Crazy Eddie, Inc. Common Size Balance Sheets March 1, 1987March 1, 1986March 1, 1985May 31, 1984 Cash3. 17%10. 47%33. 99%3. 76% Short-term investments41. 36%21. 14%0. 00%0. 00% Receivables3. 68%1. 77%4. 18%7. 12% Merchandise inventories36. 99%47. 16%40. 51%63. 83% Prepaid expenses3. 61%1. 86%0. 98%1. 41% Total current assets88. 81%82. 40%79. 66%76. 12% Restricted cash0. 00%2. 64%10. 77%0. 00% Due from affiliates0. 00%0. 00%0. 00%15. 69% Property, plant and equipment8. 95%5. 65%5. 64%5. 05% Construction in process0. 00%4. 93%1. 76%0. 00% Other assets2. 24%4. 38%2. 7%3. 14% Total assets100. 00%100. 00%100. 00%100. 00% Crazy Eddie, Inc. Common Size Income Statements Year Ended March 1, 1987Year Ended March 1, 1987Year Ended March 1, 1987Year Ended March 1, 1987 Net Sales100. 00%100. 00%100. 00%100. 00% Cost of Goods sold77. 23%74. 11%75. 87%77. 89% Gross profit22. 77%25. 89%24. 13%22. 11% Selling, general and admin expense17. 68%16. 39%15. 04%16. 43% Interest and other income2. 10%1. 22%0. 89%0. 51% Interest expense1. 48%0. 31%0. 32%0. 38% Income before taxes5. 70%10. 41%9. 66%5. 81% Pension contribution0. 14%0. 31%0. 44%0. 00% Income taxes2. 84%5. 06%4. 94%3. 06% Net income2. 72%5. 05%4. 28%2. 75% Net income per share0. 000096%0. 000183%0. 000176%0. 000131% Crazy Eddie, Inc. Key Ratios 1987198619851984 Liquidity Ratios: Current Ratio2. 40621. 39851. 56260. 9287 Quick Ratio1. 40440. 59820. 76800. 1499 Solvency Ratios: Debt to Assets Ratio0. 68370. 66430. 63590. 8298 Times Interest Earned3. 616930. 392728. 287714. 9253 Long-Term Debt to Equity2. 16171. 97861. 74624. 8755 Activity Ratios: Inventory Turnover3. 23204. 38115. 13585. 8812 Accounts Receivable Turnover32. 5026116. 771149. 751552. 208 Collection of Accounts Receivables in Days331175053 Profitability Ratios: Gross Margin0. 22770. 25890. 24130. 2211 Net Income Margin3. 00585. 04984. 27602. 7483 Return on Total Assets0. 03590. 10430. 8900. 0758 Return on Equity0. 11360. 31070. 24430. 6062 Upon analysis of Crazy Eddie’s ratios and financial statements there were several red flags that suggested the firm posed a higher-than-normal level of audit risk. Analysis of the financial statements raises several red flags. The first red flag was the shift in the balance of the cash and short-term investment accounts. In 1985 cash represented 33. 99% of total assets and in 1986 cash represented only 10. 47% of total assets.
This shift in the cash balance is most attributable to the shift in short-term investments which were 0% and 21. 14% respectively. The drop in cash shows that Crazy Eddie was beginning to experience financial issues and liquidating their cash. Crazy Eddie continued to expand in this toughening market which furthermore liquidated cash. Another red flag is the drop in value of the merchandise inventory account. In 1984 the value of the inventory was 63. 3% and in 1987 had dropped to 36. 99% which shows that they were liquidating their inventory and replacing it with short-term investments. The retail industry is composed largely of merchandise inventory and this downward trend should have been a huge red flag.
These red flags show a company who is losing market share because of the expansion of the electronics market in the late 1980’s. Analysis of key ratios continues the trend of red flags for an auditor. The first ratio that looks a bit suspicious to me is the current ratio which increased from . 3 in 1984 to 2. 41 in 1987. A current ratio over 1 generally suggest that if all of the current liabilities came due at one then the company would be able to pay the debt but in this situation for it to increase 150% over a 4 year span.
The next red flag concerning ratios is the long-term debt to equity ratio which decreased from 4. 88 to 2. 16. The ratio show how aggressive Crazy Eddie was in financing their debt. The major red flag that I see with the ratios is the collection of accounts receivables in days which well below industry average. In 1984 Crazy Eddie was able to collect on account in 53 days and this number skyrockets to 117 in 1986. This show the inability for the company to collect the debt owed to them which is also reflected in the downward trend of cash. Extremely high accounts receivable turnover rates are an indicator of credit and collection policies that are too restrictive. The fact that the Antar family had absolute control over the operations was a red flag as well.
