UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 RELEASE NO. 40002 / May 19, 1998 ACCOUNTING AND AUDITING ENFORCEMENT RELEASE NO. 1037 / May 19, 1998 ADMINISTRATIVE PROCEEDING File No. 3-9607 ______________________________ In the Matter of : ORDER INSTITUTING PROCEEDINGS, : MAKING FINDINGS AND IMPOSING RICHARD VALADE, CPA : REMEDIAL SANCTIONS PURSUANT TO : RULE 102(e) OF THE : COMMISSION'S RULES OF PRACTICE Respondent. : : ______________________________: I. The Securities and Exchange Commission (Commission) deems it appropriate and in the public interest to institute public administrative proceedings against Richard Valade, CPA (Valade) pursuant to Rule 102(e) of the Commission's Rules of Practice.<(1)> Accordingly, IT IS HEREBY ORDERED that these proceedings be, and hereby are, instituted. II. In anticipation of the institution of this administrative proceeding, Valade has submitted an Offer of Settlement (Offer) which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, Valade consents, without admitting or denying the findings, except as to jurisdiction, which he admits, to the issuance <(1)> Rule 102(e)(1) of the Commission s Rules of Practice, 17 C.F.R. Section 201.102(e), provides in pertinent part: The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice of and opportunity for hearing in the matter ...(ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct. ======END OF PAGE 1====== of this Order Instituting Proceedings pursuant to Rule 102(e) of the Commission's Rules of Practice (Order) and to the entry of the findings and imposition of sanctions as set forth below. III. FINDINGS On the basis of this Order and Valade's Offer of Settlement, the Commission finds that<(2)>: A. RESPONDENT AND OTHER RELATED PARTIES 1. Respondent Richard Valade (Valade), age 48, is a partner with Arthur Andersen, LLP (AA) based in its Detroit, Michigan Office. Valade was the engagement partner at AA for the 1991, 1992 and 1993 audits of Perry Drug Stores, Inc. (Perry). Valade also served as an engagement manager on the 1984 through 1987 Perry audits. He has been a Certified Public Accountant (CPA) licensed in the state of Michigan since 1979. 2. Other Related Party Perry Drug Stores, Inc. (Perry) was a Michigan corporation which operated a chain of drugstores located primarily in Michigan. Perry was a publicly traded company whose common stock was registered pursuant to Section 12(b) of the Securities Exchange Act of 1934 (Exchange Act). As of October 31, 1992, the end of Perry's fiscal year, Perry operated 205 retail drugstores. In January 1993, Perry filed a Form 10-K with the Commission pursuant to Section 13(a) of the Exchange Act. Perry attached a copy of AA's Report of Independent Public Accountants which contained an unqualified opinion signed by Richard Valade dated December 15, 1992, and which accompanied Perry's October 31, 1992 financial statements. B. SUMMARY Valade, the engagement partner on the Perry audit for the year ended October 31, 1992, issued an unqualified audit report on Perry's financial statements without obtaining sufficient competent evidential matter. Valade knew that Perry's valuation of physical inventory counts during the year generated results that were approximately $20 million less than the inventory carried on Perry's books and records and reflected in its financial statements. Nevertheless, Valade, relying on the results of other audit procedures and analytic data, agreed with Perry's decision to include the $20 million in inventory as an asset and signed the unqualified <(2)> The findings herein are made pursuant to Valade's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding. ======END OF PAGE 1====== audit report. Perry later determined that this inventory did not exist. C. BACKGROUND In fiscal year 1990, Perry began using a base cost method to value inventory at its stores. Perry employed an outside service to conduct physical inventory counts of its stores on a cyclical basis during each fiscal year. Perry conducted a physical inventory of a percentage of its stores each month from February through September until it had completed an inventory of all stores. Beginning in late 1991 and throughout fiscal year 1992 Perry changed to a last received cost method.<(3)> In order to value inventory and calculate cost of goods sold in the books and records, between each physical count, Perry used the gross profit method typical to retail merchants. Using this method, Perry would add to the amount of the beginning inventory the actual cost of its goods purchased through its accounts payable system (cost of goods acquired for sale). Perry would then reduce the inventory by an estimate of the cost of goods sold calculated using the estimated gross profit margin.