AC465-4:Analyze financial statement fraud schemes using red flags and targeted risk assessment

GEL-4.03:Understand patterns of human behavior based upon real world observation

Read the following fraud case study materials in Chapter 7 of your text:

• "That Way Lies Madness" attached below
• "Hiding Your Dirty Laundry in the Notes" attached below

In your analysis of this case study, please address the following:

Analyze the fraud scheme in terms of the Fraud Triangle, and include an example of incentive/pressure, opportunity, and rationalization from the case that you found in your analysis.

What were the types of financial statement fraud committed by Crazy Eddie's retail business?

What red flags were present indicating that each type of fraud may be occurring?

Explain how the risk factors you found increase fraud risk. For each fraud risk factor, suggest an internal control that will minimize the risk.

Assignment Submission Requirements

• Viewpoint and purpose should be clearly established and sustained by providing specific examples to support your assertions.
• Use correct grammar, punctuation, and spelling.
• Writing should be well ordered, logical, and unified, as well as original and insightful.
  • Explain why the person's behavior pressured them to commit fraud.
  • Where did they find the opportunity to commit fraud?
  • How did they justify (rationalize) their behavior in committing the fraud?

Case Study: That Way Lies Madness "I'm Crazy Eddie!" a goggle-eyed man screams from the television set, pulling at his face with his hands. "My prices are insane!" Eddie Antar got into the electronics business in 1969, with a modest store called Sight and Sound. Less than twenty years later, he had become Crazy Eddie, a millionaire many times over and an international fugitive from justice. He was shrewd, daring, and self-serving; he was obsessive and greedy. But he was hardly insane. A U.S. Attorney said, "He was not Crazy Eddie. He was Crooked Eddie."

The man on the screen wasn't Eddie at all. The face so dutifully watched throughout New Jersey, New York, and Connecticutthat was an actor, hired to a humiliating but effective characterization. The real Eddie Antar was not the kind of man to yell and rend his clothes. He was busy making money, and he was making a lot of it illegally. By the time his electronics empire folded, Antar and members of his family had distinguished themselves with a fraud of massive proportions, reaping more than $120 million. A senior official at the Securities and Exchange Commission (SEC) quipped, "This may not be the biggest stock fraud of all time, but for outrageousness it is going to be very hard to beat." The SEC was joined by the FBI, the Postal Inspection Service, and the U.S. Attorney in tracking Eddie down. They were able to show a multipronged fraud in which Antar

Listed smuggled money from foreign banks as sales Made false entries to accounts payable Overstated Crazy Eddie, Inc.'s inventory by breaking into and altering audit records Took credit for merchandise as "returned" while also counting it as inventory "Shared inventory" from one store to boost other stores' audit counts Arranged for vendors to ship merchandise and defer the billing, while also claiming discounts and advertising credits Sold large lots of merchandise to wholesalers, and then spread the money to individual stores as retail receipts It was a long list and a profitable one for Eddie Antar and the inner circle of his family. The seven action items were designed to make Crazy Eddie's look like it was booming. In fact, it was. It was the single biggest retailer of stereos and televisions in the New York metropolitan area, with a dominant and seemingly impregnable share of the market. That wasn't enough for Eddie. He took the chain public, and then he made some real money. Shares that initially sold at $8 each would later peak at $80, thanks to the Antar team's masterful tweaking of company accounts.

Inflating Crazy Eddie's stock price wasn't the first scam that Antar had pulled. In the early days, as Sight and Sound grew into Crazy Eddie's and spawned multiple stores, Eddie was actually underreporting his earnings. Eddie's cousin, Sam Antar, remembered learning how the company did business by watching his father during the early days. "The store managers would drop off cash to the house after they closed at ten o'clock, and my father would make one bundle for deposit into the company account, and several bundles for others in the family," Sam Antar said. "Then he would drive over to their houses and drop off their bundles at two in the morning." For every few dollars to the company, the Antars took a dollar for themselves. The cash was secreted away into bank accounts at Bank Leumi of Israel. Eddie smuggled some of the money out of the country himself, by strapping stacks of large bills across his body. The Antars sneaked away with at least $7 million over several years. Skimming the cash meant tax-free profits and one gargantuan nest egg waiting across the sea.

