Perry Drug Stores, Inc

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CASE 2.9

PERRY DRUG STORES, INC.

For decades, the corner drug store served as a hub of activity on Main Street of most small towns and cities across the country.1 Many of Norman Rockwell’s most popular works picture Moms and Dads, boys and girls, and homecoming soldiers enjoying the friendly and familiar confines of the hometown drug store. The latter part of the 20th century, however, dealt harshly with the neighborhood drug store. Nationwide drug store chains and large discount retailers, most notably Wal-Mart, forced a multitude of small drug stores out of business. To stave off larger competitors, many locally owned drug stores consolidated into regional chains. In the early 1990s, Michigan-based Perry Drug Stores, Inc., ranked as one of the largest of these regional chains.

In 1957, a 27-year-old pharmacist, Jack Robinson, founded Perry Drug Stores by buying an existing business, which had been established in 1920. Perry Drug Stores grew rapidly under Robinson’s leadership. Robinson incorporated his business in 1980 and later took the company public, listing its stock on the New York Stock Exchange. By 1994, Perry operated more than 200 retail outlets, had a workforce of approximately 5,000 employees, and boasted annual revenues of $700 million.

Although the 14th largest drug retailer in the United States by the early 1990s, Perry Drug Stores could not compete with the much larger nationwide drug store chains. Rite Aid, Eckerd, and other nationwide drug retailers benefited from economies of scale unavailable to Perry. Perry’s larger competitors had invested millions of dollars in state-of-the-art inventory management systems that linked these companies to their major suppliers via electronic data interchange (EDI) networks. These systems allowed the nationwide chains to maximize sales while minimizing inventory-related carrying costs, including losses due to inventory obsolescence. By comparison, Perry relied largely upon outdated inventory management and control systems. For example, Perry’s retail stores did not have point-of-scale scanning devices at sales terminals. Likewise, Perry had not installed computer-based logistics systems to ensure timely and accurate deliveries to retail stores from the company’s merchandise distribution centers. Perry’s inability to monitor precisely daily inventory movements and balances complicated the efforts of company executives to evaluate the results of chain-wide sales promotions and other special programs. At the store level, the absence of detailed inventory data forced the company’s store managers to rely heavily upon their own intuition in making critical decisions, such as which products to stock in their individual stores.

Perry’s inventory control problems were magnified greatly in the early 1990s. To compete more effectively with the national drug store chains, Perry rapidly expanded its product line in the “front end” of its stores to include a wide array of cosmetics, personal beauty treatment products, and home office supplies. One company executive noted that by 1991 Perry’s retail outlets stocked approximately two hundred shampoos, more than one hundred hair sprays, and two dozen mousses. In 1992, Perry’s inventory problems contributed to the company’s losing its position as the number-one drug store chain in the metropolitan Detroit area, which easily ranked as Perry’s largest sales region.

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A former Perry executive who accepted a position with one of the large nationwide drug store chains in the early 1990s commented on the stark differences between the nationwide chain and Perry. The executive noted that Perry lacked sufficient funds to invest in technology needed to effectively and efficiently manage a large retail business. He also observed that leaving Perry and accepting a position with the nationwide chain was comparable to going “from the Dark Ages to the 21st Century.”2

In 1992, Perry’s financial fortunes took a sharp turn for the worse when company executives discovered an inventory shortage of approximately $20 million, a shortage that went unreported in the company’s financial statements. The following year, Perry wrote off the inventory shortage, which contributed to the company suffering a huge loss. Late in 1994, Rite Aid, the nation’s largest drug retailer with 2,500 stores and $4 billion in annual revenues, purchased Perry for $132 million. Exhibit 1 presents key financial data for Perry Drug Stores for the period 1989-1993.

--Insert Exhibit 1--

Perry’s Inventory Problems

Perry Drug Stores used a periodic inventory system and both the LIFO and FIFO costing methods. In a typical year, Perry applied the LIFO method to approximately 70 percent of its total inventory and the FIFO method to the remainder. Throughout the early 1990s, Perry retained an outside firm to count the inventory of each of its stores. The firm performed these counts in regular cycles, meaning it counted the same group of Perry stores at approximately the same point each year. Following the completion of each cycle count, Perry adjusted the given stores’ recorded inventory balances to agree with the physical inventory results and recorded a collective “book-to-physical inventory adjustment” for the general ledger inventory account at corporate headquarters. Between the annual physical inventory counts, Perry used the gross profit method to estimate each store’s inventory and to arrive at a collective inventory figure (estimate) for the company as a whole.