<(4)> Perry included the estimated inventory balance on its general ledger, until the actual inventory was verified through a new physical count. Perry would then adjust this inventory figure to reflect the results of the physical inventory. Perry reconciled the recorded inventory at each store with the results of the physical inventory for that store when it conducted the next cyclical count. If the recorded inventory was greater than the value of the physical inventory, Perry increased the cost of goods sold and decreased the recorded inventory to reflect the results of the physical inventory. If the physical count revealed that a store had more inventory than was recorded in the books and records, Perry adjusted the general ledger to reflect the additional inventory. <(3)> Pursuant to the last received cost method, inventory is valued by multiplying the number of units of a particular product by the cost of the most recently purchased unit of that product. <(4)> The estimated gross profit margin was based upon factors such as merchandising plans and physical inventory results and generally was reviewed and adjusted more than once a year. ======END OF PAGE 2====== ======END OF PAGE 2====== D. DISCUSSION 1. Perry's Inventory Discrepancies in Fiscal 1992 Totaled over $20 Million During the second quarter of fiscal year 1992 (February through April), Perry conducted cycle counts of its inventory at approximately 48% of its stores. The valuations of these inventory counts were available in May and June 1992 and reflected store inventory in the general merchandise categories substantially less than those reflected in the recorded estimates of inventory on Perry's books. By the end of the second quarter of fiscal year 1992, Perry identified a discrepancy of approximately $8.5 million between the value of the physical inventory and the recorded inventory. Perry identified an additional discrepancy of approximately $7.6 million at the end of the third quarter and another approximately $4 million at the end of the year. Combined, these discrepancies, or "shrinks," totaled over $20 million for fiscal year 1992. The amount of these discrepancies was far in excess of discrepancies identified in prior fiscal years. As described above, Perry had historically adjusted the inventory balances recorded in its books and records by writing off the amount of the discrepancy as a part of its cost of sales. However, in fiscal year 1992, because it did not believe that the unusually large store inventory discrepancies were reasonable, Perry's management did not follow its usual course of conduct. Instead of writing off the discrepancy to cost of sales, Perry recorded it in a suspense account, which was called the "Store 100" inventory account, while it investigated the source of the discrepancy. Perry then reflected the balance of the Store 100 account in its overall store inventory in its second and third quarter and year end fiscal 1992 financial statements. In order to determine the cause of the unusually large discrepancy, Perry conducted numerous tests on its inventory systems and processes during and after fiscal year 1992. Perry also hired AA's computer risk management group to analyze the inventory related systems to determine whether systems problems were the cause of the discrepancy. Perry also hired private investigators and internal auditors to discover whether any large-scale theft had occurred. Perry also tried to determine whether the change, in fiscal year 1990, from the retail method of valuing inventory to a base cost method caused the discrepancy. Perry also conducted a more detailed internal audit of one its stores which used a point of sale ("POS") system.<(5)> Despite all of these procedures, Perry was unable to <(5)> The "POS" system was new to Perry's stores in 1992 and had only been installed in about one-third of its stores by fiscal 1992 year end. The POS system permitted a more accurate accounting of actual products sold and related gross margins on (continued...) ======END OF PAGE 3====== ======END OF PAGE 3====== explain, nor was it able to determine, the cause of the physical inventory discrepancies during fiscal year 1992. 2. The Fiscal Year 1992 Audit Conducted by Valade Failed to Verify Perry's Inventory Before the audit of Perry's 1992 financial statements began, Perry notified Valade of the inventory discrepancies described above. Perry also informed Valade of the status and results of its on-going investigation. Accordingly, as part of its fieldwork, the audit team expanded its audit work in this area and conducted numerous tests to verify the value of Perry's inventory. Under Valade's direction, the audit team conducted various analytical tests including tests to assess the validity of the gross profit margins as well as tests which examined warehouse and store data. Among other things, the team also examined margin and quantity data from warehouse shipments, available POS data, comparable industry wide margin data and Perry s historical margin data, all of which was inconsistent with the size of the shrink indicated by the physical inventory results. The audit team also investigated the possibility that thefts at the warehouse or changes in Perry's merchandising and business plans were the cause of the inventory discrepancies. The audit team also observed and tested the physical count at five Perry stores which confirmed that the value of the physical inventory at those stores was much smaller than the estimated value reflected in Perry's general ledger. However, the audit team did not recommend that Perry record the shrink at the five stores as a cost of goods sold. Instead, Perry recorded the book-to-physical differences from these five stores as an asset in the Store 100 account, along with the results of the other physical counts. None of the tests or analyses conducted by Valade and the audit team explained the cause of the inventory discrepancies. Nevertheless, Valade relied upon the results of the testing and analyses summarized above instead of the physical inventory results. 