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Case 2-9
Phar-Mor
The Dilemma
The story of Phar-Mor shows how quickly a company that built its earnings on fraudulent transactions can
dissolve like an Alka-Seltzer.
One day Stan Cherelstein, the controller of Phar-Mor, discovered cabinets stuffed with held checks
totaling $10 million. Phar-Mor couldn’t release the checks to vendors because it did not have enough cash
in the bank to cover the amount. Cherelstein wondered what he should do.
Background
Phar-Mor was a chain of discount drugstores, based in Youngstown, Ohio, and founded in 1982 by Michael
Monus and David Shapira. The company grew from 15 to 310 stores in less than 10 years and had 25,000
employees. According to Litigation Release No. 14716 issued by the SEC, Phar-Mor had cumulatively
overstated income by $290 million between 1987 and 1991. In 1992, prior to disclosure of the fraud, the
company overstated income by an additional $238 million.
The Cast of Characters
Mickey Monus personifies the hard-driving entrepreneur who is bound and determined to make it big
whatever the cost. He served as the president and chief operating officer of Phar-Mor from its inception
until a corporate restructuring was announced on July 28, 1992.
David Shapira was the chief executive officer of Phar-Mor and the CEO of Giant Eagle, Phar-Mor’s
parent company and majority stockholder. Giant Eagle also owned Tamco, which was one of Phar-Mor’s
major suppliers. Shapira left day-to-day operations of Phar-Mor to Monus until the fraud became too large
and persistent to ignore.
Patrick Finn was the CFO of Phar-Mor from 1988 to 1992. Finn, who holds the CMA, initially brought
Monus the bad news that following a number of years of eroding profits, the company faced millions in
losses in 1989.
John Anderson was the accounting manager at Phar-Mor. Hired after completing a college degree in
accounting at Youngstown State University, Anderson became a part of the fraud.
Coopers & Lybrand, prior to its merger with Price Waterhouse, were the auditors of Phar-Mor. The firm
failed to detect the fraud as it was unfolding.
How It Started
The facts of this case are taken from the SEC filing and a Public Broadcasting System Frontline program,
“How to Steal $500 Million.” The interpretation of the facts is consistent with reports, but some literary
license has been taken to add intrigue to the case.
Finn approached Monus with the bad news. Monus took out his pen, crossed off the losses, and then
wrote in higher numbers to show a profit. Monus couldn’t bear the thought of his hot growth company that
had been sizzling for five years suddenly flaming out. In the beginning, it was to be a short-term fix to buy
time while the company improved efficiency, put the heat on suppliers for lower prices, and turned a profit.
Finn believed in Monus’s ability to turn things around so he went along with the fraud. Finn prepared the
reports and Monus changed the numbers for four months before turning the task over to Finn. These reports
with the false numbers were faxed to Shapira and given to Phar-Mor’s board. Basically, the company was
lying to its owners.
The fraud occurred by dumping the losses into a “bucket account” and then reallocating the sums to one
of the company’s hundreds of stores in the form of increases in inventory amounts. Phar-Mor issued fake
invoices for merchandise purchases and made phony journal entries to increase inventory and decrease cost
of sales. The company over-counted and double-counted merchandise in inventory.
The fraud was helped by the fact that the auditors from Coopers observed inventory in only 4 out of 300
stores, and that allowed the finance department at Phar-Mor to conceal the shortages. Moreover, Coopers
informed Phar-Mor in advance which stores they would visit. Phar-Mor executives fully stocked the 4
selected stores but allocated the phony inventory increases to the other 296 stores. Regardless of the
accounting tricks, Phar-Mor was heading for collapse and its suppliers threatened to cut off the company
for nonpayment of bills.
Stan Cherelstein’s Role
Cherelstein, a CPA, was hired to be the controller of Phar-Mor in 1991 long after the fraud had begun. One
day, John Anderson, Phar-Mor’s accounting manager, called Cherelstein into his office and explained that
the company had been keeping two sets of books—one that showed the true state of the company with the
losses and the other, called the subledger, that showed the falsified numbers that were presented to the
auditors.
Cherelstein and Anderson discussed what to do about the fraud. Cherelstein was not happy about it at all
and demanded to meet with Monus. Cherelstein did get Monus to agree to repay the company for the losses
from Monus’s (personal) investment of company funds into the World Basketball League (WBL). But
Monus never kept his word. In the beginning Cherelstein felt compelled to give Monus some time to turn
things around through increased efficiencies and by using a device called exclusivity fees that were paid by
vendors to get Phar-Mor to stock their products. Over time, Cherelstein became more and more
uncomfortable as the suppliers called more and more frequently demanding payment on their invoices.
Accounting Fraud
Misappropriation of Assets
The unfortunate reality of the Phar-Mor saga was that it involved not only bogus inventory but also the
diversion of company funds to feed Monus’s personal habits. One example was the movement of $10
million in company funds to help start a new basketball league, the World Basketball League that limited
player participation to those six feet and under.
False Financial Statements
According to the ruling by the United States Court of Appeals that heard Monus’s appeal of his conviction
on all 109 counts of fraud, the company submitted false financial statements to Pittsburgh National Bank,
which increased a revolving credit line for Phar-Mor from $435 million to $600 million in March 1992. It
also defrauded Corporate Partners, an investment group that bought $200 million in Phar-Mor stock in June
1991. The list goes on including the defrauding of Chemical Bank, which served as the placing agent for
$155 million in 10-year senior secured notes issued to Phar-Mor; Westinghouse Credit Corporation, which
had executed a $50 million loan commitment to Phar-Mor in 1987; and Westminster National Bank, which
served as the placing agent for $112 million in Phar-Mor stock sold to various financial institutions in 1991.
