Brad

Farber Professor Dignam May 2nd 2013 Case 1.8 Crazy Eddie 1) During the years of 1984 thru 1987, Crazy Eddies financial statements showed a handful of red flags which should have led to auditors raising questions to the companies numbers that were be inflated by Crazy Eddie and the rest of his executive board (which was mostly his family). KEY RATIOS March 1st 1987 March 2nd 1986 March 3rd 1985 May 31 1984 Current Ratio Quick Ratio Account Rec. Turnover Inventory Turnover Debt to Assets 2.40% 1.40% 32 1.35% 0.59% 116 1.56% 0.76% 49 0.01% 0.14% 52 1.95 0.82%

4.98 0.68%

3.55 0.66%

1.89 0.63%

Debt to Equity 2.00% 1.97% 1.74% 4.97% One of the first things that pops out to me when evaluating the ratios is the drastic change in the Accounts Receivables Turnover from 1986-1987. It is just an outlier from the other 3 years and does not make much sense due to the disintegrating market conditions. The inventory turnover differential also might have drawn a red flag. Just if the auditors would have looked at these figures this might have led them to realize that Crazy Eddy overstated inventory by $2M and $9M one year later. This was a domino effect because accounts payable was understated and profits and gross profit majorly overstated to meet investors expectations. Over the 4 years, the cash, inventory accounts were constantly changing drastically year to year which was in large part due to the crazy accounting practices that were used by Eddie and his family. 2) Below is a list of specific audit procedures that might have led to the detection of some of the fraud that occurred in Crazy Eddies books. The code section that refers to proper testing is AU 318. a) The falsification of inventory counts sheets Audit Procedures: If the auditors were ever skeptical of what was going on they could have physically come onto the Crazy Eddy premises and done physical inventory counts periodically without giving the store any warning/time to allow them to conceal wrong an wrong doings.

b) Bogus debit memos for accounts payable Audit Procedures: Substantive testing should have been performed. The auditors should have sent out for confirmations to confirm with the supplier/client the validity of the phony accounts. They should have tested and traced the payable statements to the financials and see if the checks were actually written. Internal controls should have also been looked at. The internal auditor for crazy Eddie was not only doing the internal audit work but was also acting as the controller, and director of accounts payable. c) The recording of transshipping transactions as retail sales Audit Procedures: Eddie used this tactic to overstate inventory. The use of analytics could have been applied to helping the auditors discover this fraud. Peat Marwick and Hurdman could have done a better job observing the gross profit figures, sales, and inventory. All of which were heavily inflated and affected by the transshipping transactions. Cash and receipts should have also been looked over with a closer eye. d) Inclusion of consigned merchandise at year end Audit Procedures: The auditors should have looked more closely at year end inventory physical counts and asked to see documentation to where this inventory came from. If they would have looked into the proper documentation they would have found the evidence that would show that the inventory that they were recording did not in fact belong to them, but to the consignor. This could have been done my matching/tracing the vendor receipts to the financial statements and realizing that they items were never paid for but merely on consignment and should not have been recorded as inventory. 3) A good audit team well looks at internal and external market factors during the stages of planning the audit (Auditing Standard 9). During the later part of the 1980s the boom days for the electronic industries were in the past. The bubble on the industry had burst, NYC had become a saturated market, and increased competition had made things much harder for those retail stores that were still in business. The auditors should have been aware of the market situation, and realized that in times like these, a company which is showing record amounts of profit , should be looked at with a closer eye of professional skepticism. The audit risk should have been raised when that type of market condition existed. 4) The term lowballing relates to an independent audit firm giving a potential new audit client a ridiculously low price on the audit work. The motivation behind this is retain a audit client and charge them little for the audit services in hopes to them hiring you to do the consulting work for the firm as well. This is done with the hopes that they can overcharge the firm for consulting fees and bring in not only audit revenues to the practice, but consulting as well. By a firm doing both the audit and consulting work for a business, it can potentially affect the quality of the work and most definitely the independence of the audit. When a company does the audit work and consulting work it definitely creates a conflict of interest and affects the integrity and objectivity of the audit. As we saw in the case of Enron, this can lead to huge problems and can affect the independent auditor have an objective viewpoint.

 5) If I were unable to find 10 out of 60 randomly selected I would immediately reach out to my supervisor and let him know about the dilemma that I was in. If I could not find the invoices, but did see the sales order or the money going out, it could be possible that they were misplaced and therefore I would not automatically assume fraud had occurred. Besides reaching out to my supervisor, I might also reach out to the member of the client that I was in touch with and have him look into the situation. If after doing further research, an I was to found out that the invoices were non-existent and there was a potential for fraud, the partner on the engagement would be notified as well as the firms management group. 6) I personally do not feel that companies should be allowed to hire individuals who had served as their independent auditors in the past. One of the biggest disadvantages to this practice is that the person that is hired already has an advantage if they were to try to commit fraud and conceal it. After the Enron debacle and Sarbanes Oxley, tighter standards have been set into place regarding this situation. I think that it is important for people in public accounting to make the transition into the private sector, I am do not think it would be in anyone best interest for the that person to make the switch to go work for a former client. This situation might create a conflict and the cons out weighs the pros.