But entering the stock market was another story. Eddie anticipated the initial public offering (IPO) of shares by quietly easing money from Bank Leumi back into the operation. The company really was growing, but injecting the pilfered funds as sales receipts made the growth look even more impressive. Now this looks sweet: skim the money and beat the tax man, then draw out funds as you need them to boost sales figureskeeps the ship running smoothly.

But Paul Hayes, a special agent who worked the case with the FBI, pointed out Crazy Eddie's problem. "After building up the books, they set a pattern of double-digit growth, which they had to sustain. When they couldn't sustain it, they started looking for new ways to fake it," Hayes said.

Eddie, his brothers, his cousins, and several family loyalists all owned large chunks of company stock. No matter what actually happened at the stores, they wanted that stock to rise. So the seven-point plan was born. There was the skimmed money waiting overseas, being brought back and disguised as sales. But there were limits to how much cash the family had available and could get back into the country, so they turned to other methods of inflating the company's financials. In a daring part of the expanded scam, Antar's people broke into auditors' records and boosted the inventory numbers. With the stroke of a pen, 13 microcassette players became 1,327.

Better than that, the Antars figured out how to make their inventory do double work. Debit memos were drawn up showing substantial lots of stereos or VCRs as "returned to manufacturer." Crazy Eddie's was given a credit for the wholesale cost due back from the manufacturer. But the machines were kept at the warehouse to be counted as inventory. In another variation of the inventory scam, at least one wholesaler agreed to ship Crazy Eddie's truckloads of merchandise, deferring the billing to a later date. That way Crazy Eddie's had plenty of inventory volume plus the return credits listed on the account book. And what if auditors got too close and began asking questions? Executives would throw the records away. A "lost" report was a safe report.

Eddie Antar didn't stop at simple bookkeeping and warehouse games; he "shared inventory" among his nearly forty stores. After auditors had finished counting a warehouse's holdings and had gone for the day, workers tossed the merchandise into trucks. The inventory was hauled overnight to an early morning load-in at another store. When the auditors arrived at that store, they found a full stockroom waiting to be counted. Again, this ruse carried a double payoff. The audit looked strong because of the inventory items counted multiple times. And the bookkeeping looked good because only one set of invoices was entered as payable to Eddie's creditors. Also, the game could be repeated for as long as the audit route demanded.

Eddie's trump card was the supplier network. He had considerable leverage with area wholesalers because Crazy Eddie's was the biggest and baddest retail outlet in the region. Agent Paul Hayes remembers Eddie as "an aggressive businessman: He'd put the squeeze on a manufacturer and tell them he wasn't going to carry their product. Now, he was king of what is possibly the biggest consolidated retail market in the nation. Japanese manufacturers were fighting each other to get into this market. So when Eddie made a threat, it was a threat with serious potential impact."

Suppliers gave Crazy Eddie's buyers extraordinary discounts and advertising rebates. If they didn't, the Antars had another method: they made up the discount. For example, Crazy Eddie's might owe George-Electronics $1 million; by claiming $500,000 in discounts or ad credits, the bill was cut in half. Sometimes there was a real discount, sometimes there wasn't. (It wasn't easy, after Eddie's fall, to tell what a shrewd business deal was and what was fraud. "They had legitimate discounts in there," says Hayes, "along with the criminal acts. That's why it was tough to know what was smoke and what was fire.")

Eddie had yet another arrangement with manufacturers. For certain high-demand items, high-end stereo systems, for example, a producing company would agree to sell only to Crazy Eddie's. Eddie placed an order big enough for what he needed, and then added a little more. The excess he sold to a distributor who had already agreed to send the merchandise outside Crazy Eddie's tri-state area. And then the really good part: By arrangement, the distributor paid for the merchandise in a series of small checks$100,000 worth of portable stereos would be paid off with ten checks of $10,000 each. Eddie sprinkled this money into his stores as register sales. He knew that Wall Street analysts used comparable store sales as a bedrock indicator. New stores are compared with old stores, and any store open more than a year is compared with its performance during the previous term. The goal is to outperform the previous year. So the $10,000 injections made Eddie's "comps" look fantastic.

As the doctored numbers circulated in enthusiastic financial circles, CRZY stock doubled its earnings per share during its first year on the stock exchange. The stock split two-for-one in both of its first two fiscal terms as a publicly traded company. As chairman and chief executive, Eddie Antar used his newsletter to trumpet soaring profits, declining overhead costs, and a new 210,000-square-foot corporate headquarters. Plans were underway for a home-shopping arm of the business. Besides the electronics stores, there was now a subsidiary, Crazy Eddie Record and Tape Asylums, in the Antar fold. At its peak, the operation included 43 stores and reported sales of $350 million a year. This was a long way from the Sight and Sound storefront operation where it all began.

