Fraud of ZZZ Best Company
The ZZZ Best was the carpet cleaning company that was started by 15 year old Barry Minkow in 1982. He was inspired to enter into this industry by his mother when he was 12 years old. His mother was working as a telephone solicitor for a small carpet cleaning firm. Though most of the companies in carpet cleaning industry were legitimate, the nature of this business attracts many seedy characters of the malpractice. There are no barriers for any entry even no license was required. It was too easy that a 16 year old boy can start this business with his new driver’s license. The boy started his business as “rug sucker”. Minkow started his business named ZZZZ Best Carpet Cleaning Company in Reseda, San Fernando Valley, California. In the beginning stage Minkow ran his home based business out of his parent’s garage.

Minkow soon realized that a small carpet cleaning business grew rapidly in next five years, but Minkow realized that it was difficult to earn from this business. To make earning better he had to face the cutthroat competition. The young boy had to face customer complaints, bad checks, and nagging vendors also demanding payment. And within very short time phrase he faced the fact of shortage of working capital. And moreover because of Minkow’s young age and the fact that ZZZZ Best was only marginally profitable business. All the local banks refused to give him loan. So, this teenager was looking for some easy ways of earning. Like check kiting, credit card forgeries, and the staging of thefts to fleece his insurance company. But because of his young age and charm, in this early stage he was able to escape unharmed from the law. And as he came to know the easiest way to make money he wanted to earn more and more. And this inspired him to make his plans larger. The ease with which the system could be beaten encouraged him to exploit it on a larger scale.

Minkow was the ambitious teenager who started the company from garage, had the explosive growth in both revenue and also profit. In the period of 1984 to 1987 the net profit of the company increased from $200,000 to more than $5 million. Also the company grew from a small door to door carpet cleaning service with few employers to a company with 1400 employees. The employees were specialized in “insurance restoration” cleaning. One of the first contracts ZZZZ Best received was from the Genovan Mafia family.

During 1986-87, Minkow took the way to frequent television commercials. This advertisement showed Minkow in sharp business suit, selling confidently selling the superiority of the ZZZZ Best Company. Minkow worked hard to get more and more business. Even he had one man called Tom Padgett of Interstate Appraisal Services, an insurance claim adjuster. He was the one who used to get him larger restoration contracts. Even the ZZZZ Best Company did not clean the carpets as the company was claiming in the advertisement. But this was the way to attract investment for his new plan called Ponzi scheme. Minkow generated fraudulent paper trails to fool the investors. Also Interstate Appraisal Services was created as a separate company to support ZZZZ Best Company.

Minkow got money by dividing his accounts that he was receiving for work under contract. He also hired the reputable accountants and lawyers to make his image better and more reliable. In this way he fabricated contracts, altered his sales, and also took money for this organized crime. By use of all such means Minkow was making millions of dollars with his company. In 1986, this company was having the capital of over $200 million. And when being suspected, Minkow was in trouble when some officers came to inspect his offices. To overcome this matter, Minkow borrowed fake offices for the officers and took them to the tour of “Interstate Appraisal Services”, also he hired one under construction building to show the restoration job.

Minkow used $2 million to complete the building in few days. There were some problems but the investors were so impressed by Minkow that they were ready to neglect those problems. The Chief Financial Officer of the company was also the owner of a florist business. The company was accused of having stolen over $92,000 by charging flowers to customers’ credit cards without any authorization from them. But young Minkow ignored all these as he was facing the competition from Feshback Brothers.

The U.S. Securities and Exchange Commission and FBI with two accounting firms took the investigation against the company. Minkow bribed the security guard to get the access to a newly constructed building in Sacramento, California to present to the investigating team that ZZZZ Best had just finished restoring and was about to buy rival carpet cleaning company KeyServe when their stock was absorbed. But the investigating team found that the company’s most of the contracts were false. This report spread in Los Angeles Times and the FBI found Minkow involved in all the organized crime.

