Regina Company, Inc

CASE 1.12

REGINA COMPANY, INC.

Donald Sheelen was born into a middleclass family in upstate New York in 1946. In high school, the handsome Sheelen was the prototype of the allAmerican boy, excelling in both academics and athletics. Following graduation, Sheelen attended the University of Dayton, where he was elected president of his senior class and named a Big Man on Campus. After earning an MBA from SyracuseUniversity, Sheelen landed a job with a large Wall Street brokerage firm and then three years later accepted a middle-management position with Johnson & Johnson. At the age of thirtyfour, Sheelen was hired by Regina Company, Inc., and placed in charge of the company’s marketing department.

Regina was a wholly-owned subsidiary of the large conglomerate General Signal Corporation. Founded in Rathway, New Jersey, in 1892, Regina had originally been a music box manufacturer before entering the floorcare industry in the early 1900s. Throughout most of its existence, Regina was known as a complacent, slow-growth company and was dominated within the floorcare industry by Hoover and Eureka. Regina’s corporate

image changed quickly after Donald Sheelen signed on with the company.

Cornflakes, Celebrity, and Cash for Donald Sheelen

After becoming company president in 1983, Sheelen announced that he intended to make Regina the industry’s dominant firm by the end of the decade. He repeatedly vowed that Regina would bombHoover, the number one firm in the industry at the time. The exuberant executive even laid a Hoover doormat outside his office so that each day he could “walk over” his company’s major rival.1 Sheelen believed that to challenge Hoover and Eureka, Regina had to expand its product line and dramatically increase its advertising expenditures. Under his leadership, Regina introduced a series of new products, including a portable spa and an upright vacuum cleaner. To promote these and other new products, Sheelen poured millions of dollars into Regina’s advertising budget. Eventually, the company’s annual advertising expenditures exceeded 20 percent of its annual sales and eclipsed the combined advertising outlays of Hoover and Eureka.

Sheelen became well known both inside and outside the floorcare industry for his socalled cornflake routine that he often performed at trade shows and during news conferences. This routine involved sprinkling crushed cereal on a carpet and then demonstrating that a Regina vacuum cleaner did a much better job of cleaning up the mess than did a Hoover. Sheelen converted this demonstration into a television advertisement and was promptly sued by Hoover, which forced him to cancel the popular commercial. Hoover proved that the commercial was misleading since the Regina vacuum cleaner used in the cornflake caper had an industrialstrength suction not available on the model sold to retail customers.

Regina’s board of directors named Sheelen the company’s chief executive officer in early 1984. A few months later, he and several other Regina executives bought a majority interest in the company via a leveraged buyout. Sheelen personally invested only $750,000 in the venture but emerged with more than a 50 percent equity interest in Regina, which had total assets approaching $40 million at the time. The following year, Sheelen and his partners took Regina public. Surging sales and profits quickly landed Regina on the “buy” lists of several large brokerage firms and tagged the company’s stock as a “can’t miss” investment on Wall Street. (Exhibit 1 presents Regina’s balance sheets and income statements for 1986 through 1988.) In commenting on the company, one financial analyst noted, “Regina is not only an earnings play but an investment in a skilled management team that has turned the company around.”2

--Insert Exhibit 1--

Within two years after going public, Regina’s stock price had soared by nearly 500 percent and analysts expected it to go much higher. Regina’s lofty stock price made Sheelen and the company’s other principal stockholders millionaires many times

over. Sheelen’s stock alone had a market value of almost $100

million by 1988.

Regina’s Profits: Just So Much Hot Air

Unfortunately, the toogoodtobetrue story of Regina Company was . . . too good to be true. The sparkling sales and earnings figures released by Regina after it went public had been doctored by Sheelen. For the fiscal year ended June 30, 1988, the company actually suffered a multimillion-dollar loss rather than the reported $11 million profit. Instead of a growth company with bright prospects, Regina was a dying company mired in mounting losses.

