Crazy Eddie, Inc.

Case 1.6
 Crazy Eddie Facts
 High school drop out at age sixteen. Began his career by peddlimg TVsets in
his Brooklyn neighborhood.
 Famous for his “crazy” sales tactics and advertisements. Sometimes he would
lock the door until the customer bought an item. His TV and radio ads were
memorable as well as annoying.
 Most distinctive trait was his inability to trust anyone outside his large extended
family; evidenced by their appointment as officers of his company.
 In the early 1980s, sales of electronics exploded. Crazy Eddie had seven distinct
product lines by 1987.
 In 1984, Crazy Eddie went public. It took the underwriting firm more than a
year to publicly offer the stock as they found the company’s financial records to
be in disarray (extensive related party transactions, interest-free loans to
employees, highly speculative investments, and numerous family member
executives).
 Crazy Eddie Facts, cont’d
 Once public, Antar strived to convince the world that his firm was financially strong
and well managed. His efforts worked as analysts from prominent investment firms
wrote glowing reports regarding Crazy Eddie’s management team and the company’s
bright prospects for the future.
 In 1986, Antar resigned as company president after realizing more than $50 M on the
sale of Crazy Eddie stock. In his absence, the company’s financial condition
worsened rapidly.
 Shortly after a hostile takeover in November 1987, a physical inventory count
revealed a $65 M shortage of inventory that equaled the total profits reported by
Crazy Eddie since going public in 1984.
 What were Antar’s tactics for accounting irregularities? He required subordinates to
book false entries (sales and inventory that didn’t exist) and prepare inventory count
sheets for items that did not exist.
 Four different accounting firms audited Crazy Eddie’s financial statements over its
turbulent history.
 Crazy Eddie Facts, cont’d
 Main Hurdman supposedly “lowballed” to obtain the Crazy Eddie audit. The
accounting firm’s objectivity was questioned as it audited the inventory
system that it developed itself. Their independence was questioned because
many of Crazy Eddie’s accountants were former members of that accounting
firm.
 During court cases, it was revealed that Antar and his associates engaged in a
large-scale plan to deceive the auditors (collusion). They destroyed
incriminating physical documents to conceal inventory shortages; stopped
using the sophisticated, computer based inventory system and returned to the
old manual system to make it more difficult to find irregularities; and shipped
inventory from store to store just before they were to have inventory counts.
 When finally caught in May 1994, Antar was sentenced to 12 years in prison
and ordered to pay restitution of $121 M to former stockholders and creditors.
Financial Analysis and Red Flags
Student 1
 Cra zy Ed die, I nc.
Common Size Balance Sheet
Consolidated
(000's omitted)

% of total assets % of total assets % of total assets % of total assets

March 1, 1987 March 2, 1986 March 3, 1985 May 31, 1984
Current assets
Cash $ 3% 10% 34% 4%
Short-term investments 41% 21% - -
Receivables 4% 2% 4% 7%
Merchandise inventories 37% 47% 41% 64%
Prepaid expenses 4% 2% 1% 1%
Total current assets $ 89% 82% 80% 76%
Restricted cash - 3% 11% -
Due from affiliates - - - 16%
Property, plant and equipment 9% 6% 6% 5%
Construction in process - 5% 2% -
Other assets 2% 4% 2% 3%
Total assets $ 100% 100% 100% 100%

Current liabilities
Accounts payable $ 17% 41% 35% 55%
Notes payable - - - 8%
Short-term debt 17% 2% 1% 0%
Unearned revenue 1% 3% 2% 2%
Accrued expenses 2% 13% 13% 17%
Total current liabilities $ 37% 59% 51% 82%
Long-term debt 3% 6% 12% 0%
Convertible subordinated debentures 27% - - -
Unearned revenue 1% 1% 1% 1%
Stockholder's equity
Common stock 0% 0% 0% 0%
Additional paid-in capital 20% 14% 19% 2%
Retained earnings 12% 19% 17% 15%
Total stockholder's equity $ 32% 34% 36% 17%
Total liabilities and
stockholder's equity $ 100% 100% 100% 100%
 Crazy Eddie, I nc.
Common Size Income Statement
Consolidated
(000's omitted)

