PRINCIPLES OF FRAUD EXAMINATION

Chapter 12: Fraudulent Financial Statement Schemes

Case Study: Rite Aid

Case Narrative
When the first Rite Aid Drugstore opened its doors in Scranton, Pennsylvania in 1962, founder
Alex Grass had every hope and aspiration for his business venture to be highly successful.
Today, as the third largest drugstore chain in the United States, Rite Aid boasts 75,000
employees and 3,600 stores in 30 states. While such statistics appear promising, Rite Aid
continues to suffer from the effects of one of the largest financial frauds in recent history.

The problem began when the Alex Grass passed on the title of Rite Aid CEO to his son Martin.
Known for his shrewd and yet questionable business strategies, Martin began a rapid corporate
expansion which was accompanied by large trails of debt. Facing pressure from Rite Aid’s
major investors, who desired improved stock performance, Martin Grass used his CEO position
to issue forth an era plagued by financial statement fraud, corruption, and collusion among
senior management officials.

According to Wayne M. Carlin, Regional Director of the Securities and Exchange

Commission’s (SEC) Northwest Regional Office, “Rite Aid’s former senior management
employed an extensive bag of tricks to manipulate the company’s reported earnings and defraud
its investors.” In its report, the SEC charged Grass, former CFO Frank Berganzi, and former
Vice-Chairman Franklin Brown with using a variety of financial statement fraud schemes to
overstate quarterly income (earnings) for two years. The schemes included concealing liabilities
and expenses, booking fictitious revenues, improper asset valuations, and timing differences.

The corporation, for example, did not record the expenses for Stock Appreciation Rights (SAR)
it provided to employees. Accrued SAR expenses of $22 million and $33 million were absent
from the financial statements in the two years in question. The SEC’s investigation documented
that former CFO Berganzi lied to external auditors about the SAR’s ever having existed.

In another effort to conceal expenses, Berganzi took advantage of the accounting department by
instructing staff to make false adjusting entries to reduce liability (accounts payable) and
expense accounts (cost of goods sold). The result of this single scheme caused a $100 million
overstatement of pre-tax income for the second quarter of the second year. Berganzi even had
accounting staff reverse actual expenses already paid in order to overstate income during certain
quarters. The expenses were moved to the following quarter to produce timing differences,
which led to a $9 million overstatement of income during the second quarter of the first year.

Rite Aid further overstated income by deceiving its vendors. Most vendors have agreements
with customers that permit the customers to deduct defected and outdated products from future
payments. The SEC charged that Rite Aid took advantage of this agreement by claiming 50%
more damaged goods than actually existed, eventually leading to the overstatement of the first
fiscal year’s pre-tax income by $30 million. According to the SEC’s investigation, “Grass and
Berganzi both permitted the practice to continue even after other Rite Aid personnel had raised
with them the question of whether the practice was proper” (SEC Report). During the second
year, Berganzi again instructed accounting staff to make false entries in order to record fictitious
credits in the form of vendor rebates. Cost of goods sold and accounts payable were reduced by
This case study was contributed by Alberto Garza. It is based on the June 22, 2002, Baltimore Sun article entitled
“Portrait of deceit at Rite Aid”; the June 17, 2003, Forbes article entitled “Rite Aid ex-CEO Grass: I’m guilty”
and the June 21, 2002, SEC Investigation Report on Rite Aid.
 PRINCIPLES OF FRAUD EXAMINATION

Chapter 12: Fraudulent Financial Statement Schemes

Case Study: Rite Aid

$42 million. Fictitious revenue in the amount of $17 million was also recognized in the second
year as income from a litigation settlement that had not yet been settled and made official.

Rite Aid officials further added improper asset valuations to the long list of fraud schemes by
wrongly capitalizing “dead deal” expenses (expenses for planning possible locations of stores
which were later rejected) instead of immediately expensing them as required under GAAP.
Staff recorded $10.6 million in such expenses during the second year.

