Brad

 Farber  
Professor  Dignam  
May  2nd  2013  
Case  1.8  Crazy  Eddie  
 
1) During  the  years  of  1984  thru  1987,  Crazy  Eddies  financial  statements  showed  a  handful  of  
red  flags  which  should  have  led  to  auditors  raising  questions  to  the  companies  numbers  that  
were  be  inflated  by  Crazy  Eddie  and  the  rest  of  his  executive  board  (which  was  mostly  his  
family).      
KEY  RATIOS   March  1st  1987   March  2nd  1986   March  3rd  1985   May  31  1984  

 
Current   Ratio     2.40%     1.35%     1.56%     0.01%  

 
Quick   Ratio     1.40%     0.59%     0.76%     0.14%  

 Account  Rec.          
Turnover   32   116   49   52  

 
Inventory   Turnover     4.98     3.55     1.89     1.95  

 
Debt   to  Assets     0.68%     0.66%     0.63%     0.82%  

 
Debt   to  Equity     2.00%     1.97%     1.74%     4.97%  
 
One  of  the  first  things  that  pops  out  to  me  when  evaluating  the  ratios  is  the  drastic  change  in  the  
Accounts  Receivables  Turnover  from  1986-­‐1987.    It  is  just  an  outlier  from  the  other  3  years  and  does  
not  make  much  sense  due  to  the  disintegrating  market  conditions.        The  inventory  turnover  
differential  also  might  have  drawn  a  red  flag.    Just  if  the  auditors  would  have  looked  at  these  figures  
this  might  have  led  them  to  realize  that  Crazy  Eddy  overstated  inventory  by  $2M  and  $9M  one  year  
later.    This  was  a  domino  effect  because  accounts  payable  was  understated  and  profits  and  gross  
profit  majorly  overstated  to  meet  investors  expectations.    Over  the  4  years,  the  cash,  inventory  
accounts  were  constantly  changing  drastically  year  to  year  which  was  in  large  part  due  to  the  “crazy”  
accounting  practices  that  were  used  by  Eddie  and  his  family.    
 
 
2)  Below  is  a  list  of  specific  audit  procedures  that  might  have  led  to  the  detection  of  some  of  the  fraud  
that  occurred  in  Crazy  Eddies  books.    The  code  section  that  refers  to  proper  testing  is  AU  318.      
 
a)  The  falsification  of  inventory  counts  sheets  
Audit  Procedures:    If  the  auditors  were  ever  skeptical  of  what  was  going  on  they  could  have  
physically  come  onto  the  Crazy  Eddy  premises  and  done  physical  inventory  counts  periodically  
without  giving  the  store  any  warning/time  to  allow  them  to  conceal  wrong  an  wrong  doings.  
 
 
 
b)  Bogus  debit  memos  for  accounts  payable  
Audit  Procedures:    Substantive  testing  should  have  been  performed.  The  auditors  should  have  sent  
out  for  confirmations  to  confirm  with  the  supplier/client  the  validity  of  the  phony  accounts.    They  
should  have  tested  and  traced  the  payable  statements  to  the  financials  and  see  if  the  checks  were  
actually  written.    Internal  controls  should  have  also  been  looked  at.    The  internal  auditor  for  crazy  
Eddie  was  not  only  doing  the  internal  audit  work  but  was  also  acting  as  the  controller,  and  director  
of  accounts  payable.      
 
 
c)  The  recording  of  transshipping  transactions  as  retail  sales  
Audit  Procedures:    Eddie  used  this  tactic  to  overstate  inventory.    The  use  of  analytics  could  have  
been  applied  to  helping  the  auditors  discover  this  fraud.    Peat  Marwick  and  Hurdman  could  have  
done  a  better  job  observing  the  gross  profit  figures,  sales,  and  inventory.    All  of  which  were  heavily  
inflated  and  affected  by  the  transshipping  transactions.    Cash  and  receipts  should  have  also  been  
looked  over  with  a  closer  eye.          
 
 
d)  Inclusion  of  consigned  merchandise  at  year  end  
Audit  Procedures:  The  auditors  should  have  looked  more  closely  at  year  end  inventory  physical  
counts  and  asked  to  see  documentation  to  where  this  inventory  came  from.    If  they  would  have  
looked  into  the  proper  documentation  they  would  have  found  the  evidence  that  would  show  that  
the  inventory  that  they  were  recording  did  not  in  fact  belong  to  them,  but  to  the  consignor.    This  
could  have  been  done  my  matching/tracing  the  vendor  receipts  to  the  financial  statements  and  
realizing  that  they  items  were  never  paid  for  but  merely  on  consignment  and  should  not  have  been  
recorded  as  inventory.      
 
