1

CASE 1.12

REGINA COMPANY, INC.

Donald Sheelen was born into a middle-class family in

upstate New York in 1946. In high school, the handsome Sheelen
was the prototype of the all-American boy, excelling in both
academics and athletics. Following graduation, Sheelen attended
the University of Dayton, where he was elected president of his
senior class and named a Big Man on Campus. After earning an MBA
from Syracuse University, Sheelen landed a job with a large Wall
Street brokerage firm and then three years later accepted a
middle-management position with Johnson & Johnson. At the age of
thirty-four, Sheelen was hired by Regina Company, Inc., and
placed in charge of the company’s marketing department.
Regina was a wholly-owned subsidiary of the large
conglomerate General Signal Corporation. Founded in Rathway, New
Jersey, in 1892, Regina had originally been a music box
manufacturer before entering the floorcare industry in the early
1900s. Throughout most of its existence, Regina was known as a
complacent, slow-growth company and was dominated within the
floorcare industry by Hoover and Eureka. Regina’s corporate
image changed quickly after Donald Sheelen signed on with the
company.
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Cornflakes, Celebrity, and Cash for Donald Sheelen

After becoming company president in 1983, Sheelen announced
that he intended to make Regina the industry’s dominant firm by
the end of the decade. He repeatedly vowed that Regina would
bomb Hoover, the number one firm in the industry at the time.
The exuberant executive even laid a Hoover doormat outside his
office so that each day he could “walk over” his company’s major
rival.1 Sheelen believed that to challenge Hoover and Eureka,
Regina had to expand its product line and dramatically increase
its advertising expenditures. Under his leadership, Regina
introduced a series of new products, including a portable spa and
an upright vacuum cleaner. To promote these and other new
products, Sheelen poured millions of dollars into Regina’s
advertising budget. Eventually, the company’s annual advertising
expenditures exceeded 20 percent of its annual sales and eclipsed
the combined advertising outlays of Hoover and Eureka.
 Sheelen became well known both inside and outside the
floorcare industry for his so-called cornflake routine that he
often performed at trade shows and during news conferences. This
routine involved sprinkling crushed cereal on a carpet and then
demonstrating that a Regina vacuum cleaner did a much better job
of cleaning up the mess than did a Hoover. Sheelen converted
this demonstration into a television advertisement and was
promptly sued by Hoover, which forced him to cancel the popular
commercial. Hoover proved that the commercial was misleading
since the Regina vacuum cleaner used in the cornflake caper had
an industrial-strength suction not available on the model sold to
retail customers.
Regina’s board of directors named Sheelen the company’s
chief executive officer in early 1984. A few months later, he
and several other Regina executives bought a majority interest in
the company via a leveraged buyout. Sheelen personally invested
only $750,000 in the venture but emerged with more than a 50
percent equity interest in Regina, which had total assets
approaching $40 million at the time. The following year, Sheelen
and his partners took Regina public. Surging sales and profits
quickly landed Regina on the “buy” lists of several large
brokerage firms and tagged the company’s stock as a “can’t miss”
investment on Wall Street. (Exhibit 1 presents Regina’s balance
sheets and income statements for 1986 through 1988.) In
commenting on the company, one financial analyst noted, “Regina
is not only an earnings play but an investment in a skilled
management team that has turned the company around.”2
--Insert Exhibit 1--
 Within two years after going public, Regina’s stock price
had soared by nearly 500 percent and analysts expected it to go
much higher. Regina’s lofty stock price made Sheelen and the
company’s other principal stockholders millionaires many times
over. Sheelen’s stock alone had a market value of almost $100

million by 1988.

