Lessons to be learned - ZZZZ Best, Regina, and Lincoln Savings. (Lincoln Savings and Loan) (Auditing)By James D. Stice, W. Steve Albrecht, and Leslie M. Brown, Jr.
Public accountants continually find themselves in liability disputes involving the quality of services provided by their firms.
Although standard setters have refined the auditor's role in detecting material errors and irregularities, the recent crisis involving the savings and loan industry illustrates that accountants have a long way to go before the public is satisfied with their performance. Instances abound of how carefully constructed frauds can deceive accountants, banks, creditors, stockholders, government agencies and others. This article uses three recent cases, ZZZZ Best, Regina, and Lincoln Savings & Loan, to highlight some of the issues that accountants must be aware of when dealing with clients. The red flags common to these three companies are identified to suggest important early warning signals for auditors.
Lessons to Be Learned
There are several lessons that can be learned from ZZZZ Best, Regina, and Lincoln Savings that should help accountants exercise more care in the future. The first and most discouraging of these lessons is that a well-orchestrated fraud will often succeed (at least for a time) even against well-intentioned, hard-working individuals. The people deceived in these three examples include at least four large CPA firms, several Boards of Directors, vendors, customers, investors, attorneys, underwriters, the press, state and federal governments and numerous charitable organizations that executives of these companies supported.
ZZZZ Best went to extraordinary lengths to deceive its victims. For example, Barry Minkow, ZZZZ Best's president, spent $2 million to lease an entire building in downtown San Diego and another $2 million to hire an army of construction workers to refurbish the inside of the building to make it look like a legitimate restoration project when the auditors insisted on visiting the site. The executives of Lincoln Savings spent over $50 million in legal fees to fend off challenges from regulators and other investigators.
It should be noted that Regina and ZZZZ Best are proven frauds, but Lincoln Savings is only an alleged fraud.
Other, more constructive lessons to be learned from these cases include 1) accountants should exercise extreme care when dealing with young, extremely rapidly growing organizations, especially those that change the nature of their business, 2) accountants must exercise extreme care when associating with new clients, and 3) accountants must thoroughly investigate the backgrounds and management characteristics of key officers.
Young, Rapidly-Growing Organizations
ZZZZ Best went from a start-up organization with no assets, to a multi-million dollar company in less than five years. During this period, its primary business changed from carpet-cleaning to insurance restoration. In a prospectus related to a public offering in late 1986, the company stated that 86% of ZZZZ Best's business was in the insurance restoration area. However, an investigation of several insurance restoration projects, including a $2.3 million job in an eight story building in Arroyo Grande, California, a $7 million contract in Sacramento, a $2.8 million job in San Diego, and a $13.8 million job in Dallas, resulted in none of the jobs being verified. In fact, Arroyo Grande was a town of only 13,000 people with no building over three stories, city and county officials in Sacramento never issued permits for any such job in Sacramento, the insurance company who supposedly awarded the San Diego job says it had nothing to do with any such job, and in Dallas there were no restoration jobs approaching $13.8 million.
Regina went from a one product company with $60 million in sales in 1985 to a four product company with $181 million in sales in 1988. In the effort to boost sales, however, proper testing of new products was eliminated. Consequently, Regina began experiencing a large number of product returns. An internal memo showed that customers returned more than 40,000 Housekeeper vacuums in the quarter ended on September 30, 1988. The problem became so severe that Don Sheelen, the CEO, eventually leased a building to store the defective products. Regina also began booking sales when an order was received rather than when the company shipped the goods. In addition, Regina's computer system was modified to generate approximately 200 fictitious invoices worth $5.4 million on the last three business days of the fiscal year ended June 30, 1988.
Lincoln Savings grew from a $1 billion company in 1984 to a $5 billion company in 1988. Further, it dramatically changed the nature of its business. When Charles Keating purchased Lincoln Savings in 1984, its business was comprised almost exclusively of home mortgages. By 1988, home mortgages were almost nonexistent while direct investments in stocks and bonds were commonplace. For example, Lincoln bought $11.8 million in Circus Circus junk bonds and, on another occasion, they invested $132 million in the stock of Gulf Broadcasting Co. which was involved in a takeover fight. Regulators also reported that Lincoln had made $600 million more in direct investments than regulatory limits allowed. Lincoln was also sending millions of dollars to its parent company, Phoenix-based American Continental Corp., supposedly to cover federal income taxes. However, the parent did not have a federal income- tax liability.
Very few companies grow as fast as these. Those that do rarely undergo a complete change of direction as did ZZZZ Best and Lincoln. How could these firms grow so rapidly when other firms in the same industries could not? Auditors must be aware of the fraud possibilities in fast- growing companies. Many major financial statement frauds have involved fast-growing companies, including Allied Crude Vegetable Oil Refining Corporation, Westec, National Student Marketing, and ESM Government.
Care with New Clients
One way fraudulent companies hide problems from their accountants is to keep hiring new ones. The risk of fraud and other difficulties such as pending litigation, tax evasion, criminal relationships, and involvement in illegal business practices is much higher with new clients than with existing clients because new accountants know less about both company operations and company executives. In the ZZZZ Best case, the audit firm performed a limited review of the financial statements without an audit base. Regina was not the same company during 1985-1988 that it had been during its previous 92-year history. Its management had changed completely. Three of its four major products were time pattern of the physical usage of the leased property."
