Question

The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year-old boy from Reseda, California, who was driven to be successful, regardless of the costs. His name is Barry Minkow. Although this case dates back over 30 years, it does serve as an example of what can happen when auditors do not look too hard to find fraud.

Minkow had high hopes to make it big—to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets, but that he could in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Because the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done, and perhaps not be all that concerned with how much it would cost. The only problem with Minkow’s insurance restoration idea was that it was all a fiction. Allegedly, over 80 percent of his revenue was from this work. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst & Whinney (now EY), into thinking the insurance restoration business was real. The auditors never caught on until it was too late.

How Barry Became a Fraudster

Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback, that provides some insights into the mind of a 15-year-old kid who was called a “wonder boy” on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in his garage-office, Minkow called Channel 4 in Los Angeles. He disguised his voice so he wouldn’t sound like a teenager and told a producer that he had just had his carpets cleaned by the 16-year-old owner of ZZZZ Best. He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business. The producer bought it lock, stock, and carpet cleaner. Minkow gave the producer the phone number of ZZZZ Best and waited. It took less than five minutes for the call to come in. Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said, “Who may I say is calling?” Within days, a film crew was in his garage shooting ZZZZ Best at work. The story aired that night, and it was followed by more calls from radio stations and other television shows wanting to do interviews. The calls flooded in with customers demanding that Barry Minkow personally clean their carpets.

As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking account. He managed to find a banker that was so moved by his story that the banker agreed to allow an underage customer to open a checking account. Minkow used the money to buy cleaning supplies and other necessities. Even though his business was growing, Minkow ran into trouble paying back loans and interest when due.

Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage—where all his great ideas first began—and looked at his bank account statement, which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers, so they didn’t yet show up on the bank statement. Voilá! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best account on the last day of the reporting period and deposit it into another. The check wouldn't clear Bank # 1 for at least one day so he could count the cash in both accounts (back then, checks weren’t always processed in real time the way they are today).

It wasn’t long thereafter that Minkow realized he could kite checks big time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in Bank #1 and carry it onto the balance sheet. Because Minkow did not count the check written on his account in Bank #1 as an outstanding check, he was able to double-count.

Time to Expand the Fraud

Over time, Minkow moved on to bigger and bigger frauds, like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs. Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best. He had cash remittance forms made up from nonexistent customers with whatever sales amount he wanted to appear on the document. He even had a co-conspirator write on the bogus remittance form, “Job well done.” Minkow could then show a lot more revenue than he was really making.

Minkow’s phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets. However, Minkow’s personal tastes had become increasingly more expensive, including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000-square-foot home. So, the question was: How do you solve a perpetual cash flow problem? You go public! That’s right, Minkow made a public offering of stock in ZZZZ Best. Of course, he owned a majority of the stock to maintain control of the company.

Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, CPAs, and attorneys all working for him—the now 19-year-old kid from Reseda, California, who had turned a mom-and-pop operation into a publicly owned corporation.

Barry Goes Public

Pressured to get a big-time CPA firm to do his audit by the underwriting firm selling his stock, Minkow hired Ernst & Whinney to perform the April 30, 1987, fiscal year-end audit. Minkow continued to be one step ahead of the auditors—that is, until the Ernst & Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business—all the revenue—that Minkow had said was coming in to ZZZZ Best was real.

The engagement partner drove to an area in Sacramento, California, where Minkow did a lot of work—supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn’t clear, but he identified a building that seemed to be the kind that would be a restoration job in progress.

Earlier in the week, Minkow had sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it, Minkow’s associate picked out the same site as had the partner later on. Minkow’s cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend. Minkow’s helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time, but it looked as if some restoration work was going on at the site.

Minkow was able to pull it off in part due to luck and in part because the Ernst & Whinney auditors did not want to lose the ZZZZ Best account. It had become a large revenue producer for the firm, and Minkow seemed destined for greater and greater achievements. Minkow was smart and used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they became too curious about the insurance restoration jobs. He would even threaten to take his business from Ernst & Whinney and give it to other auditors. To get on their good side, he would wine and dine the auditors and even invite them to his house.

Minkow also took a precaution with the site visit. He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work. This prevented the auditors from corroborating the insurance restoration contracts with independent third parties.

The Fraud Starts to Unravel

It was a Los Angeles housewife who started the problems for ZZZZ Best that would eventually lead to the company’s demise. Because Minkow was a well-known figure and flamboyant character, the Los Angeles Times did a story about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for its carpet cleaning services.

Minkow had gambled that most people don’t check their monthly statements, so he could get away with the petty fraud. However, the housewife did notice the overcharge and complained to Minkow, and eventually he returned the overpayment. She couldn’t understand why Minkow would have had to resort to such low levels back then if he was as successful as the Times article made him out to be. So she called the reporter to find out more, and that ultimately led to the investigation of ZZZZ Best and future stories that weren’t so flattering.

Because Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money. It got so bad over time that he was close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn’t pay his suppliers. The complaints kept coming in, and eventually the house of cards that was ZZZZ Best came crashing down.

During the time that the fraud was unraveling, Ernst & Whinney decided to resign from the ZZZZ Best audit. It had started to doubt the veracity of Minkow and his business at ZZZZ Best. Of course, by then it mattered little because the firm had been a party to the cover-up for some time.

Legal Liability Issues

The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst & Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report issued by Ernst & Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report because Ernst & Whinney had expressly disclaimed issuing any opinion on the statements. The firm lucked out in that the judge understood that a review engagement only provides limited assurance rather than the reasonable assurance of the audit.

Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years.

The external auditors at Ernst and Whinney succumbed to which part of the fraud triangle?

A) Opportunity

B) Incentive pressure

C) Rationalization

D) Opportunity and rationalization

Answer 1

The external auditors at Ernst and Whinney succumbed to opportunity. Opportunity is the favorable circumstance that allows a fraud to occur. There were poor internal controls placed due to which there was a huge opportunity to commit fraud. There were many red flags which pointed out that something was wrong but it was not taken care of by the auditors. Whenever the auditors found something and questioned Barry, he threatened auditors and auditors did not act as they did not want to lose business with ZZZZ Best. Also the independence of auditors was hampered due to confidentiality agreements signed which restricted them to cross check the information provided to them. Auditors should have exercised extreme care as they were dealing with young and extremely rapidly growing organization. Also auditors failed to do a thorough background check of the principals, the financial history of the company, past business activities, and organizational structure of the business. All the reasons point out that auditors gave enough opportunity to conduct fraud without being detected for a long time.