It was almost eerie how deliberately the Antar conspirators manipulated investors, and how directly their crimes impacted brokers' assessments. At the end of Crazy Eddie's second public year, a major brokerage firm issued a gushing recommendation to "buy." The recommendation was explicitly "based on 35 percent EPS [earnings per share] growth" and "comparable store sales growth in the low double-digit range." These double-digit expansions were from the "comps" that Eddie and his gang had cooked up with wholesalers' money and by juggling inventories. CRZY stock, the report predicted, would double and then some during the next year. As if following an Antar script, the brokers declared, "Crazy Eddie is the only retailer in our universe that has not reported a disappointing quarter in the last two years. We do not believe that is an accident... . We believe Crazy Eddie is becoming the kind of company that can continually produce above-average comparable store sales growth." But what the analysts failed to do was ask a very basic but very pertinent question: what magic did Crazy Eddie's possess that was not available to its competitors?

The brokers could not have known what Herculean efforts were needed to yield just that impression. The report praised Eddie's management skills. "Mr. Antar has created a strong organization beneath him that is close-knit and directed... . Despite the boisterous (less charitable commentators would say obnoxious) quality of the commercials, Crazy Eddie management is quite conservative."

Well, yes, in a manner of speaking. They were certainly holding tightly to the money as it flowed through the market. According to federal indictments, the conspiracy inflated the company's value during the first year by about $2 million. By selling off shares of the overvalued stock, the partners pocketed over $28.2 million. The next year they illegally boosted income by $5.5 million and retail sales by $2.2 million. This time the group cashed in their stock for a cool $42.2 million windfall. In the last year before the boom went bust, Eddie and his partners inflated income by $37.5 million and retail by $18 million. They didn't have that much stock left, though, so despite the big blowup they cashed in for only about $8.3 million.

Maybe he knew the end was at hand, but with takeovers looming, Eddie kept fighting. He had started his business with one store in Brooklyn almost twenty years before, near the neighborhood where he grew up, populated mainly by Jewish immigrants from Syria. Despite these humble beginnings, he would one day be called "the Darth Vader of capitalism" by a prosecuting attorney, referring not just to his professional inveigling but to his personal life as well. Eddie's affair with another woman broke up his marriage and precipitated a life-long break with his father. Eventually he divorced his wife and married his lover. Rumors hinted that Eddie had been unhappy because he had five daughters and no sons from his first marriage. Neighbors said the rest of the family sided with the ex-wife. Eddie and his brothers continued in business together, but they had no contact outside the company. Allen Antar, a few years younger, should have been able to sympathizehe had also been estranged from the family when he filed for a divorce and married a woman who wasn't Jewish. (Allen eventually divorced that woman and remarried his first wife.) Later at trial, the brothers Antar were notably cold to one another. Even Eddie's own lawyer called him a "huckster."

But this Darth Vader had a compassionate side. Eddie was known as a quiet and modest man. He was seldom photographed and almost never granted interviews. He was said to have waited hours at the bedside of a dying cousin, Mort Gindi, whose brother, also named Eddie, was named as a defendant in the Antars' federal trial. His cousin Sam remembers him as "a leader, someone I looked up to since I was a kid. Eddie was strong; he worked out with weights. When the Italian kids wanted to come into our neighborhood and beat up on the Jewish kids, Eddie would stop them. That was when we were kids. Later, it turned out different."

Eddie had come a long way. He had realized millions of dollars by selling off company stock at inflated prices. This money was stashed in secret accounts around the world, held under various assumed identities. In fact, Eddie had done so well that he was left vulnerable as leader of the retail empire. When Elias Zinn, a Houston businessman, joined with the Oppenheimer-Palmieri Fund and waged a proxy battle for Crazy Eddie's, the Antars had too little shareholders power to stave off the bid. They lost. For the first time, Crazy Eddie's was out of Eddie's hands.

