Profitability Issues Plague Thriving Discount Grocery Store, Phar Mor Inc

Phar-Mor, Inc was a thriving discount grocery store in the late 1980’s. Phar-Mor was moving product quickly but profit margins were not significant enough to pay the bills. By the early 1990’s, Phar-Mor declared bankruptcy due to fraudulent financial reporting and misappropriation of assets, making it one of the largest frauds in U.S. history. Below, we will use auditing standard AU 316.85 Appendix A in conjunction with the video “How to Steal $500 million” to analyze how incentives/pressures, opportunities, and attitudes/rationalizations allowed for fraud to start and continue at Phar-Mor.

Incentives/Pressures

Annual reoccurring losses due to small margins put pressure on the CFO and controller to divide the overall loss incurred by Phar-Mor upon each of the individual stores, making the dollar amount of loss per store appear much less material than the millions actually incurred. Phar-Mor’s threat of facing bankruptcy was an incentive for the president, CFO, accounting manager and controller to find ways to “cook the books”, such as overstating the price of inventory.

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Each character involved had significant incentive and felt a lot of pressure to allow the fraud to continue. At one part in the documentary, the controller for Phar-Mor even stated that he, “feared physical harm,” should he not go along with the fraud.

It was the president, who was the one who initially decided not to post the losses, but told his CFO and controller to hide the company’s losses in a separate subledger while continuing to tell the CEO and board members that the company was in good financial standing.

The president felt significant pressure as the business model was his, and the simple notion of pride can sometimes propel people to do the wrong thing. Appendix A.2 of AU 316 lists several factors that incentivize and pressure employees into committing fraud. It states that if “Financial stability or profitability is threatened by economic, industry, or entity operating conditions,” one may be more inclined to perpetrate fraud. Obviously, all those involved realized that Phar-Mor would not be able to remain in business should they report the losses. In an industry as highly competitive as the discount grocery/retail business, declining margins are a death sentence.

Appendix A.2 also states that if “Excessive pressure exists for management to meet the requirements or expectations of third parties,” there will be more incentive to purposely misstate transactions/reports. In the case with Phar-Mor, management not only felt pressure from an upcoming IPO (which will be analyzed in the subsequent paragraph), but also from vendors who sold products at Phar-Mor. If the vendors knew that Phar-Mor was experiencing losses too big to recoup, they would pull their line from Phar-Mor locations and that would spell the end to Phar-Mor.

Another incentive/pressure described in Appendix A.2 states that the company may be committing fraud if “Information available indicates that management or the board of directors’ personal financial situation is threatened by the entity’s financial performance.” In the midst of the substantial misstatements that were being done by Phar-Mor management, the company was preparing an IPO, from which upper-management, namely the president and CEO, were set to make millions. This was a strong incentive to allow the fraud to continue.

Most associated with the fraud never meant to start it, but they never did anything to stop it until they were about to get caught. Once they started following orders from the president, they were under increased pressure to continue covering up the fraud or risk being harmed, financially or physically. Personal financial obligations of those involved in the fraud allowed for them to justify the misappropriation of assets.

Opportunities

When the CFO informed the president that Phar-Mor was in the red, Phar-Mor’s president knew of ways to fraudulently report the losses on the financial statements and misappropriate the assets. A trusting board of directors and no internal audit committee allowed fraudulent financial statements to be reported for many years. The organizational structure of Phar-Mor was ineffective and lacked many control activities including: segregation of duties, authorization, documentary and IT controls. As a result, Phar-Mor’s president had a stronghold on certain upper level management and executives which gave him the opportunity to control the fraud and hide it from other members of the organization and supposedly Phar-Mor’s auditors, Coopers and Lybrand LLP.

Phar-Mor was a large grocery story and had thousands of inventory items on hand at each store which processed significant amounts of cash each day. The organizational structure of Phar-Mor allowed for inadequate and fraudulent recording keeping of assets as well as authorization and approval of purchasing transactions. Phar-Mor’s IT system of event logs was not robust enough to see which transactions had been modified, deleted or created, which allowed Phar-Mor to overstate the value of inventory.

Appendix A.2 also lists several factors that could provide opportunities for management/employees to commit fraud. One factor that could lead to fraud is if, “There is ineffective monitoring of management as a result of: domination of management by a single person or small group without compensating controls.” The auditors should have taken notice of the lack of controls and segregation of duties with respect to Phar-Mor’s president. He had far too much control and was able to perform his duties without any internal controls to limit his ability to affect the financial statements.