3. Valade was Aware of the Inventory Discrepancies Prior to Issuing the Audit Report In September 1992, Valade and the Senior Accountant on the Perry engagement drafted a General Risk Analysis Memorandum (GRA) for the fiscal year 1992 Perry audit. Valade noted in the GRA the significant inventory <(5)>(...continued) those sales than was possible using Perry's former "department key" method. Traditionally, Perry accumulated sales information by classifying merchandise into six register keys. Key 1, the largest category, encompassed general non-pharmacy items. ======END OF PAGE 4====== ======END OF PAGE 4====== discrepancies and the need to evaluate the problem during the audit. The GRA concluded that the risk of the overall audit would be "moderate" with emphasis placed on auditing inventory and payables. A "moderate" risk assessment reflects that the auditor expects errors but has reason to believe they are not likely to be material in relation to the financial statements. In the GRA, the audit team also set a materiality standard of $700,000. At the time Valade drafted the GRA with a "moderate" risk rating, he was aware that: (1) Perry had discovered at least $17 million in inventory discrepancies, (2) Perry had not recorded, as cost of sales, any of the inventory discrepancies; and (3) neither Perry nor anyone on the audit team could explain the cause of the inventory discrepancies. In addition, Valade was aware of the study conducted by his firm's computer risk management group. The group concluded that while the inventory systems were operating as designed, the systems might not provide an accurate estimate of the value of the inventory in all circumstances. Finally, Valade was aware of extensive month-long testing done on one of Perry's stores identified as "Store 152." In this testing Perry audited all shipments and followed all deliveries to the store to ensure that shipments were delivered. The company also did an extensive analysis regarding inventory reconciliations. Valade felt that these results verified the accuracy of the gross profit margin. However, this testing also showed the existence of an unusually large inventory discrepancy which was consistent with the physical counts done at other stores. Valade relied on the results of the analytic work rather than the data which showed the existence of the shrink in inventory. 4. Despite Uncertainties as to the Inventories' Existence, Valade Caused an Unqualified Audit Opinion to be Issued on the 1992 Financial Statements. In December 1992, Perry's management recommended to its board of directors and its audit committee that the company continue to include the $20 million in Store 100 inventory as an asset on its October 31, 1992 balance sheet. During the audit, Valade consulted with a number of his partners concerning the inventory issue, including the Regional Practice Director. After further audit tests and additional discussions with his partners, Valade and two of his partners, attended Perry's Audit Committee meeting on this issue, which was also attended by Perry's outside counsel. At that meeting, Valade reported that he did not object to including the Store 100 inventory as an asset on Perry's balance sheet and that he would sign an unqualified opinion. Valade acknowledged the possibility that the unexplained inventory discrepancy could have resulted from several changes in costing procedures over the previous three years. The minutes of the December 1992 Board Meeting reflect "uncertainties" as to the reasons for the inventory discrepancy. The minutes also reflect that Valade recommended that Perry ======END OF PAGE 5====== ======END OF PAGE 5====== conduct additional tests, including a simultaneous chain-wide inventory, as soon as possible to discover the reasons for the discrepancy. Pursuant to the discussions at the Board Meeting, including a separate discussion by the outside directors with outside counsel, Perry's Board approved the filing of financial statements filed with Perry's 1992 Form 10-K which included the $20 million of inventory in the Store 100 account as an asset. This represented over fourteen percent of the approximately $140 million in inventory that Perry carried on its books and reported in its balance sheet and over seven percent of its assets of approximately $270 million. Had Perry followed its normal procedure of expensing inventory shrinks to cost of sales, Perry would have reported a net loss of close to $6 million for fiscal year 1992 instead of the net income of $8.3 million it originally reported. Indeed, despite uncertainties as to the Store 100 inventory's existence that led to Valade's recommendations for further testing, Valade signed an unqualified audit opinion on Perry's 1992 financial statements, which included the $20 million of Store 100 inventory as an asset. As previously stated, Valade recommended that Perry conduct additional inventory counts and value the physical inventory using both the cost and retail methods at 20 stores. Valade also recommended that Perry conduct a simultaneous inventory of all its stores to reduce the number of variables that could have skewed the results of the inventories taken at the stores. Perry accepted Valade's recommendation for a simultaneous chain-wide physical store inventory, and scheduled it to be taken early in calendar 1993, shortly after the Christmas sales season. Valade also recommended that Perry reduce the gross profit margin being used