Regina’s financial difficulties stemmed largely from product quality problems. Sheelen and the company’s other top executives failed to pay sufficient attention to quality control issues during the manufacturing process for the new products introduced during the mid1980s. These new products were innovative and less expensive than those of the company’s competitors. They were also unreliable, having been rushed to the market without being adequately tested. Customer return rates several times greater than those of Regina’s competitors negated the impressive sales figures registered following the introduction of the new products. One major retailer reported a return rate of 50 percent for a Regina vacuum cleaner, while the comparable models of Hoover and Eureka had return rates of less than 1 percent.

By 1987, Sheelen realized that Regina was in deep trouble. Rather than admitting the problems facing the company, Sheelen chose to conceal them via several illicit accounting schemes. In a subsequent investigation, the Securities and Exchange Commission (SEC) charged that inflating Regina’s stock price was the prime motive behind these schemes. Colleagues of Sheelen later corroborated this allegation when they testified that he was obsessed with maintaining the company’s stock price at a high level: “Nothing fired Sheelen’s emotions like the company’s stock price. Even a temporary flutter would cause him to rush to the phone to drum up support. He would pick up the phone himself

and say, ‘Why don’t you [a financial analyst] write something to get the stock up?’”3

Sheelen began earnestly manipulating Regina’s reported operating results during the second quarter of the company’s 1988 fiscal year. Regina had posted steady increases in sales and earnings from 1985 through most of 1987. By December 31, 1987, the end of the second quarter of fiscal 1988, Regina’s huge sales returns were threatening the company’s impressive sales and earnings trends. At that point, Sheelen began establishing target sales and earnings goals that he believed Regina had to reach for the company to sustain “the confidence of the securities markets.”4

To meet his financial targets for the second quarter of 1988, Sheelen instructed Vincent Golden, Regina’s chief financial officer, to understate the company’s product returns for that quarter: “With Golden’s approval, employees altered Regina’s computer system so that products returned by certain large volume customers could be processed through Regina’s customer service department but would not be recorded on the company’s books.” Sheelen and Golden continued to misrepresent Regina’s product returns for the final two quarters of fiscal 1988. According to the SEC, the company understated its sales returns by at least $13 million for the year.

During the fourth quarter of fiscal 1988, Sheelen realized that slashing recorded sales returns alone would not allow Regina to achieve the sales and earnings goals he had established for that year. With Golden’s help, Sheelen came up with several other accounting schemes to ensure that Regina reached his 1988 target sales and earnings figures of approximately $180 million and $1.20 per share, respectively. Sheelen instructed Golden to record bogus sales during the fourth quarter of fiscal 1988: “With Golden’s approval, Regina’s computer system was programmed to create false invoices in amounts of prior orders from certain large volume customers. Large volume customers were used because Golden and certain members of his staff believed that such customers were less likely than smaller customers to respond to audit confirmations.” Golden also made sure that the bogus invoices were not sent to Regina’s customers or routed to members of the company’s accounting department who were unaware of the earnings manipulation scheme. In total, Golden and his subordinates generated 200 bogus invoices, representing collective sales of more than $5 million.

Another method Sheelen used during 1988 to inflate Regina’s revenues involved booking what Golden referred to as “shipinplace” sales. These items were sales orders that Regina had received but not filled as of June 30, 1988. In fact, some of the orders were not due to be shipped for several weeks following Regina’s fiscal year-end. Golden recorded approximately $6 million of shipinplace sales in the last few days of fiscal 1988. The SEC charged that the recording of these sales blatantly violated generally accepted accounting principles: “The shipinplace transactions did not qualify for revenue recognition under GAAP because no exchange had taken place, the risks of loss and rights of ownership had not passed from Regina to customers, and there was no substantial business purpose for structuring the transactions as shipinplace transactions.” The last measure Sheelen and Golden used to attain Regina’s earnings goal for 1988 was simply to understate the company’s cost of goods sold for the fourth quarter by more than $3 million.

In the late summer of 1988, Regina released its fiscal 1988 financial statements. Those statements reported net sales of approximately $181 million and earnings per share of $1.21. In Regina’s 1988 annual report, Sheelen boasted of the company’s financial performance and suggested that the following year it would produce even better operating results. (Exhibit 2 contains excerpts from Sheelen’s 1988 letter to Regina’s stockholders.)