The Appendix also states that fraud opportunities could arise if “Internal controls components are deficient as a result of: inadequate monitoring of controls.” Obviously in the case of Phar-Mor, the internal controls were deficient. The monitoring of controls was woefully inadequate which allowed for the president and others to continue perpetrating the fraud for years.

One of the reasons that Phar-Mor was able to commit such a substantial amount of fraud for as long as it did was its business model was highly unique and perhaps not well understood. The more “complex” a company is, and the harder it is to understand, the easier it will be for said company to commit fraud.

The CFO, accounting manager, and controller were all presented with “opportunities” to perpetrate the fraud, simply due to the fact that the president himself instructed them to misstate the financial statements, or simply “go along with it.” However, it was the lack of internal controls that provided the opportunity for the president to initiate the fraud in the first place.

Attitudes/Rationalizations

As noted in Appendix A of AU 316, the “risk factors reflective of attitudes/rationalizations by board members, management, or employees, that allow them to engage in and/or justify fraudulent financial reporting, may not be susceptible to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence of such information should consider it in identifying the risks of material misstatement arising from fraudulent financial reporting.”

It would be hard for any auditor to identify any members of management or employees who may be rationalizing their involvement in an act of fraud. As stated in the video, Phar-Mor’s external auditors said their job is to be a watch dog, not a bloodhound, in reference to finding misstatements in the reported assets or financial statements. However, the documentary was able to shed light on the many different rationalizations made by those involved with the fraud at Phar-Mor.

Phar-Mor’s president and those associated with the fraud made plenty of rationalizations to continue justifying material misstatements on the financial statements and misappropriating company assets. When employees make rationalizations related to committing fraud, an auditor will have a hard time detecting the fraud because the employee will do everything in their power not to get caught. In Phar-Mor’s case, when a group of employees with so much power and authority in the company collaborate to commit fraud, an auditor will have an even lower chance of detecting the fraud

At the onset of the fraud it was initially rationalized by those involved because according to them, they were just “buying time” and eventually they would be able to improve efficiency and all would be well. Also, while the first misstatements made by the president/CFO were illegal, they were initially made on an internal document, so Phar-Mor was in essence only, “lying to its owners”. As time went on, several of those involved still felt that there were ways to fix the problem, but eventually it got to the point where most realized that it was a lost cause.

Conclusion

The president of Phar-Mor instilled a very negative “tone at the top” which trickled down to his direct reports. His attitude and disregard for internal controls by continually overriding transactions scared the employees involved with the fraud. Most importantly, he never wanted to correct the overridden controls, digging the fraud hole bigger and bigger every year. Even when he knew Phar-Mor was in financial trouble he continued to use company money to fund his personal investments such as LPGA events and the World Basketball League. The president’s lavish lifestyle created an illusion to investors, creditors, and customers that Phar-Mor was doing well financially. He bullied suppliers into giving him a certain amount of product for a lower price per unit, as well as large sums of money in order not to sell a certain competitors products. He would then misstate the actual price of inventory by increasing the cost and use the difference, plus the extra money given by suppliers, to pay expenses.

The documentary makes the point that our society likes that our entrepreneurs are inherent risk takers. However, there is a fine line between an aggressive, calculated risk taker and an irresponsible gambler. It is incumbent upon an auditor to determine whether individuals in management positions have crossed that line in order to fully assess the fraud risk associated with a company. In the case of Phar-Mor we fully opine that the company’s president acted irresponsibly and crossed the line with regards to legality and risk. We also believe that it was incumbent upon the CEO, CFO, account manager, and controller to correct any misstatements and put an end to any fraudulent/illegal activity as soon as they became aware the fraud was occurring.

An auditor’s consideration of fraudulent financial reporting and misappropriation of assets happens throughout every audit. Using the three risk factors stated above (incentives/pressures, opportunities, and attitudes/rationalizations), an auditor will assess the risk for each job accordingly. The auditors of Cooper and Lybrand LLP did not do a thorough job in assessing the amount of risk Phar-Mor’s financial statements were materially misstated or assets were misappropriated. Using horizontal and vertical analyses, the auditors should have modified their planning and audit procedures to further investigate large increases in certain accounts which could have detected fraudulent transactions much sooner.