% of net sales % of net sales % of net sales % of net sales

March 1, 1987 March 2, 1986 March 3 1985 May 31, 1984

Net sales $ 100.0% 100.0% 100.0% 100.0%

Cost of goods sold (77.2%) (74.1%) (75.9%) (77.9%)
Gross profit $ 22.8% 25.9% 24.1% 22.1%
Selling, general and (17.4%) (16.4%) (15.0%) (16.4%)
administrative expense
Interest and other income 2.1% 1.2% 0.9% 0.5%
Interest expense (1.5%) (.3%) (0.3%) (0.4%)
Income before taxes 6.0% 10.4% 9.7% 5.8%
Pension contribution (.1%) (.3%) (0.4%) -
Income taxes (2.8%) (5.1%) 4.9% (3.1%)
Net income $ 3.0% 5.0% 4.3% 2.7%
 Cra zy Eddi e, I nc.
Analytical Review: Balance Sheet
Year Ended March 1, 1987
(000's omitted)

March 1, 1987 March 2, 1986 $ Change % Change

Current assets
Cash $ 9,347 13,296 (3,949) -29.7%
Short-term investments 121,957 26,840 95,117 354.4%
Receivables 10,846 2,246 8,600 382.9%
Merchandise inventories 109,072 59,864 49,208 82.2%
Prepaid expenses 10,639 2,363 8,276 350.2%
Total current assets $ 261,861 104,609 157,252 150.3%
Restricted cash - 3,356 (3,356) -100.0%
Due from affiliates - - - -
Property, plant and equipment 26,401 7,172 19,229 268.1%
Construction in process - 6,253 (6,253) -100.0%
Other assets 6,596 5,560 1,036 18.6%
Total assets $ 294,858 126,950 167,908 132.3%

Current liabilities
Accounts payable $ 50,022 51,723 (1,701) -3.3%
Notes payable - - - -
Short-term debt 49,571 2,254 47,317 2099.2%
Unearned revenue 3,641 3,696 (55) -1.5%
Accrued expenses 5,593 17,126 (11,533) -67.3%
Total current liabilities $ 108,827 74,799 34,028 45.5%
Long-term debt 8,459 7,701 758 9.8%
Convertible subordinated debentures 80,975 - 80,975 100.0%
Unearned revenue 3,337 1,829 1,508 82.4%
Stockholder's equity
Common stock 313 280 33 11.8%
Additional paid-in capital 57,678 17,668 40,010 226.5%
Retained earnings 35,269 24,673 10,596 42.9%
Total stockholder's equity $ 93,260 42,621 50,639 118.8%
Total liabilities and
stockholder's equity $ 294,858 126,950 167,908 132.3%
 Cra zy Edd i e, I nc.
Analytical Review: Balance Sheet
Year Ended March 2, 1986
(000's omitted)

March 2, 1986 March 3, 1985 $ Change % Change

Current assets
Cash $ 13,296 22,273 (8,977) -40.3%
Short-term investments 26,840 - 26,840 100.0%
Receivables 2,246 2,740 (494) -18.0%
Merchandise inventories 59,864 26,543 33,321 125.5%
Prepaid expenses 2,363 645 1,718 266.4%
Total current assets $ 104,609 52,201 52,408 100.4%
Restricted cash 3,356 7,058 (3,702) -52.5%
Due from affiliates - - - -
Property, plant and equipment 7,172 3,696 3,476 94.0%
Construction in process 6,253 1,154 5,099 441.9%
Other assets 5,560 1,419 4,141 291.8%
Total assets $ 126,950 65,528 61,422 93.7%