The question arises in practice as to what constitutes physical usage of the leased property. Under FTB 85-3, companies were maintaining that during the period that the premises were unoccupied or being renovated to a condition suitable for use by the company, there was effectively no "use benefit" derived from the property. Why should the company recognize rent expense on two premises while it was only physically occupying and using one? The FASB recognized that confusion still existed in this area and, therefore, issued FTB 88-1.
FTB 88-1 reaffirmed the conclusions of FTB 85-3. Paragraph four of FTB 88-1 indicates that "this Technical Bulletin considers the right to control the use of the leased property as the equivalent of physical use." Once a company is able to control the use of such property (for instance, it can control when construction should occur or which construction company should perform any necessary renovations), the extent that the company (lessee) is actually using the property should not affect the recognition of rental expense. Therefore, all rental payments, including escalated rentals, should be recognized on a straight line basis.
However, FASB also recognized that some leases give the lessee the right to control all of the use of the leased property at the beginning of the lease term, while some do not. FASB determined that "if rents escalate in contemplation of the lessee's physical use of the leased property, including equipment, but the lessee takes possession of or controls the physical use of the property at the beginning of the lease term, all rental payments, including escalated rents should be recognized ... in accordance with paragraph 15 of Statement 13 and Technical Bulletin 85-3 ...." If, however, the rents escalate because the lessee will obtain control over additional leased property, then an alternative treatment would be appropriate. In that situation rent expense on the additional leased property would not be recognized until control of the additional property is obtained. According to FASB, that was always the intent of SFAS 13 and FTB 85-3. developed during the latter four years. Its marketing focus had changed to using discount chains, almost exclusively, to merchandise its products. When major changes such as these occur, auditors should view their clients as new companies, not organizations that have existed for several years. Lincoln Savings' parent company, American Continental, had hired four auditors over the previous four years.
These are not the first cases in which new clients have resulted in accountants and other being associated with fraudulent activities. Home- Stake Production Company, National Student Marketing, Republic National Life Insurance Company, and Stirling Homex were all frauds associated with first-year clients.
Investigating Client Officers and Owners
CPA firms should conduct thorough background checks of new clients. These background checks must include backgrounds of the principals, the financial history of the company, past business activities, and organizational structure of the business. ZZZZ Best had been investigated by the SEC and had been associated with other scams through its Floral Fantasy and Reliable Auto subsidiaries. Jack Catain, an officer of ZZZZ Best, had frequently run afoul of law-enforcement authorities and had a record of extortion, trading in stolen goods, money laudering and counterfeiting. Maurice Rind, also an officer of ZZZZ Best, was a former convict who was sentenced in 1976 to 18 months in prison and fined $10,000 for conspiracy to violate federal securities laws, mail fraud, interstate transportation of forged securities and other violations. Records filed with the California secretary of state's office indicated that Barry Minkow was also the agent for B & M Insurance Services, whose owner and president, Robert Viggiano, was indicted in December 1968 by a federal grand jury on charges of extortionate credit transactions in an alleged loan-sharking scheme and in 1973 got five years' probation after pleading guilty to attempted grand larceny in connection with the 1968 theft of $750,000 in jewels from the Long Island Diamond & Jewelry Exchange in Garden City, N.Y.
Dan Sheelen led Regina in a $31.3 million leveraged buyout. He assembled a small, high-performance management team and took Regina public in November 1985. However, turnover in his management ranks was high. His drive to succeed alienated many peole in the company. He often expressed his resentment that his sister was highly successful in the business world and he swore he would "not be last in a foot race with her." During his quick advancements and successes he always let people know that he was in charg. What Sheelen wanted, he usually got. He was easily able to intimidate his CFO into misstating the financial records. Auditors must be cautious when one individual has this much "unchecked" power.
Charles Keating,Jr., had previously been charged by the SEC with "untrue statements" and "fraud or deceit." According to a 51-page complaint filed in U.S. District Court in Washington, DC, the SEC said Keating and an associate authorized or permitted Provident Bank of Cincinnati, Ohio, to make $14 million in preferential loans to insiders, including Mr. Keating himself. These loans were often made without collateral or the usual credit checks. In addition, Charles Keating III was a college dropout who was working as a busboy at a country club prior to being appointed as chairman of Lincoln's board by his father.
There are, however, glaring similarities among the three recent cases reviewed here, and prior management fraud cases. By realizing this and by exercising due care in discharging their duties, auditors can reduce their exposure to risk and liability. Carefully evaluating the reasons surrounding a predecessor accountant's or auditor's leaving, evaluating the basis for a company's fast growth, and conducting careful background checks of key principals should aid auditors in assessing the risks of an engagement and taking appropriate action to mitigate those risks.
By James D. Stice, PhD, Brigham Young University, W. Steve Albrecht, PhD, CPA, Brigham Young University, and Leslie M. Brown, Jr., Price Waterhouse
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