All appeared well at Silverware Corporation, a Guntersville, Alabama based electronics company, until word hit the streets November 25, 1992 that there had been a fraud. When reports surface
In this case, pay attention to look for strengths and weaknesses of internal control, find risks, and suggest additional controls
CASE STUDY ? SILVERWARE CORP.
INTRODUCTION
All appeared well at Silverware Corporation, a Guntersville, Alabama based electronics company, until word hit the streets November 25, 1992 that there had been a fraud. When reports surfaced that three of the companys top executives had inflated company earnings for the past three years, the companys stock price plummeted 72% in one day, closing at $6.025 a share down from the previous days closing at $22 a share.
The Securities and Exchange Commissions (SEC) subsequent investigation determined that Silverwares chief executive officer (CEO), chief operating officer (COO), and controller/treasurer all colluded to overstate assets and profits by recording fictitious transactions. The three executives overrode existing internal controls so that others at Silverware would not discover the scheme. All this unraveled when the executives surprisingly confessed to the companys board that they had improperly valued assets, overstated sales, and understated expenses. The three were immediately suspended from their duties.
Within days, class action lawsuits were filed against the company and the three executives. Immediately, the companys board of directors formed a special committee to investigate the alleged financial reporting fraud, an interim executive team stepped in to take charge, and Arthur Andersen, LLP was hired to conduct a detailed fraud investigation. Residents of the small Alabama town were stunned. How could a fraud occur so close to home? Were there any signs of trouble that were ignored?
BACKGROUND
Silverware based its principal operations in Guntersville, a town of approximately 7,000 residents located about 35 miles southeast of Huntsville, Alabama. The company provided contract manufacturing services to original equipment manufacturers in the electronics industry. Its primary product was circuit boards for personal computers and medical equipment. Neighboring Huntsvilles heavy presence in the electronics industry provided Silverware a local base of customers for its circuit boards. In addition to the Alabama facility, the company also maintained manufacturing facilities in San Jose, California, and Colorado Springs, Colorado. In total, Silverware employed about 1800 people at the three locations and was one of the largest employers in Guntersville. The company was formed in the early 1980s by individuals who met while working in the electronics industry in nearby Huntsville. Three of those founders became senior officers of the company. William J. Hebding (called William hereafter) became Silverwares chairman and CEO, Allen L. Shifflett (called Allen hereafter) became Silverwares president and COO, and J. Paul Medlin (called Paul hereafter) served as the controller and treasurer. Prior to creating Silverware, all three men worked at SCI Systems, a booming electronics maker. Mr. William joined SCI Systems in the mid-1970s to assist the chief financial
officer (CFO). While in that role, he met Mr. Allen, the SCI Systems operations manager. Later, when Mr. William become SCI Systems CFO, he hired Mr. Paul to assist him. Along with a few other individuals working at SCI Systems, these three men together formed Silverware in late 1983 and early 1984.
The local townspeople in Guntersville were excited to attract the startup company to the local area. The city enticed Silverware by providing it with an empty knitting mill in town. As an additional incentive, a local bank offered Silverware an attractive credit arrangement.
Silverware in turn appointed the local banker to its board of directors. Town business leaders were excited to have new employment opportunities and looked forward to a boost to the local economy.
The early years were difficult, with Silverware suffering losses through 1986. Local enthusiasm for the company attracted investments from venture capitalists. One of those investors included a partner in the Massey Burch Investment Group, a venture capital firm located in Nashville, Tennessee, just more than 100 miles to the north. The infusion of venture capital allowed Silverware to generate strong sales and profit growth during 1987 and 1988.
Based on this strong performance, senior management took the companys stock public in 1989, initially selling Silverware stock at $5 a share in the over-the-counter markets.
THE ACCOUNTING SCHEME
According to the SECs investigation, the fraud began soon after the company went public in 1989 and was directed by top company executives. Mr. William as chairman and CEO, Mr. Allen as president and COO, and Mr. Paul as controller and treasurer used their positions of power and influence to manipulate the financial statements issued from early 1989 through November 1992.
They began their fraud scheme by first manipulating the quarterly statements filed with the SEC during 1989. They misstated those statements by inappropriately transferring certain costs from cost of goods sold into inventory accounts. This technique allowed them to overstate inventory and understate quarterly costs of goods sold, which in turn overstated gross margin and net income for the period. The three executives made monthly manual journal entries, with the largest adjustments occurring just at quarters end. Some allege that the fraud was motivated by the loss of a key customer in 1989 to the three executives former employer, SCI.