Current liabilities
Accounts payable $ 51,723 23,078 28,645 124.1%
Notes payable - - - -
Short-term debt 2,254 423 1,831 432.9%
Unearned revenue 3,696 1,173 2,523 215.1%
Accrued expenses 17,126 8,733 8,393 96.1%
Total current liabilities $ 74,799 33,407 41,392 123.9%
Long-term debt 7,701 7,625 76 1.0%
Convertible subordinated debentures - - - -
Unearned revenue 1,829 635 1,194 188.0%
Stockholder's equity
Common stock 280 134 146 109.0%
Additional paid-in capital 17,668 12,298 5,370 43.7%
Retained earnings 24,673 11,429 13,244 115.9%
Total stockholder's equity $ 42,621 23,861 18,760 78.6%
Total liabilities and
stockholder's equity $ 126,950 65,528 61,422 93.7%
 Cra zy Edd i e, I nc.
Analytical Review: Balance Sheet
Year Ended March 3, 1985
(000's omitted)

March 3, 1985 May 31, 1984 $ Change % Change

Current assets
Cash $ 22,273 1,375 20,898 1519.9%
Short-term investments - - 26,840 100.0%
Receivables 2,740 2,604 136 5.2%
Merchandise inventories 26,543 23,343 3,200 13.7%
Prepaid expenses 645 514 131 25.5%
Total current assets $ 52,201 27,836 24,365 87.5%
Restricted cash 7,058 - 7,058 100.0%
Due from affiliates - 5,739 (5,739) -100.0%
Property, plant and equipment 3,696 1,845 1,851 100.3%
Construction in process 1,154 - 1,154 100.0%
Other assets 1,419 1,149 270 23.5%
Total assets $ 65,528 36,569 28,959 79.2%

Current liabilities
Accounts payable $ 23,078 20,106 2,972 14.8%
Notes payable - 2,900 (2,900) -100.0%
Short-term debt 423 124 299 241.1%
Unearned revenue 1,173 764 409 53.5%
Accrued expenses 8,733 6,078 2,655 43.7%
Total current liabilities $ 33,407 29,972 3,435 11.5%
Long-term debt 7,625 46 7,579 16476.1%
Convertible subordinated debentures - - - -
Unearned revenue 635 327 308 94.2%
Stockholder's equity
Common stock 134 50 84 168.0%
Additional paid-in capital 12,298 574 11,724 2042.5%
Retained earnings 11,429 5,600 5,829 104.1%
Total stockholder's equity $ 23,861 6,224 17,637 283.4%
Total liabilities and
stockholder's equity $ 65,528 36,569 28,959 79.2%
 Crazy Eddie, I nc.
Analytical Review: Income Statement
Year Ended March 1, 1987
(000's omitted)

March 1, 1987 March 2, 1986 $ Change % Change

Net sales $ 352,523 262,268 90,255 34.4%

Cost of goods sold (272,255) (194,371) (77,884) 40.1%
Gross profit $ 80,268 67,897 12,371 18.2%
Selling, general and (61,341) (42,975) (18,366) 42.7%
administrative expense
Interest and other income 7,403 3,210 4,193 130.6%
Interest expense (5,233) (820) (4,413) 538.2%
Income before taxes 21,097 27,312 (6,215) -22.8%
Pension contribution (500) (800) 300 -37.5%
Income taxes (10,001) (13,268) 3,267 -24.6%
Net income $ 10,596 13,244 (2,648) -20.0%
 Crazy Eddie, I nc.
Analytical Review: Income Statement
Year Ended March 2, 1986
(000's omitted)

March 2, 1986 March 3, 1985 $ Change % Change

Net sales $ 262,268 136,319 125,949 92.4%

Cost of goods sold (194,371) (103,421) (90,950) 87.9%
Gross profit $ 67,897 32,898 34,999 106.4%
Selling, general and (42,975) (20,508) (22,467) 109.6%
administrative expense
Interest and other income 3,210 1,211 1,999 165.1%
Interest expense (820) (438) (382) 87.2%
Income before taxes 27,312 13,163 14,149 107.5%
Pension contribution (800) (600) (200) 33.3%
Income taxes (13,268) (6,734) (6,534) 97.0%
Net income $ 13,244 5,829 7,415 127.2%
 Crazy Eddie, I nc.
Analytical Review: Income Statement
Year Ended March 3, 1985
(000's omitted)

