Reference no: EM131046745

ZZZZ Best - How to Fool the Auditors

Story ZZZZ Best began operations in the fall of 1982 as a door-to-door carpet cleaning business operating out of the Reseda, California, the garage of 16-year-old Barry Minkow. In the threeyear period from 1984 to 1987, net income grew from less then $200,000 to more than $5 million on revenue of $50 million. In the spring of 1987, ZZZZ Best had a market value of $200 million. By the end of 1987 the company was in bankruptcy and the assets were auctioned off for only $64,000 (Knapp 2004). The company for almost its entire history was a fraud. ZZZZ Best had a legitimate carpet-cleaning business that accounted for 20 percent of reported revenue and a phony building restoration business which was 80 percent of revenue. To create loans for the company, ZZZZ Best management made fraudulent invoices, set up checking accounts for front companies, created fraudulent vendors, wrote checks for phony expenses, and kept the money circulating by check kiting at several banks. (Knapp 2004)

False Documents

Thousands of company checks in the company written by hand, in large numbers, and often payable to cash were made out to different people or firms but paid into the same account. The same money-obtained from ZZZZ Best investors and lenders kept going around and around from ZZZZ Best to phony vendors and customers and back to ZZZZ Best The purpose of all these movement was to make ZZZZ Best look like a legitimate business. (Akst & Berton 1988) "Accounts receivable are a wonderful thing," Barry Minkow said, "They are a tool used by a fraudster like me to ask to borrow money and to show earnings." (ACFE 2002) He would create an invoice from a phony customer, write a check to ZZZZ Best from the front company's checking account, and deposit it to the company account. "One way you cannot dispute a receivable is if it has been paid ... I was a paperwork manufacturing machine," he said. (ACFE 2002)

Convincing the Auditors

To avoid the auditors finding anything, Minkow employed a number of tricks besides false documentation. He steered the auditors to examine the legitimate carpet cleaning business instead of the non-existent building restoration business. "The restoration business was 80 percent of the revenue, but I made sure that the auditors did 80 percent of due diligence in the carpet cleaning business," he said. He also intimidated the auditors, ingratiated himself to the auditors, and in one instance created a completely false audit environment. Auditing is a very competitive business. "Competition is what you leverage," Minkow said. "I can't remember how many times [I said] "Larry, I just know Coopers and Lybrand would love this account." Does he want to go back to his clients and managers and say that he lost the ZZZZ Best account because he wanted to be petty?" No, he does not want to lose the ZZZZ Best account, "and I leveraged that to the hilt, too." (ACFE 2002) Minkow's charm and entrepreneurial spirit caused the media to tout him as an example of what America's youth could obtain if they applied themselves. As a guest on the The Oprah Winfrey Show on US network television in April 1987 he encouraged his peers to adopt his personal motto, "The sky is the limit." (Knapp 2004) He ingratiated himself by having dinner with the auditors and their wives. He felt that if the wives like him and the auditor wanted to be hard on Minkow, the wives would say, "but he is such a nice kid." Minkow said, "The final touch was ‘Well, the kid is on Wall Street. If there was something wrong, someone would have found out by now.' " (ACFE 2002)

Classic Tricks

Minkow's tricks to mislead the accountants doing audit procedures are classic. They included phony confirmations, financial statements manipulated to reflect industry standards, false documentation and, in one instance, creation of an entire false audit environment. Minkow paid an insurance claims adjuster from a legitimate company to confirm over the telephone to banks and any other interested third parties that ZZZZ Best was the recipient of insurance restoration contracts. ZZZZ Best's first external auditor, George Greenspan, maintained that he performed analytical procedures comparing the company to the industry, confirmed the existence of contracts, and obtained and reviewed copies of key documents. Greenspan, however, did not inspect any restoration sites. (US Congress 1988) Ernst & Whinney (E&W) took over as ZZZZ Best's auditor in 1986. E&W repeatedly insisted on visiting several of the largest of the contract sites, so that finally Minkow agreed to a visit. E&W wanted to visit a large site in Sacramento, California for which ZZZZ Best claimed to have a multi-million dollar contract. Minkow sent two associates to Sacramento to find a large building under construction or renovation that would be a plausible site for a restoration contract. Posing as leasing agents, they convinced the supervisor of the construction site to provide keys to the building one weekend on the pretext that a possible future tenant wanted to tour the building. Before E&W visited the site, placards were placed on the walls indicating that ZZZZ Best was the contractor for building renovation. The building's security officer was paid to greet the visitors and demonstrate that he was aware in advance of the auditor's visit. (US Congress 1988) Another site visit by E&W required that ZZZZ Best lease a partially completed building and hire subcontractors to do a large amount of work on the site. In total ZZZZ Best spent several million dollars just to deceive its auditors. (US Congress 1988) ZZZZ Best required that E&W sign a confidentiality agreement before the visits were made on the pretext that that the insurance company required it. The agreement required that E&W not disclose the location of the building and not "make any follow-up telephone calls to any contractors, insurance companies, building owner or other individuals." (Knapp 2004)

Discussion Questions

¦ What procedures should an auditor carry out to determine the validity of a significant source of company revenue?

¦ What actions of Minkow and the company's audit history would have caused an auditor to become suspicious?

¦ How does signing a confidentiality agreement affect auditor substantive procedures?