Eddie Antar knew that if he kept the company controlled by family members that they would remain loyal. They were able to manipulate all aspects of the company. There were “major self-dealing transactions and related party transactions by family members” (Antar, S) The audit procedures that an auditor is supposed to perform are there to help protect from fraud that may occur. The falsification of inventory count sheets could have been prevented if the auditor would have verified the information that was on the sheets. Crazy Eddie executives were excellent at staying one step ahead of the auditor because they knew in advance which stores the auditors would visit, then they would ship merchandise to those specific stores. The bogus debit memos should have been authenticated by contacted some of the vendors of Crazy Eddie’s and asking for supporting documentation. “Unfortunately for the CPA, it is too easy for the client to conceal liabilities” (Wells). The auditors should have confirmed the notes payables with the bank to verify their existence which would have also shown the inflation of the accounts payable account. The recording of transshipping transactions as retail sales should have been authenticated by a review of the total sales at the specific store versus the gross profit and merchandise levels. The auditors should have followed the paper trail in this situation to see where the specific merchandise was coming from all the way to the sale of the merchandise. If the auditors had performed this necessary step they would have seen that sales were inflated and inventory was overstated with an increase in gross profit from sales.
The inclusion of consigned merchandise in year-end inventory could have easily been detected had the auditors verified the merchandise records. The auditors should have seen that the merchandise was to be returned to the suppliers. An auditor should be very well educated in the trends of the industry for which they are performing an audit. The industry was booming in the early 1980’s and began to slow as the decade continued. As the 1980’s continued, Crazy Eddie continued to show double digit growth while the other electronic retailers were struggling to break even. If the auditors involved in the case would have examined the industry then they would have taken a closer look at Crazy Eddie. The auditors appeared to have turned a blind eye to Crazy Eddie because of the revenue that was brought to their company based on non-auditing work from Crazy Eddie’s. The first auditors was a small local firm that needed the revenue Crazy Eddie brought to them so they did as they were asked and in many situations did not ask any questions.
The second auditors Main Hurdman had a nationwide practice with several clients in the consumer electronics industry and should have known what the trend was in the industry. They too received only a small portion of the revenue from auditing Crazy Eddie versus the amount they received from computerizing inventory system. Lowballing is an unethical practice that is involved in many industries including the auditing profession. Lowballing is when services are performed below the market price just to keep the business of an existing client or to attract new clients. In this case, Main Hurdman lowballed to obtain Crazy Eddie and knew that they could make up for the lost revenue by selling consulting services. An audit can be affected because the audit firm may not use the same resources on the client. The audit firm may be more willing to use interns or less experienced auditors to perform the audit to make up for the lost revenue. The audit may also be compromised because the auditors may not perform the accurate inventory checks as well as verifying other accounts. Crazy Eddie was clearly trying to impede auditors from performing their job by “misplacing” their invoices. A company with a sound financial system would not misplace 10 invoices.
This should have been a huge red flag that Crazy Eddie was being deceptive. Unfortunately the auditors in the case just turned a blind eye and allow the company to continue to have material misstatements on their financial statements. In this situation, the auditor could request invoices from the suppliers to get an accurate count of the merchandise that was delivered to the company.
The next step would be to perform and inventory count at some of the Crazy Eddie locations without giving advance notice. I think that companies should be allowed to hire individuals who formerly served as their independent auditors. Companies are facing cost issues and are trying to save money because of our economic situation and training costs will be greatly reduced if the company can hire an individual that is already familiar with the accounting system. In considering a cooling-off period, the Independence Standards Board noted that a mandated cooling-off period for partners and professional staff might create a greater appearance of independence between the accounting firm and the registrant (U. S. Securities and Exchange Commission). The cons of this practice are that the audit firm may encourage this practice in order to keep the client as a customer which created a disadvantage for the competition. There is also the increased risk of fraud because the auditor has first-hand knowledge of how the audit will be performed. The auditor will know how to manipulate the numbers because they will know the checks that will be performed. Afterthought While doing research for the case I became intrigued with how detailed and complex the fraud became at Crazy Eddie’s. In the article titled So That’s Why It’s Called a Pyramid Scheme, the author described 5 principle types of financial statement fraud and how Crazy Eddie’s was involved in all 5. While doing research on the case I was surprised by how much information there was on the internet. I also found it interesting that Sam Antar, former CFO has his own blog site where he details the aspects of the fraud and how it was concealed from the auditors. https://www. whitecollarfraud. com/1265851. html.
Antar, Sam E. 2010. https://www. journalofaccountancy. com/Issues/2000/Oct/SoThatSWhyItSCalledAPyramidScheme. htm. So That’s Why It’s Called a Pyramid Scheme. Wells, Joseph T. 2000 https://www. sec. gov/rules/final/33-8183. htm. U. S. Securities and Exchange Commission. 2003
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