3)  A  good  audit  team  well  looks  at  internal  and  external  market  factors  during  the  stages  of  planning  
the  audit  (Auditing  Standard  9).    During  the  later  part  of  the  1980s  the  boom  days  for  the  electronic  
industries  were  in  the  past.    The  bubble  on  the  industry  had  burst,  NYC  had  become  a  saturated  
market,  and  increased  competition  had  made  things  much  harder  for  those  retail  stores  that  were  
still  in  business.    The  auditors  should  have  been  aware  of  the  market  situation,  and  realized  that  in  
times  like  these,  a  company  which  is  showing  record  amounts  of  profit  ,  should  be  looked  at  with  a  
closer  eye  of  professional  skepticism.    The  audit  risk  should  have  been  raised  when  that  type  of  
market  condition  existed.  
 
4)  The  term  “lowballing”  relates  to  an  independent  audit  firm  giving  a  potential  new  audit  client  a  
ridiculously  low  price  on  the  audit  work.    The  motivation  behind  this  is  retain  a  audit  client  and  
charge  them  little  for  the  audit  services  in  hopes  to  them  hiring  you  to  do  the  consulting  work  for  
the  firm  as  well.    This  is  done  with  the  hopes  that  they  can  overcharge  the  firm  for  consulting  fees  
and  bring  in  not  only  audit  revenues  to  the  practice,  but  consulting  as  well.    By  a  firm  doing  both  the  
audit  and  consulting  work  for  a  business,  it  can  potentially  affect  the  quality  of  the  work  and  most  
definitely  the  independence  of  the  audit.    When  a  company  does  the  audit  work  and  consulting  work  
it  definitely  creates  a  conflict  of  interest  and  affects  the  integrity  and  objectivity  of  the  audit.    As  we  
saw  in  the  case  of  Enron,  this  can  lead  to  huge  problems  and  can  affect  the  independent  auditor  have  
an  objective  viewpoint.      
 
  
 
5)  If  I  were  unable  to  find  10  out  of  60  randomly  selected  I  would  immediately  reach  out  to  my  
supervisor  and  let  him  know  about  the  dilemma  that  I  was  in.      If  I  could  not  find  the  invoices,  but  
did  see  the  sales  order  or  the  money  going  out,  it  could  be  possible  that  they  were  misplaced  and  
therefore  I  would  not  automatically  assume  fraud  had  occurred.    Besides  reaching  out  to  my  
supervisor,  I  might  also  reach  out  to  the  member  of  the  client  that  I  was  in  touch  with  and  have  him  
look  into  the  situation.    If  after  doing  further  research,  an  I  was  to  found  out  that  the  invoices  were  
non-­‐existent  and  there  was  a  potential  for  fraud,  the  partner  on  the  engagement  would  be  notified  
as  well  as  the  firms  management  group.      
 
 
 
6)  I  personally  do  not  feel  that  companies  should  be  allowed  to  hire  individuals  who  had  served  as  
their  independent  auditors  in  the  past.    One  of  the  biggest  disadvantages  to  this  practice  is  that  the  
person  that  is  hired  already  has  an  advantage  if  they  were  to  try  to  commit  fraud  and  conceal  it.      
After  the  Enron  debacle  and  Sarbanes  Oxley,  tighter  standards  have  been  set  into  place  regarding  
this  situation.    I  think  that  it  is  important  for  people  in  public  accounting  to  make  the  transition  into  
the  private  sector,  I  am  do  not  think  it  would  be  in  anyone  best  interest  for  the  that  person  to  make  
the  switch  to  go  work  for  a  former  client.    This  situation  might  create  a  conflict  and  the  cons  out  
weighs  the  pros.