Perry would add to the amount of the [recorded] 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. Perry included the estimated inventory balance on its general ledger, until the actual inventory was verified through a new physical count.3

Arriving at a reasonable estimated gross profit margin percentage is the most critical step in applying the gross profit method. If an entity’s estimated gross profit margin percentage varies significantly from the actual percentage, the resulting estimates of cost of sales and inventory will be unreliable. The estimates yielded by the gross profit method can be made more reliable by applying an estimated gross profit margin percentage to each major inventory group. However, Perry used an overall estimated gross profit margin percentage in applying this method. Perry’s management regularly reviewed the estimated gross profit margin percentage used in applying the gross profit method. Among other factors, the company’s management considered changes in merchandising plans and the year-to-date results of its cycle inventory counts during these reviews. Perry typically revised its estimated gross profit margin percentage more than once per year.

Perry’s cycle counts in early fiscal 1992 revealed much larger differences than normal between the book inventories and inventory values determined by physical inventory counts. (Recognize that the book inventories reflected estimates resulting from yearlong application of the gross profit method.) By the end of the second quarter of fiscal 1992, these differences totaled $7.6 million. Following the completion of all cycle counts for fiscal 1992, the collective difference amounted to more than $20 million. This figure alarmed Perry’s management since it represented approximately 14 percent of the company’s collective book inventory of $140.2 million.4

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Unlike in previous years, as fiscal 1992 progressed, Perry did not immediately adjust the corporate inventory account to recognize the book-to-physical differences uncovered by the cycle inventory counts because Perry’s management believed the large discrepancies between stores’ book and physical inventories were not “reasonable.” Instead of adjusting the corporate inventory account, management created a “suspense account” to which it transferred the differences between given stores’ book and physical inventories. That is, after adjusting a store’s book inventory to agree with its physical inventory results, Perry transferred the difference to a general ledger account referred to as the “Store 100" inventory account. (Store 100 was a fictitious store.) Perry’s management included Store 100's inventory balance in the total inventory figure reported for the company in its interim financial statements for 1992. Again, by the end of fiscal 1992 (October 31, 1992), the balance of the Store 100 inventory account exceeded $20 million.

Shortly after the 1992 cycle counts began revealing large inventory shortages, Perry’s chief financial officer (CFO), Jerry Stone, initiated a company-wide investigation to uncover the source of the shortages. Stone retained Arthur Andersen & Co., Perry’s independent audit firm, to perform a study to “determine whether systems problems were the cause of the discrepancy.” This study was carried out by members of Andersen’s computer risk management group, none of whom were involved in the annual audits of Perry. When that study suggested that computer breakdowns were not responsible for the inventory shortages, Stone hired private detectives. These detectives, along with Perry’s internal auditors, searched for evidence of large-scale inventory thefts. These efforts also failed to reveal the source of the inventory shortages. Finally, Stone’s subordinates performed an intensive study of a Perry store that had recently installed a point-of-sale system. The data collected by that store’s point-of-sale system allowed Stone to more accurately assess the company’s actual gross profit margins on the products it sold. Although Perry did not publicly reveal those data, they apparently failed to convince Stone that the estimated gross profit margin percentage being applied by the company was unreasonable.5

Resolving the Inventory Crisis: Input from Andersen

Before becoming Perry’s CFO, Stone served for twelve years as an audit partner with Arthur Andersen & Co. Quite naturally, then, Stone relied heavily on his contacts at his former firm in deciding how to resolve Perry’s 1992 inventory crisis.

Richard Valade, an Andersen audit partner, supervised the annual audits of Perry Drug Stores from 1984 through 1987 and again from 1991 through 1993. Stone notified Valade of the $20 million inventory shortage before Andersen began its audit of Perry’s 1992 financial statements. In September 1992, shortly after learning of the inventory shortage, Valade and a subordinate prepared a General Risk Analysis (GRA) memorandum for the 1992 Perry audit. Andersen prepared this document for audit engagements to identify the financial statement items requiring particular attention during each engagement. A GRA memo also identified the apparent overall audit risk posed by the engagement and the planned materiality level for the engagement.

The GRA memo for the 1992 Perry audit indicated that Andersen expected an overall “moderate” audit risk for that engagement. This assessment “reflects that auditor expects errors but has reason to believe they are not likely to be material in relation to the financial

statements.” Andersen established an overall materiality standard of $700,000 for the engagement.6

During the 1992 Perry audit, the Andersen audit engagement team applied a wide range of audit tests to Perry’s inventory, tests more extensive than those normally performed on that inventory.7 The auditors applied many of these tests expressly to determine the source of the large inventory shortage revealed by Perry’s 1992 cycle inventory counts. The SEC identified the following inventory audit procedures, among others, that Andersen completed during the 1992 Perry audit:

1. Conducted extensive analytical tests to evaluate the reasonableness of the estimated gross profit margins Perry used during 1992. These procedures included testing the actual gross profit margins of individual stores and examining Perry’s historical sales and inventory data and comparable industry data.

