Crazy Eddie Electronics was a regional electronics chain in New York City that was failed due to massive fraud committed by its management. The company appeared to be bulletproof and invisible on Wall Street but soon resulted in huge losses to many investors and employees of the retail chain. The company that was known for its eccentric advertising campaign and aggressive in-store sales techniques fell victim to not only its management but also the auditors who failed to detect the crimes. Many people feel that these fraudulent activities should have been detected by the auditors. We will examine not only why this fraud was not discovered, but also what “red flags” existed that should have been detected by the auditors. We will review each of these “red flags” and discuss what could have been done differently to prevent this fraud.
Eddie Antar the owner of Crazy Eddie Electronics used a close network of relatives to conceal a fraud that started out small but quickly ballooned out of control. Eddie was not an accountant and realized that he needed someone he could trust to help him with the company's finances. He paid for his younger brother's training to become a CPA, and Sam Antar became the mastermind behind the elaborate scheme. One of the biggest aspects of this fraud involved the manipulation of inventory. Several techniques were used to manipulate inventory, distorting the financial picture. Inventory was actually borrowed from suppliers who were involved in the fraud and not billed until after the period was over. Inventory that was counted at one store was then moved to a store that was yet to be counted resulting in the double counting of inventory and thus overstating ending inventory. Another method used to manipulate the financial data was to report some items using the cash basis approach as opposed to the GAAP approved accrual basis approach. A final method used to commit the fraud, and probably the most disturbing, was the falsifying of the auditor's documents. Crazy Eddie Incorporated gave the auditors office space in which sensitive audit documents were stored. After the auditors left for the day the information was accessed and manipulated by conspirators of the fraud.
After reviewing some methods used to accomplish this fraud many people question how the auditors were not able to discover what was happening. The fact of the matter is that certain “red flags” did exist and should have warranted the auditors to examine this company more closely. One “red flag” that occurred in this case existed in the financial ratio analysis of the company. In reviewing some of the key financial metrics the auditors should have been suspicious of the sudden decrease in the inventory turn ratio. This could have suggested that cost of goods sold were understated and gross profit percentage overstated. This should have signaled the auditors to look more closely at the physical inventory audit. They should have performed inventories at various locations at the same time to reduce the risk of inventory being double counted. They also should have verified the inventory levels themselves instead of utilizing Crazy Eddie's employees for help.
Another area of concern that should have alerted the auditors was many of the company's top officials were family members or Eddie Antar. While this is not against the law it suggests the possibility of collaboration. Some people may be willing to lie to protect a family member. It is true that the auditor has no control over whom a company hires, but the auditor does have control over the information he or she collects and interprets. The auditors should have used extreme caution when subjective evidence was provided or was not able to be provided as it could have been the result of a client-imposed scope limitation.
Another “red flag” occurred when the auditors requested important documents needed for verification but were told the documents had been destroyed. The fact that these documents were missing could be an indication that fraud has occurred and the client is disposing of the evidence. In situations like this the auditors should be searching for a scope limitation. If these documents were deemed critical by the auditors they could have issued disclaimer of opinion.
Several additional auditing vulnerabilities also existed in this fraud that should have stood out as “red flags” to the firms completing the audits. First, auditors in the field were young and did not have enough experience to conduct the audit. These firms should have provided a mixture of young field auditors and experienced auditors. As a result the auditors found themselves in situation where they did not follow through on information that had the potential for fraud. On several occasions they uncovered evidence of fraudulent activities. Instead of bringing this to attention they reviewed the information with the client who dismissed the irregularities as mistakes.
Another area of concern that should have drawn attention was Main Hurdman performing an audit for an extremely low fee. At the same time Main Hurdman was providing consulting services for a very large fee. It was not realistic to expect that a thorough and independent audit could be completed. The cost constraints did not provide the field auditors with the resources necessary to complete the audit properly. In addition the issue of auditor independence comes into question. If Main Hurdman uncovered a fraud, Crazy Eddie incorporated could have threatened to take away the consulting revenue. Currently the Sarbanes Oxley Act would have prevented this issue as it outlaws the same auditing firm from providing consulting services and performing an audit.
In conclusion we examined some of the techniques used to disguise fraudulent activities from auditors. In many situations it is very difficult for a fraud to be detected as criminals will go through great lengths to get away with the crime. Auditors however, have a responsibility to provide reasonable certainty of the financial statements accuracy. Auditors cannot afford to be complacent or they will fall victim to these criminals. In the Crazy Eddie case the auditors were careless in performing the audit. Many “red flags” went undetected and resulted in millions lost by investors. We may never be able to completely eliminate fraud from occurring, but we can learn from frauds like this one. Many of the problems that occurred in this case are now being eliminated thanks to regulations like Sarbanes Oxley which have created an awareness throughout the accounting and auditing community.
Work Cited
Alvin Arens, Randel Elder, Mark Beasley
Auditing and Assurance Services, 12th Edition ; Pg 353-358
Prentice Hall, 2008
So That's Why It's Called a Pyramid Scheme,
Joseph T. Wells
http://www.aicpa.org/pubs/jofa/oct2000/wells.htm
Takes one to know one. Peter Carbonara
Fortune Magazine, 2007
http://money.cnn.com/2007/12/21/news/newsmakers/antar.fortune/index.htm
The Accounting Profession and Financial Statement Fraud.
D. Larry Crumbley, CPA, Cr. FA and Nicholas Apostolou CPA, Cr. FA
Jan/Feb 2003, Volume 12 numbers 1 & 2
http://www.tampabaycfe.org