--Insert Exhibit 2--

On September 15, 1988, Sheelen told a group of financial analysts that Regina would be reporting an increase in sales for the first quarter of fiscal 1989. In fact, Sheelen knew that Regina’s sales had declined during that quarter. Over the next few days, Sheelen gradually realized that he could no longer conceal Regina’s deteriorating financial condition. On September 20, 1988, he called Golden into his office. The two men decided to reveal that Regina’s prior financial statements were materially misstated. Instead of disclosing the true cause of the inaccurate financial statements, Sheelen and Golden elected to blame the errors on computer malfunctions.

After meeting with Golden, Sheelen issued a press release reporting that Regina’s sales would be lower than previously forecast for the first quarter of fiscal 1989. The press release also indicated that the company would suffer a loss for that quarter. Sheelen then notified Peat, Marwick, Mitchell & Company, Regina’s audit firm, that the company’s 1988 financial statements contained errors resulting from glitches in computer processing. Sheelen asked the audit firm to review Regina’s accounting records to determine the magnitude of the errors.

The price of Regina’s common stock plunged 60 percent by the close of the financial markets on September 21, 1988, as investors reacted to Sheelen's press release. Over the next few days, Sheelen and Golden resigned their positions with Regina and Peat Marwick withdrew the unqualified audit opinion issued several weeks earlier on the company’s fiscal 1988 financial statements. In early October, a U.S. attorney initiated a criminal investigation of Regina’s financial affairs. During that investigation, Sheelen voluntarily revealed the details of the earnings manipulation schemes used to misrepresent Regina’s 1988 operating results.

Aftermath of the Regina Fraud

Donald Sheelen and Vincent Golden pleaded guilty to federal mail and securities fraud charges in February 1989. According to the U.S. attorney who prosecuted the case, the fraudulent scheme bilked investors of more than $100 million. When the company filed for bankruptcy in 1989, its common stock became essentially worthless. In July 1989, a competitor, Electrolux Corporation, acquired Regina. An Israeli company purchased Regina in 1994 and then sold it the following year to Philips Electronics, N.V., a large Dutch firm. Regina ceased operating as a separate entity after being acquired by Philips.

In May 1989, a federal judge sentenced Sheelen to a one-year prison term, a sentence that he served in a halfway house. Golden received a six-month sentence. The federal judge also fined both men and placed them on probation; Sheelen paid a $25,000 fine, while Golden was fined $12,500. According to the judge, the lenient sentences were appropriate because both men had cooperated with authorities investigating the scandal. Before beginning his sentence, Sheelen contacted Regina’s new chairman and asked if he

could return to the company. The chairman reportedly responded with a question of his own: "Are you _____ crazy?"5

One charge leveled at Sheelen and Golden by the SEC was that the former executives had repeatedly and intentionally misled the company's audit firm, Peat Marwick. As an example, the SEC pointed out that Peat Marwick auditors discovered one of the shipinplace sales transactions and notified Golden. Golden assured the auditors that no similar transactions had been recorded in Regina's accounting records. In the enforcement release that focused on the Regina scandal, the SEC did not fault Peat Marwick for failing to uncover the massive fraud masterminded by Sheelen and Golden. Nevertheless, several articles in the financial press criticized the audit firm. A Peat Marwick partner responded to such criticism by noting that "We're only human and prefer to trust the people we're auditing."6

Exhibit 1

Regina Companys 1986-1988

Financial Statements

Regina Company, Inc.