Regina’s Profits: Just So Much Hot Air

Unfortunately, the too-good-to-be-true story of Regina

Company was . . . too good to be true. The sparkling sales and
earnings figures released by Regina after it went public had been
doctored by Sheelen. For the fiscal year ended June 30, 1988,
the company actually suffered a multimillion-dollar loss rather
than the reported $11 million profit. Instead of a growth
company with bright prospects, Regina was a dying company mired
in mounting losses.
Regina’s financial difficulties stemmed largely from product
quality problems. Sheelen and the company’s other top executives
failed to pay sufficient attention to quality control issues
during the manufacturing process for the new products introduced
during the mid-1980s. These new products were innovative and
less expensive than those of the company’s competitors. They
were also unreliable, having been rushed to the market without
being adequately tested. Customer return rates several times
greater than those of Regina’s competitors negated the impressive
sales figures registered following the introduction of the new
products. One major retailer reported a return rate of 50
percent for a Regina vacuum cleaner, while the comparable models
of Hoover and Eureka had return rates of less than 1 percent.
 By 1987, Sheelen realized that Regina was in deep trouble.
Rather than admitting the problems facing the company, Sheelen
chose to conceal them via several illicit accounting schemes. In
a subsequent investigation, the Securities and Exchange
Commission (SEC) charged that inflating Regina’s stock price was
the prime motive behind these schemes. Colleagues of Sheelen
later corroborated this allegation when they testified that he
was obsessed with maintaining the company’s stock price at a high
level: “Nothing fired Sheelen’s emotions like the company’s
stock price. Even a temporary flutter would cause him to rush to
the phone to drum up support. He would pick up the phone himself

and say, ‘Why don’t you [a financial analyst] write something to

get the stock up?’”3
Sheelen began earnestly manipulating Regina’s reported
operating results during the second quarter of the company’s 1988
fiscal year. Regina had posted steady increases in sales and
earnings from 1985 through most of 1987. By December 31, 1987,
the end of the second quarter of fiscal 1988, Regina’s huge sales
returns were threatening the company’s impressive sales and
earnings trends. At that point, Sheelen began establishing
target sales and earnings goals that he believed Regina had to
reach for the company to sustain “the confidence of the
securities markets.”4
To meet his financial targets for the second quarter of
1988, Sheelen instructed Vincent Golden, Regina’s chief financial
officer, to understate the company’s product returns for that
quarter: “With Golden’s approval, employees altered Regina’s
computer system so that products returned by certain large volume
customers could be processed through Regina’s customer service
department but would not be recorded on the company’s books.”
Sheelen and Golden continued to misrepresent Regina’s product
returns for the final two quarters of fiscal 1988. According to
the SEC, the company understated its sales returns by at least
$13 million for the year.
During the fourth quarter of fiscal 1988, Sheelen realized
that slashing recorded sales returns alone would not allow Regina
to achieve the sales and earnings goals he had established for
that year. With Golden’s help, Sheelen came up with several
other accounting schemes to ensure that Regina reached his 1988
target sales and earnings figures of approximately $180 million
and $1.20 per share, respectively. Sheelen instructed Golden to
record bogus sales during the fourth quarter of fiscal 1988:
“With Golden’s approval, Regina’s computer system was programmed
to create false invoices in amounts of prior orders from certain
large volume customers. Large volume customers were used because
Golden and certain members of his staff believed that such
customers were less likely than smaller customers to respond to
audit confirmations.” Golden also made sure that the bogus
invoices were not sent to Regina’s customers or routed to members
of the company’s accounting department who were unaware of the
earnings manipulation scheme. In total, Golden and his
subordinates generated 200 bogus invoices, representing
collective sales of more than $5 million.
Another method Sheelen used during 1988 to inflate Regina’s
revenues involved booking what Golden referred to as
“ship-in-place” sales. These items were sales orders that Regina
had received but not filled as of June 30, 1988. In fact, some
of the orders were not due to be shipped for several weeks
following Regina’s fiscal year-end. Golden recorded
approximately $6 million of ship-in-place sales in the last few
days of fiscal 1988. The SEC charged that the recording of these
sales blatantly violated generally accepted accounting
principles: “The ship-in-place transactions did not qualify for
revenue recognition under GAAP because no exchange had taken
place, the risks of loss and rights of ownership had not passed
from Regina to customers, and there was no substantial business
purpose for structuring the transactions as ship-in-place
transactions.” The last measure Sheelen and Golden used to
attain Regina’s earnings goal for 1988 was simply to understate
the company’s cost of goods sold for the fourth quarter by more
than $3 million.
In the late summer of 1988, Regina released its fiscal 1988
financial statements. Those statements reported net sales of
approximately $181 million and earnings per share of $1.21. In
Regina’s 1988 annual report, Sheelen boasted of the company’s
financial performance and suggested that the following year it
would produce even better operating results. (Exhibit 2 contains
excerpts from Sheelen’s 1988 letter to Regina’s stockholders.)
--Insert Exhibit 2--
On September 15, 1988, Sheelen told a group of financial
analysts that Regina would be reporting an increase in sales for
the first quarter of fiscal 1989. In fact, Sheelen knew that
Regina’s sales had declined during that quarter. Over the next
few days, Sheelen gradually realized that he could no longer
conceal Regina’s deteriorating financial condition. On September
20, 1988, he called Golden into his office. The two men decided
to reveal that Regina’s prior financial statements were
materially misstated. Instead of disclosing the true cause of
the inaccurate financial statements, Sheelen and Golden elected
to blame the errors on computer malfunctions.
After meeting with Golden, Sheelen issued a press release
reporting that Regina’s sales would be lower than previously
forecast for the first quarter of fiscal 1989. The press release
also indicated that the company would suffer a loss for that
quarter. Sheelen then notified Peat, Marwick, Mitchell &
Company, Regina’s audit firm, that the company’s 1988 financial
statements contained errors resulting from glitches in computer
processing. Sheelen asked the audit firm to review Regina’s
accounting records to determine the magnitude of the errors.
The price of Regina’s common stock plunged 60 percent by the
close of the financial markets on September 21, 1988, as
investors reacted to Sheelen's press release. Over the next few
days, Sheelen and Golden resigned their positions with Regina and
Peat Marwick withdrew the unqualified audit opinion issued
several weeks earlier on the company’s fiscal 1988 financial
statements. In early October, a U.S. attorney initiated a
criminal investigation of Regina’s financial affairs. During
that investigation, Sheelen voluntarily revealed the details of
the earnings manipulation schemes used to misrepresent Regina’s
1988 operating results.

