Perry Drug Stores Inc. Synopsis: Perry Drug Stores Inc.

was founded by Jack Robinson on 1957 and incorporated on 1980. By 1990, Perry became the fourteenth largest drug retailer in United States. Perry Drug Stores relied on an outdated inventory management which did not have any point-of-sale scanning devices at sales terminals and computer-based logistics systems to ensure timely and accurate deliveries to retail stores. This forced the company store managers to rely on their own intuition in making critical decisions in how many to stock in their stores. Adding to this unresolved issue; Perry continued to expand their product line by adding cosmetic products and home office supplies in order to retain their position in metropolitan Detroit. By 1992, Perrys company executive discovered approximately $20 million inventory shortage that was unreported in the financial statements. This was written off the following year which contributed to a huge loss. Perry Drug Stores applied LIFO method to 70 percent of its total inventory and FIFO method to 30 percent. An outside firm counts same group of Perry stores at same point of time each year. Perry adjusted recorded inventory balances with physical inventory count and recorded a collective book-tophysical inventory adjustment for the general ledger inventory account at corporate headquarters. Perry used gross profit method to estimate each stores inventory and to arrive at the collective inventory figure for the company as a whole. His computation includes reducing inventory by the estimate of cost of goods sold calculated using the estimated gross profit margin. The balance on the inventory was added to the general ledger until actual inventory was verified through a new physical count. The percentage according to the management seems reasonable and Perry change the estimated gross profit margin percentage more than once per year. The difference between the book inventories and physical inventory grew larger by the end of the fiscal 1992. Collectively the difference amounted to $20 million which is approximately 14 percent of the collective book inventory. This difference was not adjusted to the corporate inventory account instead management created a suspense account. Perry transferred the difference to a fictitious account Store 100 inventory account. Store 100 was reported in their interim financial statements for 1992. Jerry Stone, Perrys chief financial officer, initiated a company-wide investigation to uncover the source of the inventory shortages. Stone retained Arthur Andersen $ Co., Perrys independent audit firm, to determine whether system problems were the cause of the discrepancy. The computer risk management group of Andersen, not involved in the annual audits of Perry, suggested that computer breakdowns were not the cause. Stone hired private detectives, along with Perrys internal auditors, search for evidence of large-scale inventory thefts. This did not also show promise. Finally, Stones subordinates intensively studied the recent installation of a point-of-sale system by Perry store. The data collected did not convince stone that the estimated gross profit percentage being applied by the company was unreasonable.

Richard Valade and a subordinate prepared a General Risk Analysis memorandum for 1992 Perry audit. This memo indicated that Andersen expected an overall moderate audit risk for the engagement. This assessment reflects that auditor expects errors but has reason to believe they are not likely to be material in relation the financial statements. The overall materiality standard of $700,000 was established for the engagement. The SEC identified the following audit procedures that Andersen completed during the 1992 Perry audit: conducted extensive analytical tests to evaluate the reasonableness of the estimated gross profit margin Perry used during 1992, performed tests to investigate whether theft or changes in Perrys merchandising plans and business policies be the cause of the inventory shortage, observe and tested physical inventory counts at five Perry stores, reviewed the results of Perrys investigations to identify the source of inventory shortage, and reviewed the results of the study of the computer risk management group. These audit procedures failed to uncover the source of the inventory shortage. During the companys board of directors meeting, Richard Valade did not object to the inclusion of the Store 100 inventory as an asset on Perrys balance sheet, which values $20.3 million, he would give an unqualified opinion and he recommended that Perry should have a company-wide physical inventory to find the source of inventory shortage. Perry submitted the income statement and the balance sheet to SEC in their 10-k report, with the $8.3 million income, $20.3 million Store 100 inventory account and unqualified opinion of Valade. The company-wide physical inventory confirmed the large inventory shortage discovered by the company. $33.4 million was written off in the fourth-quarter adjustment of 1993 since management deemed that $20.3 million write-off resulted from a change in estimate. The write-off was not reported separately in their 1993 fiscal report and no restatement of 1992 financial statement for the Store 100 inventory account. SEC discovered the $33.4 million adjustment recorded the company and insisted to restate their 1992 and 1993 financial statements. This would increase their cost of sales by $20.3 million in 1993 and decrease by $20.3 million in 1992 financial statement. After Perry restated their financial statements, SEC launched an investigation of the company with the reason of the not writing off the balance of the Store 100 account in fiscal 1992. In 1998, SEC issued two enforcement releases regarding the investigation. The first enforcement release, SEC chastised Stone for signing Perrys 1992 10-k and sanctioned him for failing to correct Perrys 1992 financial statements, which stopped him from making any violation and future violation. The second enforcement release, SEC criticized Valade for highly relying on physical examination rather than indirect tests to uncover inventory shortages which were unreliable. Valade failed to obtain sufficient competent evidential matter by failing to require Perry to reconcile book inventory and physical inventory and adjusting them to the books and records, failing to discredit either recorded inventory or physical inventory, failing to issue a qualified opinion and failing to refrain from issuing an audit opinion until the matter was resolved. Also in the second enforcement release, SEC censured Valade for his conduct during the 1992 Perry audit meaning he needs to comply in the future with all applicable practice requirements for auditors of SEC registrants. Both Jerry Stone and Richard Valade consented to the SEC sanctions.