In 1987, the company was able to raise $40 million from the public offering. But as the matter of fact around 90% of the revenue shown was fake. And the surprising thing was that no one was able to catch it. Not even the team of auditors, lawyers, Underwriters, and even FBI. And as a result of all these matters the company was having the market value of over $300 million. The stock of the company rose to $18 per share.

During one conversation on the Oprah Winfrey Show, Minkow revealed his personal motto that was “sky is the limit” for him. This charming young boy now started his master plan that was to take his company public and his motive was to tap the bank accounts of investors from whole nation. In May 1987, a newspaper article charged Minkow with certain wrongdoings. The stock, however, continued to be actively traded on the NASDAQ exchange. On May 19, 1987, a short article in The Wall Street Journal reported that ZZZZ Best Company, Inc., of Reseda, California, had signed a contract for a $13.8 million insurance restoration project. This project was just the most recent of a series of large restoration jobs obtained by ZZZZ Best Company.

The company went public in 1986 and Minkow and his some close associates became multi millionaires overnight. By late 1987, the company was having the market value of more than $120 million. Minkow was the youngest CEO and the richest young boy. At the very young age he owned a suburb in Los Angeles and a Fire engine red Ferrari. His charm and smart mind made him the most wanted person on all the talk shows that presented him as the example for the American youth. He was shown as the example to show that what the America youth can gain if they want. Unlike most financial frauds, the ZZZZ Best scam was perpetrated under the watchful eye of the Securities and Exchange Commission (SEC). The scrutiny of the SEC, one of the largest Wall Street brokerage houses, a large and reputable West Coast law firm that served as the company’s general counsel, and an international public accounting firm had failed to uncover Minkow’s daring scheme.

But ultimately Minkow’s fact came to public by a homemaker who was bilked out for few hundred dollars by the company. Minkow was soon exposed as fraud. The Representative John D. Dingell who was the chairman of the U.S. House Committee on Energy and Commerce, brought into the notice that the prospectus of the company showed that revenues and earnings that were shown from the restoration contracts were too high but never talked about what contracts they were offered for.

The numbers of the company were showing some picture like this:

|Exhibit 1: Selected Ratios From ZZZZ Best |
| |
|1985 |
|1986 |
| |
|Current ratio of assets to liabilities |
|36.552 |
|.0977 |
| |
|Working capital: Total assets |
|0.5851 |
|(0.0080) |
| |
|Collection ratio |
|N/A |
|26.131 |
| |
|Asset turnover |
|.144 |
|1.041 |
| |
|Debt to equity ratio |
|.017 |
|1.486 |
| |
|Receivables turnover |
|N/A |
|6.984 |
| |
|Times interest earned |
|N/A |
|43.136 |
| |
|Cost of sales: Sales |
|.465 |
|.423 |
| |
|Gross margin percentage |
|53.51% |
|57.68% |
| |
|Return on equity |
|183.75% |
|46.58% |
| |

These numbers did not make any sense. The current ratio shows that the company without any cash in 1986, records revenues. The debt to equity ratio is about 8600% from the previous year. Also the return on equity dropped more than 75% and these were not signs of a good legitimate business.

If we look at sales variable index that measures the balance between receivables and revenues of two consecutive reporting periods. Noticeable increase in this ratio shows that the receivables of the company are fake. And the ZZZZ Best Company was also under such situation.

Under normal condition the sales index can be of 1.032. But the companies who have misrepresented the numbers, they will show the hype of 1.465, that is about 42%. And ZZZZ Best Company was also showing receivables of about $700,000 that were all fake.