Balance Sheets 1986-1988 (000s omitted)

June 30,

1988 1987 1986

Current assets:

Cash $ 885 $ 514 $ 63 Receivables (net) 51,076 27,801 14,402

Inventories 39,135 19,577 9,762

Other current assets 3,015 1,449 708

Total current assets 94,111 49,341 24,935

Property, plant and equipment 21,548 14,788 16,383

Other assets 2,481 1,112 1,884

Total assets $118,140 $65,241 $43,202

Current liabilities:

Short-term borrowings $ -- $ -- $ 2,707

Current portion of long-term debt 1,250 900 --

Accounts payable 13,288 15,072 7,344

Accrued liabilities 4,710 5,468 3,127

Income taxes payable 3,782 2,619 1,554

Total current liabilities 23,030 24,059 14,732

Long-term debt:

Industrial revenue bonds 12,650 13,900 14,800

Mississippi state debt 1,975 -- --

Bank debt 47,432 5,941 --

Total long-term debt 62,057 19,841 14,800

Deferred income taxes 1,881 1,254 685

Stockholders’ equity:

Common stock 1 1 1

Additional paid-in capital 7,902 7,771 7,774

Retained earnings 23,269 12,315 5,210

Total stockholders’ equity 31,172 20,087 12,985

Total liabilities and

Stockholders’ equity $118,140 $65,241 $43,202

Exhibit 1, Cont’d

Regina Companys 1986-1988

Financial Statements

Regina Company, Inc.

Income Statements 1986-1988 (000s omitted)

Years Ended June 30,

1988 1987 1986

Net sales $181,123 $128,234 $76,144

Operating costs and expenses:

Cost of goods sold 94,934 70,756 46,213

Selling, distribution, and

administrative 21,870 14,621 10,366

Advertising 39,992 26,449 8,557

Research and development 2,423 1,530 1,182

Total operating costs and expenses 159,219 113,356 66,318

Operating income 21,904 14,878 9,826

Interest expense 3,189 1,584 1,930

Income before income taxes 18,715 13,294 7,896

Income tax expense 7,761 6,189 3,807

Net income $ 10,954 $ 7,105 $ 4,089

Earnings per share $1.21 $ .78 $ .46

Exhibit 2

Excerpts from Donald Sheelen’s 1988

Letter to Regina’s Stockholders

It feels real good to finish Fiscal 1988 and to be thankful that your company achieved its best year ever. I’m sure you can see by looking at the numbers that we have set records in both Sales and Earnings. We are very proud of this, but we are also especially proud of the consistency over the last eight years Fiscal 1988 was our eighth consecutive year of record Sales and Earnings. . . .

I feel especially good about the significant change in Regina’s product mix over the last four years. As early as 1984, virtually 100% of earnings came from one line Electrikbroom. Now, four years later, we have a broad base with five major lines contributing to our growth. Regina has gone from being the “runt” of the floorcare industry in the United States to being on the verge of taking over the Number 1 spot. . . .

Every year when I look at what our Company has achieved, I ask myself the question what about the future. I have always said to you that there are no guarantees for the future, but my level of confidence has never been greater than today. I feel this way because the number of different programs/products that we are bringing to the market have never been greater. There is no question that we will probably make a few mistakes over the next year we have in the past but I also believe that we will set new records in all areas. By the time this report reaches you, we should be on the verge of making public announcements which we believe will very much enhance our growth.

Questions

1. Prepare common-sized financial statements for Regina for the period 1986 to 1988. Also, compute key liquidity, solvency, activity, and profitability ratios for 1987 and 1988. Given these data, identify what you believe were the highrisk financial statement line items for the 1988 Regina audit.

2. Identify audit procedures that might have resulted in Peat Marwick's discovering (a) the $5 million of bogus sales recorded by Regina executives during fiscal 1988 and (b) the intentional understatement of the company's sales returns for that same period.

3. Identify and discuss the principal audit objectives associated with the performance of yearend sales cutoff tests.

Which of the fraudulent errors in Regina’s accounting records would such tests have likely uncovered? Explain.

4. Were the Peat Marwick auditors justified in relying on Golden's assertion that the shipinplace sales transaction they discovered was an isolated item? If not, what additional audit procedures do you believe Peat Marwick should have performed at that point?

5. As noted in the case, one Peat Marwick partner stated that his firm preferred “to trust the people we’re auditing.” Should auditors trust their clients? If so, under what circumstances and to what extent?