in fiscal year 1993. ======END OF PAGE 6====== ======END OF PAGE 6==== 5. Perry Continued to Improperly Account for the Inventory Shrinkage in Fiscal Year 1993 In January 1993, pursuant to Valade's recommendation, Perry took sample physical inventories at cost and retail at 19 stores to determine whether its change in accounting methodology contributed to the shrinkages. Pursuant to Valade's suggestion, Perry began the full chain-wide physical inventory in February 1993. Reconciliation of book-to-physical results from the full chain inventory were completed in May 1993. These results confirmed the inventory shrink. As a result of full chain inventories, Perry concluded that it could not verify the existence of the inventory in the Store 100 account. Near the end of fiscal year 1993, Perry disclosed a noncash charge of $33.4 million relating to, among other things, an adjustment of store inventory. Approximately two-thirds of the charge taken in 1993 had been discovered by Perry during fiscal year 1992. Nevertheless, Perry, without objection from Valade, inappropriately categorized the adjustment as a "change in estimate" and did not restate the 1992 financial statements at that time. However, on July 27, 1994, upon the insistence of the Commission's Division of Corporation Finance, Perry restated its 1992 and 1993 financial statements. The 1992 and 1993 financial statements were restated to reflect a portion of this adjustment as a "correction of error" resulting in an additional $20 million cost of sales for fiscal year 1992. E. ACCOUNTING PRINCIPLES AND AUDITING STANDARDS The auditor's role is to express an opinion about whether the audited financial statements fairly present the required information in conformity with Generally Accepted Accounting Principles (GAAP). The audit must be conducted in accordance with Generally Accepted Auditing Standards (GAAS). In reaching an opinion, auditors are required to obtain sufficient competent evidential matter. The third standard of field work of GAAS, states that sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. Auditing Standards, AU 326.01. The auditing standards specifically require those auditing inventory "to make, or observe, some physical counts of the inventory . . ." unless certain conditions, which are not applicable to the Perry Audit, are present. Auditing Standards, AU 331.12. Section 326.19 of the Auditing Standards states that evidence obtained through physical examinations is more persuasive than information obtained indirectly, such as analytical results. To the extent that the auditor remains in substantial doubt about any assertion of material significance, he or she must refrain from forming an opinion until such time as the auditor has obtained sufficient competent evidential matter to remove such substantial doubt, or he must express a ======END OF PAGE 7====== ======END OF PAGE 7====== qualified opinion or a disclaimer of opinion. Auditing Standards, AU 326.23. F. CONCLUSION Valade understood the significance of the discrepancy between the value of the physical inventory and the recorded inventory and accordingly, using various audit procedures, sought to determine whether there was any flaw in the valuations of either the physical inventory or the recorded inventory. Valade was unable to verify the accuracy of the recorded inventory through physical observations. In fact, the results of the physical inventories which the audit team observed confirmed the existence of inventory shrinks at those locations. Valade failed to identify an appropriate basis for selecting the recorded inventory over the physical inventory. He could not point to any error generated by either system of computing the inventory. Despite Valade's consultations with his partners and the additional audit procedures he performed, he nevertheless failed to obtain sufficient competent evidential matter to resolve the inventory discrepancy issue. Valade failed to either: (a) require Perry to reconcile the recorded inventory and the physical inventory and record the proper adjustment to the books and records; (b) discredit either the recorded inventory or the physical inventory and require Perry to adjust the books and records accordingly; (c) issue a qualified opinion; or (d) refrain from issuing an audit opinion until the matter was resolved. Accordingly, for the reasons set forth above, Valade failed to comply with GAAS and failed to require Perry to comply with GAAP when he signed an unqualified audit report despite the fact that he had not obtained sufficient competent evidential matter to verify the existence of the store inventory. Thus, Valade engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) of the Commission's Rules of Practice. ======END OF PAGE 8====== ======END OF PAGE 8====== IV. Based on the foregoing, the Commission deems it appropriate and in the public interest to accept Valade's Offer of Settlement. Accordingly, IT IS ORDERED that: Valade is censured pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice for the conduct described herein and undertakes that: 1. He, or any firm with which he is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent Accountant, and 2. He will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he appears or practices before the Commission as an independent accountant. By the Commission. Jonathan G. Katz Secretary ======END OF PAGE 9====== ======END OF PAGE 9======