Tamco Relationship
The early financial troubles experienced by Phar-Mor in 1988 can be attributed to at least two transactions.
The first was that the company provided deep discounts to retailers to stock its stores with product. There
was concern early on that the margins were too thin. The second was that its supplier, Tamco, was shipping
partial orders to Phar-Mor while billing for full orders. Phar-Mor had no way of knowing because it was
not logging in shipments from Tamco.
After the deficiency was discovered, Giant Eagle agreed to pay Phar-Mor $7 million in 1988 on behalf
of Tamco. Phar-Mor later bought Tamco from Giant Eagle in an additional effort to solve the inventory and
billing problems. However, the losses just kept on coming.
Back to the Dilemma
Cherelstein looked out the window at the driving rain storm. He thought about the fact that he didn’t start
the fraud or the cover-up. Still, he knows about it now and feels compelled to do something. Cherelstein
thought about the persistent complaints by vendors that they were not being paid and their threats to cut off
shipments to Phar-Mor. Cherelstein knows that without any product in Phar-Mor stores, the company could
not last much longer.
NOTES
This case discusses the accounting scandal of Phar-Mor and show the rationalization of giving time to fix a
situation, which may not be fixable. An excellent video that may still be available from the 1984 PBS
presentation is “How to Steal $500 Million.” The dialogue of the video can be found at:
http://www.pbs.org/wgbh//pages/frontline////////programs/transcripts/1304.html.
Ethical Issues
This case highlights rationalization used to justify not doing ethical obligations. The rationalization was
that all the misrepresentation was short-term so that the company could recover losses and make the
reported financial statements correct. The short term turned into long term and the losses kept mounting.
Monus refused to report losses and had taken company funds for a personal investment in the World
Basketball League. Monus failed in his fiduciary duties and the values of honesty, integrity, trustworthiness,
and responsibility. Shapira also failed on his fiduciary duties and responsibility to oversee Phar-Mor. Finn,
Cherelstein, and Anderson failed to account in accordance with GAAP and adequately disclose accounting
treatments and procedures in the financial statements. Finn, in particular, violated ethical standards of the
accounting profession by participating in and covering up the fraud.
The stakeholders of Phar-Mor have a right not to be misled by financial statements making it look as
though the company is doing better than it really is. Any attempt to intentionally misstate the financial
statements violates the categorical imperative under rights theory. From a justice perspective, stakeholder
interests are not fairly represented because the perceived interests of the management are given priority
over the interest of all other stakeholders. Mickey Monus, the chief operating officer, was greedy, pursued
power and fame, and was left unsupervised by David Shapira, the CEO of the company. There did not
appear to be an (active) board of trustees.
From a utilitarian perspective, Rule-utilitarianism: It requires that the correct rule should be followed. Act-
utilitarianism: Requires that the act that creates the greatest good for the greatest number of stakeholders
should be selected. None of the stakeholders benefit from an action that misstates net income. Even Phar-
Mor was harmed because the SEC imposed sanctions on it for false and misleading financial statements.
From a virtue perspective, honesty requires that the statements should be truthful and follow GAAP.
Trustworthiness means that the accountants should not violate the investors’ faith that the statements are
accurate and reliable. Due professional care requires that Coopers & Lybrand should have conducted the
audit with skepticism and gathered sufficient evidence upon which to base an opinion.
Objectivity requires that the company should approach its decision about the proper accounting procedures
for investments and inventory with fair-mindedness and without bias towards one set of stakeholders or
perceived company interests over others including the investors, creditors, and suppliers who were not
getting paid towards the end of the fraud.
Questions
1. How do you assess blame for the fraud? That is, to what extent was it caused by Finn’s willingness
to go along with the actions of Monus? What about Shapira’s lax oversight. Should the blame all
go to Monus? What role did Coopers & Lybrand play with respect to its professional judgment?
The blame for the fraud lies mostly with Monus; he was using company assets for his personal purposes
and pressured subordinators to go along with his schemes so that his pride would not be hurt by reporting
losses. Finn was willing to go along and believed that the situation was short term; he rationalized Mickey
Monus would find a solution to the earnings misstatements through the use of exclusivity fees. Cherelstein
accepted that position. Anderson was not a CPA and started at Phar-Mor right out of college; he may have
Professional judgment is exercised with due care, objectivity, and integrity. It seems that Coopers &
Lybrand did not exercise due care and objectivity (skepticism). Coopers & Lybrand contributed to the fraud
by not being skeptical enough; the firm’s professional judgment was improper by informing Phar-Mor of
which stores would be included in the inventory observation. The advance notification of the store locations
2. Assume Cherelstein decides to use Rest’s Model of Morality to reason out what the right thing to
do is and how to carry out the action. Apply the logic of the model to Cherelstein’s decision-
making process What do you think he should do at this point and why?
Cherelstein’s identified the moral sensitivity issue by acknowledging that fraud was occurring by Monus,
personally, and the accounting methods used by Finn to cover it up. He exhibited moral judgment by
discussing the fraud with Andersen, realizing something had to be done to bring the fraud out in the open.
The second step would be moral judgment or solutions to solve the ethical dilemma. Here, Cherelestein
should have considered going to David Shapira; in other words, going up the chain of command all the way
3. What is the ethical message of Phar-Mor? That is, explain what you think is the “moral of the
story.”
The moral of the story is the tone at the top determines practices of a company, that pride should not get in
the way of good business and that delaying bad news may only cause more harm. For Pat Finn, the message