The executives were successful in manipulating quarterly financial statements partially because their quarterly filings were unaudited. However, as fiscal year 1989 came to a close, the executives grew wary that the companys external auditors might discover the fraud when auditing the December 31, 1989, year-end financial statements. To hide the manipulations from their auditors, they devised a plan to cover up the inappropriate transfer of costs. They decided to remove the transferred costs from the inventory account just before year-end, because they
feared the auditors would closely examine the inventory account as of December 31, 1989, as part of their year-end testing. Thus, they transferred the costs back to cost of goods sold. However, for each transfer back to cost of goods sold, the fraud team booked a fictitious sale of products and a related fictitious accounts receivable. That, in turn, overstated revenues and receivables.
The net effect of these activities was that interim financial statements included understated cost of goods sold and overstated inventories, while the annual financial statements contained overstated sales and receivables. Once they had tasted success in their manipulations of yearend sales and receivables, they later began recording fictitious quarterly sales in a similar fashion.
To convince the auditors that the fictitious sales and receivables were legitimate, the three company executives recorded cash payments to Silverware from the bogus customer accounts. In order to do this, they developed a relatively complex fraud scheme. First, they recorded fictitious purchases of equipment on account. That, in turn, overstated equipment and accounts payable. Then, William, the chairman and CEO, and Paul, the controller and treasurer, cut checks to the bogus accounts payable vendors associated with the fake purchases of equipment. But they did not mail the checks. Rather, they deposited them in Silverwares disbursement checking account and recorded the phony payments as debits against the bogus accounts payable and credits against the bogus receivables. This accounting scheme allowed the company to eliminate the bogus payables and receivables, while still retaining the fictitious sales and equipment on the income statement and balance sheet, respectively.
This scheme continued over four years, stretching from the beginning of 1989 to November 1992, when the three executives confessed to their manipulations. The SEC investigation noted that financial statements for the years ended December 31, 1989, 1990, and 1991 were materially misstated as follows:
1989
1990
1991
Sales (in thousands)
Reported sales
$42,420
$70,229
$102,026
Restated sales
37,275
63,444
88,754
Overstatement of sales
5,145
6,785
13,272
Percentage overstatement
13.8%
10.7%
14.9%
Net income (in thousands)
Reported net income
$1,470
$3,028
$5,071
Restated net income
(3,524)
(3,647)
(3,225)
Overstatement of net income
4,994
6,6675
8,296
Earnings per share (EPS)
Reported EPS
$.19
$.35
$.51
Restated EPS (loss)
(.47)
(.43)
(.34)
Overstatement of EPS
.66
.78
.85
Property,Plant&Equipment(in
thousands)
Reported PPE
$18,804
$26,627
$38,720
Restated PPE
13,856
15,846
20,303
Overstatement of PPE
4,948
10,781
18,417
Percentage overstatement
35.7%
68.0%
90.7%
Stockholders equity (in thousands)
Reported stockholders equity
$19,145
$22,237
$39,676
Restated stockholders equity
14,151
10,568
18,778
Overstatement of stockholders equity
4,994
11,669
20,898
Percentage overstatement
35.3%
110.4%
111.3%
The executives fraud scheme helped the company avoid reporting net losses in each of the three years, with the amount of the fraud increasing in each of the three years affected.5 The fraud scheme also inflated the balance sheet by overstating property, plant, and equipment and stockholders equity. By the end of 1991, property, plant, and equipment was overstated by over 90%, with stockholders equity overstated by 111%.
THE COMPANYS INTERNAL CONTROLS
The three executives were able to perpetrate the fraud by bypassing the existing accounting system. They avoided making the standard entries in the sales and purchases journals as required by the existing internal control, and recorded the fictitious entries manually. Other employees were excluded from the manipulations to minimize the likelihood of the fraud being discovered. According to the SECs summary of the investigation, Silverware employees normally created a fairly extensive paper trail for equipment purchases, including purchase orders and receiving reports. However, none of these documents were created for the bogus purchases. Approval for cash disbursements was typically granted once the related purchase order, receiving report, and vendor invoice had been matched. Unfortunately, Mr. Allen or Mr. Paul could approve payments based solely on an invoice. As a result, the fraud team was able to bypass internal controls over cash disbursements. They simply showed a fictitious vendor invoice to an accounts payable clerk, who in turn prepared a check for the amount indicated on the invoice.