2. Performed tests to investigate whether theft or changes in Perry’s merchandising plans and business policies likely accounted for the inventory shortage.

3. Observed and tested physical inventory counts at five Perry stores. These audit procedures revealed that the physical inventory at these stores was “much smaller” than each store’s book inventory. (Note: Similar to its procedure involving other stores, Perry transferred the book-to-physical differences for these stores to the “Store 100 inventory” account.)

4. Reviewed the results of Perry’s investigations to identify the source of the inventory shortage.

5. Reviewed the results of the study performed by Arthur Andersen’s computer risk management group that was intended to uncover the source of the inventory shortage.

Andersen’s 1992 inventory audit procedures failed to uncover the source of the large inventory shortage. Before Andersen completed the 1992 Perry audit, Perry’s management decided not to write off the $20.3 million balance of the Store 100 inventory account. Instead, it chose to include the $20.3 million in the dollar amount reported for inventory in the company’s 1992 balance sheet. Perry executives presented this decision to the company’s board of directors during a meeting that Richard Valade attended.

Before the December 1992 meeting with Perry’s board of directors, Valade discussed the large inventory shortage with several fellow Andersen partners, including the Regional Practice Director. Valade asked two of these partners to attend the meeting with Perry’s board. During the meeting, Valade did not object to the board’s decision to ignore the apparent inventory shortage in preparing the company’s 1992 financial statements.

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. . . . The minutes [of the meeting] also reflect that Valade recommended that Perry conduct a simultaneous chain-wide [physical] inventory as soon as possible to discover the reasons for the discrepancy.

Perry filed its fiscal 1992 10-K with the SEC in late 1992. Perry’s income statement included in the 10-K reported a net income of $8.3 million, as reflected by Exhibit 1. Had Perry written off the $20.3 million balance of the Store 100 inventory account, the company would have reported a net loss of approximately $6 million for fiscal 1992. Also included in the 10-K was Andersen’s unqualified audit opinion on Perry’s 1992 financial statements, an opinion signed by Richard Valade on December 15, 1992.

SEC Investigates Perry Drug Stores

The management of Perry Drug Stores followed the recommendation of Richard Valade and took a company-wide physical inventory in the spring of 1993. That physical inventory confirmed the large inventory shortage discovered by the company in fiscal 1992. Near the end of fiscal 1993, Perry’s management decided to write off the balance of the Store 100 inventory account. Perry included this write-off in a $33.4 million fourth-quarter adjustment. Since management deemed that the $20.3 million inventory write-off resulted from a “change in estimate,” it did not report the write-off separately in its fiscal 1993 income statement, nor did the company restate its 1992 financial statements for the item. Exhibit 2 presents the paragraph from the Management’s Discussion & Analysis (MD&A) section of Perry’s 1993 annual report that disclosed the inventory adjustment. Valade did not object to Perry’s financial statement treatment of the large inventory adjustment.8

--Insert Exhibit 2--

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While reviewing the MD&A section of Perry’s 1993 10-K, the SEC discovered the $33.4 million adjustment recorded by the company during the fourth quarter of fiscal 1993. In July 1994, after discussing this matter with Perry’s management, the SEC insisted that the company restate its 1992 and 1993 financial statements. The SEC required Perry to treat the $20.3 million write-off of the Store 100 inventory account as a correction of an error. This treatment increased Perry’s cost of sales for fiscal 1992 by that amount, while decreasing 1993's cost of sales by the same figure. Exhibit 3 presents the key items affected by Perry’s restatement of its 1992 and 1993 financial statements. Exhibit 4 contains a portion of the financial statement footnote Perry included in its 1994 10-K to disclose the restatement of its 1992 and 1993 financial statements.

--Insert Exhibits 3 & 4--

Following Perry’s restatement of its 1992 and 1993 financial statements, the SEC launched an investigation of the company. The investigation centered on the circumstances surrounding Perry’s decision not to write off the balance of the Store 100 inventory account in fiscal 1992. In 1998, the SEC issued two enforcement releases reporting the results of that investigation.

The SEC’s first enforcement release focused on Jerry Stone, the former Arthur Andersen audit partner who served as Perry’s CFO during the early 1990s. In this release, the SEC chastised Stone for signing Perry’s 1992 10-K: “... by signing Perry’s 1992 Form 10-K Stone caused Perry to file with the Commission financial statements that did not accurately reflect the value of Perry’s inventory.”9 The SEC also sanctioned Stone for failing to correct Perry’s 1992 financial statements. This sanction ordered Stone to “cease and desist from causing any violation and future violation” of federal securities laws.