Phar-Mor's Rise, Deception, and Auditing Failures

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Between 1985 and 1992, Phar-Mor grew from 15 stores to 310 stores in 32 states, posting sales of more than $3 bi11ion. By seemingly a11standards, Phar-Mor was a rising star touted by some retail experts as the next Wal-Mart. In fact, Sam Walton once announced that the only company he feared at a11in the expansion ofWal-Mart was Phar-Mor. Mickey Monus, Phar-Mor's president, COO and founder, was a local hero in his hometown of Youngstown, Ohio. As demonstration of his loyalty, Monus put Phar-Mor's headquarters in a deserted department store in downtown Youngstown.

Monus-known as shy and introverted to friends, cold and aloof to others-became quite flashy as Phar-Mor grew.

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Before the fa11of his Phar-Mor empire, Monus was known for buying his friends expensive gifts and he was building an extravagant personal residence, complete with an indoor basketba11court. He was also an initial equity investor in the Colorado Rockies major league baseba11 franchise. This affiliation with the Colorado Rockies and other high profile sporting events sponsored by Phar-Mor fed Monus' love for the high life and fast action.

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He frequently flew to Las Vegas, where a suite was always available for him at Caesar's Palace.

Mickey would often impress his traveling companions by giving them thousands of do11arsto gamble. Phar-Mor was a deep-discount retail chain se11inga variety of household products and prescription drugs at substantia11ylower prices than other discount stores. The key to the low prices was "power buying," the phrase Monus used to describe his strategy of loading up on products when suppliers were offering rockbottom prices.

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The strategy of deep-discount retailing is to beat the other guys' prices, thereby attracting the cost-conscious consumers. Phar-Mor's prices were so low that competitors wondered how Phar-Mor could do it.

Monus' strategy was to underse11Wal-Mart in each market where the two retailers directly competed. Unfortunately, Phar-Mor's prices were so low that Phar-Mor began losing money. Unwi11ingto a11owthese shortfa11sto damage Phar-Mor's appearance of success, Monus and his team began to engage in creative accounting so that PharMor never reported these losses in its financial statements. Federal fraud examiners discerned later that 1987 was the last year Phar-Mor actua11ymade a profit. Investors, relying upon these erroneous financial statements, saw Phar-Mor as an opportunity to cash in on the retailing craze.

Among the big investors were Westinghouse Credit Corp. , Sears Roebuck ; Co. , ma11developer Edward J. de Bartolo, and the prestigious Lazard Freres ; Co. Corporate Partners Investment Fund. Prosecutors say banks and investors put $1. 14 biUion into Phar-Mor based on the phony records. The fraud was ultimately uncovered when a travel agent received a Phar-Mor check signed by Monus paying for expenses that were unrelated to Phar-Mor. The agent showed the check to her landlord, who happened to be a Phar-Mor investor, IUnless otherwise noted, the facts and statements included in this case are based on actual trial transcripts.

Case 6 - Phar-Mor, Inc. : Accounting Fraud, Litigation, and Auditor Liability and he contacted Phar-Mor's chief executive officer (C~O), David Shapira. On August 4, 1992, David Shapira announced to the business community that Phar-Mor had discovered a massive fraud perpetrated primarily by Michael Monus, former president and COO, and Patrick Finn, former chief financial officer (CFO). In order to hide Phar-Mor's cash flow problems, attract investors,' and make the company look profitable, Monus and Finn altered the Phar-Mor's accounting records to understate costs of goods sold and overstate inventory and income.

In addition to the financial statement fraud, internal investigations by the company estimated an embezzlement in excess of$10 million. 2 Phar-Mor's executives had cooked the books and the magnitude of the collusive management fraud was almost inconceivable. The fraud was carefully carried out over several years by persons at many organizational layers, including the president and COO, CFO, vice president of mark~ting, director of accounting, controller, and a host of others. Many factors facilitated the Phar-Mor fraud.

The following list outlines seven key factors contributing to the fraud and the ability to cover it up for so long.

The lack of adequate management information systems (MIS). According to the federal fraud examiner's report, Phar-Mor's MIS was inadequate on many levels. At one point, a Phar-Mor vice president raised concerns about the company's MIS systems and organized a committee to address the problem. However, senior officials involved in the scheme to defraud Phar-Mor dismissed the vice president's concerns and ordered the committee disbanded.
Poor internal controls. For example, Phar-Mor's accounting department was able to bypass normal accounts payable controls by maintaining a supply of blank checks on two different bank accounts and using them to make disbursements. Only those involved in the fraud were authorized to approve use of these checks.
The hands-off management style of David Shapira, CEO. For example, in at least two instances Shapira was made away of potential problems with Monus' behavior and Phar-Mor financial information. In both cases Shapira chose to distance himself from the knowledge.
Inadequate internal audit function. Ironically, Michael Monus was appointed a member of the audit cOIpmittee. When the internal auditor reported that he wanted to investigate certain payroll irregularities associated with some of the Phar-Mor related parties, the CFO forestalled these activities and then eliminated the internal audit function all together.
Collusion among upper management. At least six members ofPhar-Mor's upper management, as well as other employees in the accounting department, were involved in the fraud.
Phar-Mor's knowledge of audit procedures and objectives. Phar-Mor's fraud team was made up of several former auditors, including at least one 2Stem, Gabriella, "Phar-Mor Vendors Halt Deliveries; More Layoffs Made," The Wall Street Journal, August 10, 1992. 27 Beasley / Buckless / Glover / Prawitt fonner auditor who had worked for Coopers on the Phar-Mor audit. The fraud team indicated that one reason they were successful in hiding the fraud from the auditors was because they knew what the auditors were looking for.
Related parties. Coopers ; Lybrand, in a countersuit, stated that Shapira and Monus set up a web of companies to do business with Phar-Mor. Coopers contended that the companies fonned by Shapira and Monus received millions in payments from Phar~Mor. The federal fraud examiner's report confirms Coopers' allegations. The complexity of the related parties involved with Phar-Mor made detection of improprieties and fraudulent activity difficult. During its investigation, the federal fraud examiner identified 91 related parties.

Attorneys representing creditors and investors pointed out that every year from 1987 to 1992, Coopers ; Lybrand acted as Phar-Mor's auditor and declared the retailer's books in order. At the same time, Coopers repeatedly expressed concerns in its annual audit reports and letters to management that Phar-Mor was engaged in hardto-reconcile accounting practices and called for improvements. Coopers identified Phar-Mor in its audit planning documents as a "high risk" audit, and their auditors documented that Phar-Mor appeared to be systematically exaggerating its accounts receivables and inventory, its primary assets.