Internal controls were also insufficient to detect the manipulation of sales and accounts receivable. Typically, a shipping department clerk would enter the customer order number and the quantity
to be shipped to the customer into the computerized accounting system. The accounting system then automatically produced a shipping document and a sales invoice. The merchandise was shipped to the customer, along with the invoice and shipping document.
Once again, Mr. Paul, as controller and treasurer, had the ability to access the shipping department system. This allowed him to enter bogus sales into the accounting system. He then made sure to destroy all shipping documents and sales invoices generated by the accounting system to keep them from being mailed to the related customers. The subsequent posting of bogus payments on the customers accounts was posted personally by Mr. Paul to the cash receipts journal and the accounts receivable subsidiary ledger.
The fraud scheme was obviously directed from the top ranks of the organization. Like most companies, the senior executives at Silverware directed company operations on a day-today basis, with only periodic oversight from the companys board of directors.
The March 1992 proxy statement to shareholders noted that the Silverware board of directors consisted of seven individuals, including Mr. William who served as board chairman. Of those seven individuals serving on the board, two individuals, Mr. William, chairman and CEO and Mr. Allen, president and COO, represented management on the board. Thus, 28.6% of the board consisted of inside directors. The remaining five directors were not employed by Silverware. However, two of those five directors had close affiliations with management. One served as the companys outside general legal counsel and the other served as vice president of manufacturing for a significant customer of Silverware. Directors with these kinds of close affiliations with company management are frequently referred to as ?gray? directors due to their perceived lack of objectivity.
The three remaining ?outside? directors had no apparent affiliations with company management. One of the remaining outside directors was a partner in the venture capital firm that owned 574,978 shares (5.3%) of Silverwares common stock. That director was previously a partner in a Nashville law firm and was currently serving on two other corporate boards. A second outside director was the vice chairman and CEO of the local bank originally loaning money to the company. He also served as chairman of the board of another local bank in a nearby town. The third outside director was president of an international components supplier based in Taiwan. All of the board members had served on the Silverware board since 1984, except for the venture capital partner who joined the board in 1988 and the president of the key customer who joined the board in 1990.
Each director received an annual retainer of $3,000 plus a fee of $750 for each meeting attended. The company also granted each director an option to purchase 5,000 shares of common stock at an exercise price that equaled the market price of the stock on the date that the option was granted. The board met four times during 1991. The board had an audit committee that was charged with recommending outside auditors, reviewing the scope of the audit engagement, consulting with the external auditors, reviewing the results of the audit examination, and acting as
a liaison between the board and the internal auditors. The audit committee was also charged with reviewing various company policies, including those related to accounting and internal control matters. Two outside directors and one gray director made up the three-member audit committee. One of those members was an attorney, and the other two served as president and CEO of the companies where they were employed. There was no indication of whether any of these individuals had accounting or financial reporting backgrounds. The audit committee met twice during 1991.
MANAGEMENT BACKGROUND
The March 1992 proxy statement provided the following background information about the three executives committing the fraud: Mr. William, Mr. Allen, and Mr. Paul.
William served as the Silverware Chairman and CEO. He was responsible for sales and marketing, finance, and general management of the company. He also served as a director from 1984 until 1992 when the fraud was disclosed. He was the single largest shareholder of Silverware common stock by beneficially owning 6.7% (720,438 shares) of Silverware common stock as of March 2, 1992. Before joining Silverware, Mr. William worked for SCI Systems Inc. from 1974 until October 1983. He held the title of treasurer and CFO at SCI from December 1976 to October 1983. In October 1983, Mr. William left SCI to form Silverware. He graduated from the University of North Alabama with a degree in accounting and was a certified public accountant. Mr. Williams 1991 cash compensation totaled $187,996.
Allen served as Silverwares president and COO, and was responsible for manufacturing, engineering, and programs operations. He also served as a director from 1984 until 1992 when the fraud unfolded. He owned 4% (433,496 shares) of Silverware common stock as of March 2, 1992. Like Mr. William, he joined the company after previously being employed at SCI as a plant manager and manufacturing manager from October 1981 until April 1984 when he left to help form Silverware. Mr. Allen obtained his B.S. degree in industrial engineering from Virginia Polytechnic Institute. Mr. Allens 1991 cash compensation totaled $162,996.
