFirm Rotation and Audit Quality," The CPAJourrutl, January 2005).

In retrospect, it would also be easy toargue that had a mandatory rotation of auditfirms been in place prior to 1985, the Phar-Mor hankruptcy could well have beenavoided. Much of the reason for the suc-cess of the fraud team was due to theknowledge the individuals had of the auditpractices of Coopers. If a new audit firmhad taken over the audit, managementwould have had to deal with new proce-dures, and the new firm may not haveignored transactions within zero-balanceaccounts.

It would seem that the Phar-Mor Inc.bankruptcy was what could be considetedthe perfect storm of corporate managementmalfeasance. It was the senior manage-ment—the individuals responsible for per-sonal and inappropriate use of corporateassets, the individuals who refused toacknowledge operating losses, tho.se respon-sible for development and implementationof intemal controls, tho.se responsible foraccurate financial reporting, iuid tho.se attest-ing to their auditors and investors—whowere responsible for the fraud. This caseappears to point out that laws designed toprotect the public, which may be extremelycostly to implement, may not always re.sultin the desired outcome. Q

S. Lansing Williams, CPA, MBA, is anassistant professor of business managementat Washington College, Chestertown, Md.

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