Other schemes employed by Grass and his senior level accomplices blended elements of
financial statement fraud with corruption, specifically conflicts of interest. Grass used his
authority to prevent Rite Aid from properly disclosing related party transactions he had actually
initiated. One such transaction included the wiring of $2.6 million of company money to a
partnership owned by Grass and his brother-in-law. The funds were used to purchase 83 acres
of land and to pay off personal debts. Desperate to feign Rite Aid’s stability, Grass also
fabricated minutes for a finance committee meeting that never occurred. The minutes were used
to authorize a pledge of stock as collateral in a company. The only authorization needed to
make the minutes official was Grass’s signature.

During the fourth quarter of the second year, Rite Aid’s investors finally voted to remove Grass
from his position after numerous allegations arose from other current and former employees
regarding fraudulent business practices. Berganzi and Brown also left by the end of that year.
Unfortunately for Rite Aid, the full ramifications of Grass’s schemes would not be realized until
the next July. By that time, Rite Aid had acquired new management and had switched external
auditors. A financial statement audit revealed that Rite Aid had to retroactively lower net
income by $1.6 billion, “the largest restatement ever by a public company” at the time (SEC
Report). An SEC investigation was immediately launched, leading to the indictment of Grass,
Berganzi, and Brown by a federal grand jury. The investigation also revealed that even after he
stepped down as CEO, Grass signed and backdated letters on Rite Aid letterhead granting key
employees enhanced benefit packages. Exactly one year later, all three men pleaded guilty to
fraud and conspiracy among other charges. As a part of plea bargain, Grass faces up to 96
months in prison, a $500,000 fine and must forfeit $3 million. He also faces up to three years of
supervised probation.

Q1: Please summarize the case background.

Perpetrator: Alex Grass former CEO, former CFO Frank Berganzi, and former Vice-Chairman
Franklin Brown
Victim organization: Rite Aid and its investor
Legal outcome: removed from positions, jail sentences, fines, forfeit millions in bonuses
Total losses: decline in stock prices for shareholders, had to lower net income by $1.6 billion

Q2: Please categorize & explain fraud schemes perpetrated in this case.

This case study was contributed by Alberto Garza. It is based on the June 22, 2002, Baltimore Sun article entitled
“Portrait of deceit at Rite Aid”; the June 17, 2003, Forbes article entitled “Rite Aid ex-CEO Grass: I’m guilty”
and the June 21, 2002, SEC Investigation Report on Rite Aid.
 PRINCIPLES OF FRAUD EXAMINATION

Chapter 12: Fraudulent Financial Statement Schemes

Case Study: Rite Aid

- Financial statement fraud:

o False adjusting entries
o Fictitious revenues: Fictitious revenue in the amount of $17 million was also
recognized in the second year as income from a litigation settlement that had not
yet been settled and made official.
o Improper asset valuation: applies to timing diff too
o Timing differences: Berganzi even had accounting staff reverse actual expenses
already paid in order to overstate income during certain quarters. The expenses
were moved to the following quarter to produce timing differences, which led to
a $9 million overstatement of income during the second quarter of the first year
o Concealed liabilities and expenses:
 wrongly capitalizing “dead deal” expenses (expenses for planning
possible locations of stores which were later rejected) instead of
immediately expensing them as required under GAAP. Staff recorded
$10.6 million in such expenses during the second year.
 Berganzi even had accounting staff reverse actual expenses already paid
in order to overstate income during certain quarters. The expenses were
moved to the following quarter to produce timing differences, which led
to a $9 million overstatement of income during the second quarter of the
first year
o Payroll fraud/ bribery: Grass signed and backdated letters on Rite Aid letterhead
granting key employees enhanced benefit packages

Q3: Please recommend & explain prevention & detection measures that would be effective in
this case.

This case study was contributed by Alberto Garza. It is based on the June 22, 2002, Baltimore Sun article entitled
“Portrait of deceit at Rite Aid”; the June 17, 2003, Forbes article entitled “Rite Aid ex-CEO Grass: I’m guilty”
and the June 21, 2002, SEC Investigation Report on Rite Aid.