March 3, 1985 May 31, 1984 $ Change % Change

Net sales $ 136,319 137,285 (966) -0.7%

Cost of goods sold (103,421) (106,934) 3,513 -3.3%
Gross profit $ 32,898 30,351 2,547 8.4%
Selling, general and (20,508) (22,560) 2,052 -9.1%
administrative expense
Interest and other income 1,211 706 505 71.5%
Interest expense (438) (522) 84 -16.1%
Income before taxes 13,163 7,975 5,188 65.1%
Pension contribution (600) - (600) 100.0%
Income taxes (6,734) (4,202) (2,532) 60.3%
Net income $ 5,829 3,773 2,056 54.5%
 Red Flags: Financial
 Current Ratio is going up. Inventory represents half of total assets and
since inventory is volatile, then that ratio should be questioned further.
 Inventory Turnover is getting slower. Since sales are going up, you’d
assume inventory would be turning over faster.
 Consider the electronics industry: you would assume that the goods
would turnover more often than 4 months (113 days).
 Accounts Receivable Turnover: every 7 days? Seems odd…
 Gross margin and Profit margin going down, but sales going up…
something is fishy.
 Sales went from -7% to +92% to +34%. Very volatile.
 Red Flags: Nonfinancial
 Integrity of Antar: high school dropout; began business by pedalling
TVs in his Brooklyn neighborhood
 Related Parties: large number of the company’s officers were family
members
 Switched auditors four times
 Crazy Eddie’s accountants were former employees of their auditing
firm (Main Hurdman)
Irregularities
Student 2
 Irregularities
 Falsification of inventory count sheets
– Analytical procedures
 Inventory turnover ratio [113 days -’87 v. 162 in’86]

 Age of Inventory [112 days - ‘87 v. 80 in ‘86]

 Compare actual v. budget

 Compare client to industry

 Review nonfinancial and outside information

 Trace to supporting documentation

 Irregularities ,cont’d
– Physical Inventory (GAAS - AU 331)
 Appropriate instructions

 Cut off procedures

 Trace tags to physical counts

 Vouch inventory to accounts payable

 Inquire about consigned goods

 Note any obsolete inventory

– Cutoff
 Irregularities, cont’d
 Bogus Debit Memos for Accounts Payable
– Analytical procedures
 Scan detail for debit memos

 Compare with prior years and industry

 Inquire as to nature

– Trace to supporting documentation

– Statistical sampling (SAS 39)
 Recording of transshipping transactions as retail sales
– Valuation
 Compare recorded costs to current vendor costs

 Review related party transactions

– Cutoff
 Irregularities, cont’d
 Inclusion of consigned goods in inventory
– Physical observation
 Inquire with client personnel

– Review correspondence
 Possible confirmation (SAS 67)

– Evaluate sales and receivable records

 Vouch purchases to detect unrecognized consigned

goods
Changing Industry and Lowballing

Student 3
 Retail Consumer Electronics Industry
 During the early 1980s, the electronics industry was undergoing
dramatic changes.
 How do the changes within an industry affect audit planning
decisions?
– The primary concern involves the increased inherent risk of the audit.
In this particular case, the electronics industry introduces the possibility
of inventory obsolescence. The correct response to these demands
would be different staffing of the audit team. For instance, the audit team
may consist of several seniors and managers rather than the typical team,
which includes staff accountants and seniors.
– In addition, audit planning involves developing an overall strategy for the
expected conduct and scope of the audit. (AU 311).
Discussion of Audit Planning (cont’d)