|Exhibit 2: ZZZZ Best Financials |
| |
|1985 |
|1986 |
| |
|Sales |
|$1,240,524 |
|$4,845,347 |
| |
|Cost of goods sold |
|$576,694 |
|$2,050,779 |
| |
|Accounts receivable |
|0 |
|$693,773 |
| |
|Current assets |
|$107,096 |
|$1,727,973 |
| |
|Total assets |
|$178,036 |
|$5,045,671 |
| |
|Fixed assets |
|$125,519 |
|$2,564,532 |
| |
|Accumulated depreciation |
|$68,029 |
|$163,145 |
| |
|Net fixed assets |
|$57,490 |
|$2,401,387 |
| |
|General expenses |
|$306,016 |
|$1,125,541 |
| |
|Depreciation |
| |
|$95,116 |
| |
|Cash |
|$30,321 |
|$87,014 |
| |
|Current liabilities |
|$2,930 |
|$1,768,435 |
| |
|Notes payable—current |
|0 |
|$780,507 |
| |
|Income taxes payable |
|0 |
|$28,027 |
| |
|Working capital |
|$104,166 |
|($40,462) |
| |

The formula for the days’ sales in receivables index is
[pic]
Using numbers from the ZZZZ Best financials, the index is calculated as follows:
[pic]
As the result of it we can see that the material increases may not be the result of receivables manipulation, but it could be caused by some real factors like liberalized credit policies in the years.
.While talking about Gross Margin Index we can see that the company’s performance is always related to its gross margin. If the gross margins on sales decline from one period to another it shows that the risk is higher and management is involved in fraud to show the artificial profits or decrease losses. If the company is the nonmanipulators it will be 1.014 and for manipulators it is 1.193 that is 18% increase.
The formula for the gross margin index is
[pic]
ZZZZ Best’s numbers in this equation were
[pic]
Now talking about asset quality ratio is arrived at by dividing noncurrent assets by total assets. It is the measure of the proportion of total assets for which future benefits may be less certain. For nonmanipulators this measure is 1.039, and for manipulators 1.254, an increase of 21%. ZZZZ Best’s index was 2.043, a 97% increase. The formula for the asset quality index is
[pic]
ZZZZ Best’s numbers were
[pic]
So, when we talk about fraud, it is always hard to detect intentional fraud. But the auditor has to be extra cautious while auditing. The probability of the fraud leaving undetected can be minimized if the auditor is using the ratio analysis. The ratios show the real picture of the financial condition of any organization. And if the auditors of the ZZZZ Best Company would have used the ratio analysis in the beginning, then they would have been successful in stopping the fraud at such large extent. Minkow used the accounting tricks in such a manner that even the professionals were not able to detect the fraud.

References: http://www.aicpa.org/pubs/jofa/aug2001/wells.htm |Zzzz Best |
| |
| |
|ZZZZ Best, Inc. |
| |
|The start of ZZZZ Best: |
|ZZZZ Best started as a carpet cleaning company. Barry Minkow founded ZZZZ Best in his parents’ garage in 1982 when he was only |
|sixteen years old. Due to high competition in the industry, low enter barriers, and bad internal control, this young |
|entrepreneur started to have cash flow problems, and a shortage of working capital. |
|Pressure Leads to Fraud: |
|Under financial pressure, Minkow started to commit fraud. He forged credit card applications, staged theft, used bogus financial|
|statements, and used his networking skills to entice wealthy investors. The most serious fraud he made was inflating the value |
|of the company’s insurance restoration contracts (Knapp, 2006). |
|Inflated Insurance Restoration Contract |
|Minkow created two property management companies, the Interstate Appraisal Service and Assured Property Management. He also |
|hired a well-known insurance agent, Tom Padgett, to be the principal officer of Interstate Appraisal Service and used these two |
|companies to generate paper profit. The falsified paper profit accounted for almost 90% of ZZZZ Best’s revenue. |
|Deception of Auditors: |
|1. False confirmations |
|Since most of revenue came from insurance restoration contracts, George Greenspan, the first auditor of ZZZZ Best, contacted Tom|
|Padgett to confirm the existence of the insurance restoration contracts. Padgett, being in on the fraud, lied and gave Greenspan|
|a positive answer. |
|2. Misleading auditors: |
|Barry Minkow dismissed Greenspan after his audit of 1986 financials and hired Larry Gray from Ernst & Whinney. Because the |
|amount of insurance restoration contracts was material, Gray informed ZZZZ Best of his wish to observe the restoration sites to |
|... |
| |