Internal Controls Lessons from Crazy Eddie, Inc.
I thought it would be interesting to review the lessons proffered from Sam E. Antar - the former CFO of Crazy Eddie, Inc. His website is whitecollarfraud.com and he has some pointed things to say about internal controls and Sarbanes-Oxley. And he should know, as one of the co-conspirators of an amazingly complex fraud scheme that made his family nearly $100 million in the 1980's - long before Enron, Tyco, and WorldCom.
Crazy Eddie Inc. was a family-run, consumer electronics chain that went public in 1984 and built itself on a massive fraud scheme. They employed a wide variety of deceptive practices and outright fraud, and conspired to fool their auditors over the course of many years (which is all described in fascinating detail on Sam's website). In 1987, they experienced a hostile takeover from some investors. And since that time, Sam has become an expert witness, served his jail time, and regularly speaks about white collar fraud.
In 2006 he sent letters to both Christopher Cox and Nancy Morris at the SEC to offer his views on Sarbanes-Oxley and current audit practices. His comments on the need for internal controls included:
"Many critics of SOX have argued that internal controls are too costly for small companies. The auditors of Crazy Eddie tried to remedy the situation by doing a so called "substantive audit" with no reliance on internal controls since the company's internal controls were very poor. While in theory you can conduct an audit without reliance on internal controls, the absence of adequate internal controls poses the problem of making almost all companies difficult or virtually impossible to audit. Therefore, the review of internal controls of a company by independent outside auditors is crucial for effective auditing. It is evident that a company must have a viable system of internal controls to be auditable. Both items are not mutually exclusive.
In many instances I found that the size of the accounting firm had no bearing on their ability to conduct an audit. The accounting firm that ranked number 9 in the world and audited Crazy Eddie from 1984 to 1986 merged into a "Big Eight" firm in 1987 (a ‘big four" firm now) the last year of our fraud. Ultimately, the Crazy Eddie fraud was not uncovered by the company's auditors but as a result of informants due to family infighting."
The following statement from Antar's FAQ also crystalizes his commitment to the need for internal controls:
"Can any amount of audit procedures make up for a lack of internal controls?
For example, (as noted in the 1986 fraud above) we inflated our sales and cash balance by $2,000,000 by depositing previously skimmed funds into the Crazy Eddie bank balances. The bank accounts were reconciled.
However, there were no controls over sales invoices, inventory, and cash by Crazy Eddie. The auditors did not perform sales and cut-off testing and they did not review deposits in transit.
Crazy Eddie's comparable store sales, earnings, and cash were overstated in 1986.
The money was in the bank and the auditors assumed that it came from legitimate sales. However, the auditors never considered that even if the company had such money in its accounts, there was a possibility that such funds could come from sources used to manipulate earnings.
A credible audit cannot be made in the absence good internal controls. A so called strong audit and strong internal controls are not mutually exclusive."
We at Vibato certainly agree with his rationale and believe that an independent look at a company's internal controls, even when self-reporting under SOX 404(a), is the best way to ensure that internal controls exist and are functioning properly.
Antar's analysis in 2006 was prescient: despite Sarbanes-Oxley requirements, we continue to see earnings restatements and challenges related to ineffective internal controls in public companies of all sizes and types.
Certainly, the lessons learned from the accounting shenanigans at Crazy Eddie, Inc., -- and advice from a main perpetrator of the fraud there -- can help further the discussion on the continuing challenges related to transparent financial reporting in the post-SOX world.