The new owners didn't have long to celebrate. They discovered that their ship was sinking fast. Stores were alarmingly understocked; shareholders were suing; and suppliers were shutting down credit lines because they were either paid late or never paid. An initial review showed the company's inventory had been overstated by $65 milliona number later raised to over $80 million. In a desperate maneuver, the new management set up a computerized inventory system and established lines of credit. They made peace with the vendors and cut 150 jobs to reduce overhead. But it was too late. Less than a year after the takeover, Crazy Eddie's was dead.

Eddie Antar, on the other hand, was very much alive. But nobody knew where. He had disappeared when it became apparent that the takeover was forcing him out. He had set up dummy companies in Liberia, Gibraltar, and Panama, along with well-supplied bank accounts in Israel and Switzerland. Sensing his days as Crazy Eddie were numbered, he fled the United States, traveling the world with faked passports and calling himself, at different times, Harry Page Shalom and David Cohen. Shalom was a real person, a longtime friend of Eddie's, another in a string of chagrined and erstwhile companions.

It was as David Cohen that Eddie ended his flight from justice and reality. After twenty-eight months on the run, he stalked into a police station in Bern, Switzerland, but not to turn himself in. "David Cohen" was demanding help from the police. He was mad because bank officials refused to let him at the $32 million he had on account there. The bank wouldn't tell Cohen anything, just that he couldn't access those funds. But officials discreetly informed police that the money had been frozen by the U.S. Department of Justice. Affidavits in the investigation had targeted the account as an Antar line. It didn't take long to realize that David Cohen, the irate millionaire in the Bern police station, was Eddie Antar. It was the last public part Crazy Eddie would play for a while. He eventually pled guilty to racketeering and conspiracy charges and was sentenced to eighty-two months in prison with credit for time served. This left him with about three and a half years of jail time. He was also ordered to repay $121 million to bilked investors. Almost $72 million was recovered from Eddie's personal accounts. "I don't ask for mercy," Eddie told the judge at his trial. "I ask for balance."

Eddie's brother, Mitchell, was first convicted and given four and a half years, with $3 million in restitution burdens, but his conviction was overturned because of a prejudicial remark by the judge in the first trial. Mitchell later pled guilty to two counts of securities fraud, and the rest of the charges were dropped. Allen Antar was acquitted at the first trial, but he and his father, Sam, were both later found guilty of insider trading and ordered to pay $11.9 million and $57.5 million, respectively, in disgorgement and interest.

What happened to the Crazy Eddie's stores? In 1998, Eddie's nephews attempted to revive the legacy and held a grand opening for a new electronics store in New Jersey. At the beginning of the new millennium, the store's doors closed and Crazy Eddie's shifted focus to become a dot-com retailer. But by 2004, the company had once again faltered and closed, this time amid allegations of reselling unauthorized products online.

Hiding Your Dirty Laundry in the Notes: Anatomy of the Crazy Eddie's Accounts Payable Fraud Financial statements are often accompanied by notes that are seldom read and often not thoroughly analyzed by investors. One of the many frauds committed by me at Crazy Eddie's involved manipulating just two words in our notes.

Prior to 1987, Crazy Eddie's accounting policy for purchase discounts and allowances was: Purchase discounts and trade allowances are recognized when received. This accounting policy meant that even if Crazy Eddie's had "earned" a discount it could not be recognized as income until a credit was received from the vendor.

In fiscal year 1987, I changed Crazy Eddie's accounting policy (as reflected in the notes) to: Purchase discounts and trade allowances are recognized when earned. Now, in theory, Crazy Eddie could recognize a discount as income when it is earned (e.g., when we reached the manufacturer's benchmark of buying 10,000 units to qualify for a volume rebate) and not have to wait for a credit from the vendor. I could simply write a debit memo (an offset to what I owed the vendor) to recognize the discount and increase our reported profits.

A change of accounting policy would normally give rise to a separate disclosure about its effect on earnings. However, in the Crazy Eddie's fraud, we made no such disclosure, and the auditors made no relevant computations despite the change in accounting principle. The auditors simply ignored the effects of the change in accounting for discounts.

By now being able to recognize discounts "when earned" instead of having to wait for credits to be received from vendors, I had the opportunity to add $20 million on phony debit memos (phony discounts and trade allowances) charged to vendors.

Crazy Eddie's accounts payable was reduced from about $70 million to $50 million through the use of phony debit memos, and this was facilitated by our change in accounting policies for purchase discounts and trade allowances from changing just two words in our notes.