Aftermath of the Regina Fraud

 Donald Sheelen and Vincent Golden pleaded guilty to federal
mail and securities fraud charges in February 1989. According to
the U.S. attorney who prosecuted the case, the fraudulent scheme
bilked investors of more than $100 million. When the company
filed for bankruptcy in 1989, its common stock became essentially
worthless. In July 1989, a competitor, Electrolux Corporation,
acquired Regina. An Israeli company purchased Regina in 1994 and
then sold it the following year to Philips Electronics, N.V., a
large Dutch firm. Regina ceased operating as a separate entity
after being acquired by Philips.
In May 1989, a federal judge sentenced Sheelen to a one-year
prison term, a sentence that he served in a halfway house. Golden
received a six-month sentence. The federal judge also fined both
men and placed them on probation; Sheelen paid a $25,000 fine,
while Golden was fined $12,500. According to the judge, the
lenient sentences were appropriate because both men had cooperated
with authorities investigating the scandal. Before beginning his
sentence, Sheelen contacted Regina’s new chairman and asked if he
could return to the company. The chairman reportedly responded
with a question of his own: "Are you _____ crazy?"5
 One charge leveled at Sheelen and Golden by the SEC was that
the former executives had repeatedly and intentionally misled the
company's audit firm, Peat Marwick. As an example, the SEC
pointed out that Peat Marwick auditors discovered one of the
ship-in-place sales transactions and notified Golden. Golden
assured the auditors that no similar transactions had been
recorded in Regina's accounting records. In the enforcement
release that focused on the Regina scandal, the SEC did not fault
Peat Marwick for failing to uncover the massive fraud
masterminded by Sheelen and Golden. Nevertheless, several
articles in the financial press criticized the audit firm. A
Peat Marwick partner responded to such criticism by noting that
"We're only human and prefer to trust the people we're
auditing."6

Exhibit 1
Regina Companys 1986-1988
Financial Statements

Regina Company, Inc.

Balance Sheets 1986-1988 (000s omitted)

June 30,
1988 1987 1986
Current assets:
Cash $ 885 $ 514 $ 63
Receivables (net) 51,076 27,801 14,402
Inventories 39,135 19,577 9,762
Other current assets 3,015 1,449 708
Total current assets 94,111 49,341 24,935

Property, plant and equipment 21,548 14,788 16,383

Other assets 2,481 1,112 1,884
 Total assets $118,140 $65,241 $43,202

Current liabilities:
Short-term borrowings $ -- $ -- $ 2,707
Current portion of long-term debt 1,250 900 --
Accounts payable 13,288 15,072 7,344
Accrued liabilities 4,710 5,468 3,127
Income taxes payable 3,782 2,619 1,554
Total current liabilities 23,030 24,059 14,732

Long-term debt:
Industrial revenue bonds 12,650 13,900 14,800
Mississippi state debt 1,975 -- --
Bank debt 47,432 5,941 --
Total long-term debt 62,057 19,841 14,800

Deferred income taxes 1,881 1,254 685

Stockholders’ equity:
Common stock 1 1 1
Additional paid-in capital 7,902 7,771 7,774
Retained earnings 23,269 12,315 5,210
Total stockholders’ equity 31,172 20,087 12,985
Total liabilities and
Stockholders’ equity $118,140 $65,241 $43,202
Exhibit 1, Cont’d

Regina Companys 1986-1988

Financial Statements

Regina Company, Inc.

