Reference no: EM13886666

Read the following case about MiniScribe and answer the following questions.

a. How did MiniScribe inflate its financial statements?

b. What are some of the factors that led to the inflated financial statements?

c. What red flags should have raised the auditor's suspicions about phony sales and other attempts to inflate income?

d. What substantive audit procedures could have uncovered the fraud?

In October 1988, MiniScribe, a computer disk drive manufac- turer, announced its 13th consecutive record-breaking quarter, while its competitors were laying off hundreds of employees. MiniScribe's receivables had increased significantly, and inventories had increased to a dangerous level because disk drives can become obsolete from one quarter to the next. The company's stock price had quintupled in just two years. It had apparently risen from the dead under the lead- ership of Q. T. Wiles, who had resurrected other companies and was known as Dr. Fix-It. It looked as if he had done it again.

Seven months later, it was announced that MiniScribe's sales gains had been fabricated.

What was supposed to be the crowning achievement of Wiles's career became an epitaph; he resigned and is living in near seclusion. An internal investigation concluded that senior management appar- ently perpetrated a massive fraud on the company, its directors, its outside auditors, and the investing public. Most of MiniScribe's top management was dismissed, and layoffs shrank its employment by more than 30% in one year. MiniScribe might have to write off as much as $200 million in bad inventory and uncollectible receivables.

Wiles's unrealistic sales targets and abusive management style created a pressure cooker that drove managers to cook the books or perish. The managers responded by booking sales prematurely, manipulating reserves, and simply fabricating figures in order to maintain the illusion of unbounded growth even after the industry was hit by a severe slump.

When Wiles arrived at MiniScribe in mid-1985, it had just lost its biggest customer, IBM, which decided to make its own drives. With the personal computer industry then slumping, MiniScribe was drowning in red ink.

Dr. Fix-It's prescription was to cut 20% of the workforce and overhaul the company from top to bottom. As part of the overhaul, several semiautonomous divisions were created. Each division manager set the division's own budget, sales quotas, incentives, and work rules. The company became a chaotic Babel of at least 20 minicompanies that were constantly being changed and reorga- nized. One employee held 20 different positions in less than seven years.

Wiles turned up the heat under his lieutenants. Four times a year, he would summon as many as 100 employees for several days of intense meetings, at which they were force-fed his idiosyncratic management philosophy. At one of the first such meetings he held, Wiles demanded that two controllers stand, and he fired them on the spot, saying, "That's just to show everyone I'm in control of the company."

At each of these meetings, division managers had to present and defend their business plans. Invariably, Wiles would find such plans deficient and would berate their authors in front of their peers. A former controller says Wiles would throw, kick, and rip the plan books that displeased him, showering his intimidated audience with paper while yelling, "Why don't you understand this? Why can't you understand how to do this?"

Then something changed. Wiles started saying, "I no longer want to be remembered as a turnaround artist. I want to be remembered as the man who made MiniScribe a billion-dollar company." Sales objectives became the company's driving force, and financial results became the sole determinant of whether bonuses were awarded.

Wiles said, "This is the number we want to hit first quarter, second quarter, third quarter, and so on," and it was amazing to see how close they could get to the number they wanted to hit.

Hitting the number became a companywide obsession. Although many high-tech manufacturers accelerate shipments at the end of a quarter to boost sales-a practice known as stuffing the channel- MiniScribe went several steps beyond that. On one occasion, an ana- lyst relates, the company shipped more than twice as many disk drives to a computer manufacturer as had been ordered; a former sales manager says the excess shipment was worth about $9 million. MiniScribe later said it had shipped the excess drives by mistake. The extras were returned-but by then MiniScribe had posted the sale at the higher number. Wiles denied this practice.

Other accounting maneuvers involved shipments of disk drives from MiniScribe's factory in Singapore. Most shipments went by air freight, but a squeeze on air cargo space toward the end of each quarter would force some shipments onto cargo ships, which required up to two weeks for transit. On several occasions, said a former division manager, MiniScribe executives looking to raise sales changed purchase orders to show that a customer took title to a shipment in Singapore when, in fact, title would not change until the drives were delivered in the United States.

MiniScribe executives tried to persuade an audit team that 1986 year-end results should include as sales the cargo on a freighter that they contended had set sail in late December. The audit team declined to do so. Eventually, the cargo and the freighter, which did not exist, were simply forgotten.

MiniScribe executives also found other ways to inflate sales fig- ures. One was to manipulate reserves for returns of defective mer- chandise and bad debts. The problem of inadequate reserves grew so great that private analysts began noticing it. MiniScribe was booking less than 1% reserves; the rest of the industry had reserves ranging from 4% to 10%.

To avoid booking losses on returns in excess of its skimpy reserves, defective drives would be tossed onto a rejection pile and booked as inventory. Eventually, the defective drives would be shipped out again to new customers, continuing the cycle. Returns of defective merchandise ran as high as 15%.

At a time of strong market demand, such ploys enabled MiniScribe to seem to grow almost exponentially, posting sales of $185 million in 1986 and $362 million in 1987. In early 1988, Wiles was confidently forecasting a $660 million year, and he held fast to his rosy forecast even as disk drive sales started slipping industry wide in late spring and nose-dived in the autumn. Meanwhile, Wiles increased the pressure on his managers. Division reports would be doctored as they rose from one bureaucratic level to the next.

Before long, the accounting gimmickry became increasingly bra- zen. Division managers were told to "force the numbers." Workers whispered that bricks were being shipped just so a division could claim to have met its quota. Others joked that unwanted disk drives were being shipped and returned so often that they had to be repackaged because the boxes wore out.

Employees also joked about shipments to "account BW," an acronym for "big warehouse"-but that wasn't just a joke.

MiniScribe established several warehouses around the country and in Canada as just-in-time suppliers for distributors. Customers wer- en't invoiced until they received shipments from the warehouses.

MiniScribe, however, was booking shipments to the warehouses as sales. The number of disk drives shipped to the warehouses was at MiniScribe's discretion. It is estimated that between $80 million and $100 million worth of unordered disk drives went to the warehouses.

Wall Street began to smell trouble. Analysts could find no sig- nificant customers other than Compaq to support MiniScribe's bullish forecasts. Several major anticipated orders from Apple Computer and Digital Equipment Corp. fell through. MiniScribe reported a fourth-quarter loss and a drop in net income for 1988 despite a 66% increase in sales-that is, on paper. A week later, Wiles abruptly resigned. The stock price tumbled from a high of $15 to less than $3 per share, a decline that upset many stockholders.

An investigative committee of MiniScribe's outside directors reported that senior company officials:

? Apparently broke into locked trunks containing the auditors' working papers during the year-end 1986 audit and changed inventory figures, inflating inventory values by approximately $1 million.

? Packaged bricks and shipped them to distributors as disk drives in 1987, recording $4.3 million in sales; when the shipments were returned, MiniScribe inflated its inventory by the pur- ported cost of the bricks.

? Packaged approximately 6,300 disk drives that had been con- taminated to inflate inventory during the fourth quarter of 1988.

Several lawsuits were filed charging MiniScribe with engineering phony sales artificially to inflate its stock to benefit insiders. The suits also charged that its auditors participated in the conspiracy by falsely certifying the company's financial statements.