Paul served as Silverwares controller and treasurer. He also previously worked at SCI, as Mr. Williams assistant after graduating from the University of Alabama. Mr. Paul did not serve on the Silverware board. The 1992 proxy noted that the board of directors approved a company loan to him for $79,250 on November 1, 1989, to provide funds for him to repurchase certain shares of common stock. The loan, which was repaid on May 7, 1991, bore interest at an annual rate equal to one percentage point in excess of the interest rate designated by the companys bank as that banks ?Index Rate.? The 1992 proxy did not disclose Mr. Pauls 1991 cash compensation.
The company had employment agreements with Mr. William and Mr. Allen, which expired in April 1992. Those agreements provided that if the company terminated employment with them prior to the expiration of the agreement for any reason other than cause or disability, they would each
receive their base salary for the remaining term of the agreement. If terminated for cause or disability, each would receive their base salary for one year following the date of such termination.
The company had an Employee Stock Incentive Plan and an Employee Stock Option Plan that the compensation committee of the board of directors administered. The committee made awards to key employees at its discretion. The compensation committee consisted of three nonemployee directors. One of these directors was an attorney who served as Silverwares outside counsel on certain legal matters. Another served as an officer of a significant Silverware customer. The third member of the committee was a partner in the venture capital firm providing capital for Silverware.
The SECs investigation noted that during the period of the fraud, the three men each sold thousands of shares of Silverware common stock. Their knowledge of material, non-public information about Silverwares actual financial position allowed them to avoid trading losses in excess of $500,000 for Mr. William and Mr. Allen, and over $90,000 for Mr. Paul. Each also received bonuses: $198,000 for Mr. William, $148,000 for Mr. Allen, and $46,075 for Mr. Paul. These bonuses were granted during the fraud years as a reward for the supposed strong financial performance.
After the fraud was revealed, newspaper accounts reported that red flags had been present. The New York Times reported that Mr. William and Mr. Allen created reputations in the local community that contrasted with their conservative professional reputations. Mr. William purchased a home worth over $1 million, often described as a mansion, with two boathouses, a pool, a wrought-iron fence with electric gate, and a red Jaguar in the driveway. The Atlanta Journal and Constitution reported that Mr. Williams marriage had failed, and that he had led an active bachelors life that led to some problems in town. He also had a major dispute with another company founder who was serving as executive vice president. That individual was suddenly fired from Silverware in 1989. Later it was revealed that he was allegedly demoted and fired for trying to investigate possible wrongdoing at Silverware.
Mr. Allen, too, had divorced and remarried. He and his second wife purchased an expensive scenic lot in an exclusive country club community in a neighboring town. Mr. Allen reportedly had acquired extensive real estate holdings in recent years.
Others were shocked, noting that they would be the last to be suspected of any kind of fraud. In the end, it was unclear why the three stunned the board with news of the fraud. There was some speculation that an on-going IRS tax audit triggered their disclosure of the shenanigans.
EPILOGUE
After the fraud was revealed, all three men were suspended and the board appointed an interim CEO and an interim president to take over the reins. The SECs investigation led to charges being filed against all three men for violating the antifraud provisions of the Securities Act of 1933 and
the Securities and Exchange Act of 1934, in addition to other violations of those securities acts. None of the men admitted or denied the allegations against them.
However, all three men agreed to avoid any future violations of the securities acts. They also consented to being permanently prohibited from serving as officers or directors of any public company. The SEC ordered them to pay back trading losses avoided and bonuses paid to them by Silverware during the fraud period, and it directed Mr. William and Mr. Allen to pay civil penalties of $100,000 and $50,000, respectively. The SEC did not impose civil penalties against Mr. Paul due to his inability to pay.
The company struggled financially. It sold its San Jose operations in 1994 to Sanmina Corporation, a California-based electronics manufacturer. Silverware eventually filed for Chapter 11 bankruptcy protection in August 1996, which allowed the company to continue operating while it developed a restructuring plan. In September 1996, the company announced that it had sold substantially all of its remaining assets to Sanmina Corp. As a result of the sale, the secured creditors of Silverware were fully repaid; however, the unsecured creditors received less than 10 cents on the dollar.
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