Income Statements 1986-1988 (000s omitted)

Years Ended June 30,

1988 1987 1986
Net sales $181,123 $128,234 $76,144
Operating costs and expenses:
Cost of goods sold 94,934 70,756 46,213
Selling, distribution, and
administrative 21,870 14,621 10,366
Advertising 39,992 26,449 8,557
Research and development 2,423 1,530 1,182
Total operating costs and expenses 159,219 113,356 66,318
Operating income 21,904 14,878 9,826
Interest expense 3,189 1,584 1,930
Income before income taxes 18,715 13,294 7,896
Income tax expense 7,761 6,189 3,807
Net income $ 10,954 $ 7,105 $ 4,089

Earnings per share $1.21 $ .78 $ .46

Exhibit 2

Excerpts from Donald Sheelen’s 1988

Letter to Regina’s Stockholders

It feels real good to finish Fiscal 1988 and to be thankful that

your company achieved its best year ever. I’m sure you can see
by looking at the numbers that we have set records in both Sales
and Earnings. We are very proud of this, but we are also
especially proud of the consistency over the last eight years --
Fiscal 1988 was our eighth consecutive year of record Sales and
Earnings. . . .

I feel especially good about the significant change in Regina’s

product mix over the last four years. As early as 1984,
virtually 100% of earnings came from one line -- Electrikbroom.
Now, four years later, we have a broad base with five major lines
contributing to our growth. Regina has gone from being the
“runt” of the floorcare industry in the United States to being on
the verge of taking over the Number 1 spot. . . .

Every year when I look at what our Company has achieved, I ask
myself the question what about the future. I have always said to
you that there are no guarantees for the future, but my level of
confidence has never been greater than today. I feel this way
because the number of different programs/products that we are
bringing to the market have never been greater. There is no
question that we will probably make a few mistakes over the next
year -- we have in the past -- but I also believe that we will
set new records in all areas. By the time this report reaches
you, we should be on the verge of making public announcements
which we believe will very much enhance our growth.
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Questions

1. Prepare common-sized financial statements for Regina for the

period 1986 to 1988. Also, compute key liquidity, solvency,
activity, and profitability ratios for 1987 and 1988. Given
these data, identify what you believe were the high-risk
financial statement line items for the 1988 Regina audit.

2. Identify audit procedures that might have resulted in Peat

Marwick's discovering (a) the $5 million of bogus sales recorded
by Regina executives during fiscal 1988 and (b) the intentional
understatement of the company's sales returns for that same
period.

3. Identify and discuss the principal audit objectives

associated with the performance of year-end sales cutoff tests.
Which of the fraudulent errors in Regina’s accounting records
would such tests have likely uncovered? Explain.

4. Were the Peat Marwick auditors justified in relying on

Golden's assertion that the ship-in-place sales transaction they
discovered was an isolated item? If not, what additional audit
procedures do you believe Peat Marwick should have performed at
that point?

5. As noted in the case, one Peat Marwick partner stated that

his firm preferred “to trust the people we’re auditing.” Should
auditors trust their clients? If so, under what circumstances
and to what extent?
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Footnotes

1. J.A. Byrne, “How Don Sheelen Made a Mess That Regina Couldn’t
Clean Up,” Business Week, 12 February 1990, 46-50.

2. G.G. Marcal, “Regina Keeps Cleaning Up,” Business Week, 12

January 1987, 117.

3. Byrne, “How Don Sheelen Made a Mess,” 47.

4. This and all subsequent quotations, unless indicated

otherwise, were taken from Securities and Exchange Commission,
Accounting and Auditing Enforcement Release No. 215, 8 February
1989.

5. Byrne, “How Don Sheelen Made a Mess,” 50.

6. L. Berton, “Battle of the Books: Audit Firms Are Hit by More

Investor Suits for Not Finding Fraud,” The Wall Street Journal,
24 January 1989, A1, A12.