– Moreover, the audit planning varies with the size and complexity of the
entity, experience with the entity, and knowledge of the entity’s business.
 The auditor should obtain a level of knowledge of the entity’s business
that will enable him to plan and perform his audit in accordance with
GAAS. That level of knowledge should enable him to obtain an
understanding of the events, transactions, and practices that may have
a significant effect on the financial statements . The knowledge helps
the auditor identify areas that need special consideration; assess
conditions under which accounting data are produced, processed,
reviewed, and accumulated; evaluate the reasonableness of estimates;
and make judgments about the appropriateness of accounting
principles.
Discussion of Audit Planning (cont’d)
 The auditor should also obtain a knowledge of matters that relate
to the nature of the entity’s business, its organization, and operating
characteristics. These matters include types of business; types
of products and services; capital structure; related parties;
locations; and production, distribution, and compensation methods.
Additional consideration should be given to the economic conditions,
gov’t regulations and changes in technology.
 That knowledge is ordinarily obtained through experience with the entity
or industry and inquiry of personnel of the entity. Working papers from
prior years may provide some additional insight about the entity and
its industry. Other sources that the auditor may consult include AICPA
accounting and auditing guides, industry publications, F/S of other
entities in the industry, textbooks, periodicals, and individuals with
knowledge of the industry (specialists).
 The Importance of Understanding the Clients Industry

 In the case of Crazy Eddie, Inc., understanding the clients industry was
of utmost importance in detecting errors and misstatements in the financial
statements.
 More specifically, the inventory account should have been examined carefully
due to the nature of technology and the potential for obsolete inventory.
 In addition, a closer look into the transactions of Crazy Eddie, Inc. may have
potentially uncovered some of the problems with the inventory account.
For instance, the practice of buying electronics at wholesale prices and
selling them for just below retail to competitors does not seem to be a
normal industry practice for a retail electronics dealer.
 Furthermore, the examination of Crazy Eddie’s distribution methods may have
uncovered the stockpiling of inventory scheme that enabled the corporation to
overstate the inventory balance by $65 million.
 Another factor involves the hiring of family members to run the corporation,
which was experiencing a period of phenomenal growth.
 Lowballing and Its Effects on Audits

 Lowballing (quasi rents) is a practice

utilized by auditors, whereby the
auditing firm bids for an audit at a
price below its cost.
120
 In other words, the firm is charging 100
a fee below the marginal cost of the 80
audit. 60
Rev
Cost
 The primary reason that auditors 40

20
employ this practice is to ensure that 0

receive and retain a client base. 1 2 3 4 5 6 7 8 9 10

 The theory is that the initial loss will be

recovered in future years when the
audit costs remain constant while
audit fees increase.
The Effect of Lowballing on Independent Audit Services

 Critics of the auditing profession often allege that the practice of

lowballing creates a potential incentive to auditors to reduce the
quality of the audit.
 This contention states that auditors will make concessions
(about accounting treatment) to their clients in order to retain
the client in future engagements.
 As a result, many studies have been conducted on this relatively
new issue. However, no definitive answer has been reached
about this contention.
Audit Sampling and Independence

Student 4
 Audit Sampling

 Question #5 You test the year-end inventory cutoff procedures,

and 10 out of 30 invoices are missing. What course of action
would be appropriate?
 Find this to be material, since 10 missing invoices constitutes one
third of the sample
 Ask questions to the individuals involved with the transactions
– Trace receiveing report to related purchase voucher
 Get in touch with the customers involved with the transactions for
independent verification
 Report to the senior manager your findings
 AU Section 331- “Inventories”
 Independence

 Question # 6 What are the pros and cons of hiring individuals

who have formerly served as a company’s independent auditor?
 Cons
– Independence becomes questionable
– Ability to objectively audit the company becomes
questionable
– Critics say “A company that hires one of its former auditor
can more easily conceal fraudulent activities during the
course of audits”
– AU Section 220 Independence
– ET Section 102 Integrity and Objectivity
 Independence, cont’d
 Pros
– Big accounting firms encourage their personnel to work for
clients in the apparent belief that it helps cement the
accountant-client relationship
– The former independent auditor would have a greater
understanding and greater knowledge of the business and
how it functions
– AU Section 8310 Knowledge of the Business
Related Academic Research
 Additional
comments/Information
Questions?