Montclair State TruServ Scheme to Understate the Merchandise Payable Accrual Essay

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I’m working on a accounting report and need an explanation and answer to help me learn.

In 2003, the Securities and Exchange Commission released an Accounting and Auditing Enforcement Release (AAER) describing charges and discipline against TruServ Corporation and the company’s chief financial officer. The charges claimed that TruServ underestimated the accrual for merchandise payable.RequiredRead the enclosed 2003 AAER related to TruServ Corporation. Explain the scheme that the company used to understate the accrual for merchandise payable. Finally, what audit procedures might an auditor use to uncover this misstatement?

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March 4, 2003
1727 / March 4, 2003
Truserv Corporation,
The Securities and Exchange Commission (“Commission”) deems it appropriate that public
cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the
Securities Exchange Act of 1934 (the “Exchange Act”) against TruServ Corporation (“TruServ” or
In anticipation of the institution of these proceedings, TruServ has submitted an Offer of
Settlement (the “Offer”) which the Commission has determined to accept. Solely for the purpose
of these proceedings and any other proceedings brought by or on behalf of the Commission, or
to which the Commission is a party, and, without admitting or denying the findings contained
herein, except as to the Commission’s jurisdiction over it and over the subject matter of these
proceedings, TruServ consents to entry of this Order Instituting Cease-and-Desist Proceedings,
Making Findings and Imposing Cease-and-Desist Order Pursuant to Section 21C of the Securities
Exchange Act of 1934 (“Order”) as set forth below.
On the basis of this Order and the Respondent’s Offer of Settlement, the Commission finds that:
1. TruServ, a Delaware corporation, is a hardware store buying cooperative headquartered in
Chicago, Illinois. TruServ was created in July 1997 by the merger of two competing hardware
buying cooperatives. TruServ currently has approximately 7,600 shareholders. Most of the
shareholders are members of the cooperative. Members of the cooperative principally operate
hardware stores, principally under the True Value name. TruServ is required to file periodic
reports to the Commission pursuant to the Exchange Act, but its shares do not trade on any
public market.
2. This matter involves financial misstatements by TruServ as a result of its inadequate internal
controls. From approximately July 1997 through the end of 1999, TruServ’s accounting systems
and internal controls related to inventory management were inadequate. In particular, these
deficiencies caused TruServ to understate expenses such as cost of goods sold, resulting in
overstatement of net income.
3. On March 31, 2000, TruServ reported a loss of more than $131 million for fiscal year 1999,
which included expenses it failed to report during fiscal years 1997 and 1998. As a result, from
1997 through the end of 1999, TruServ filed with the Commission annual and quarterly reports
that were false and failed to keep books, records and accounts that fairly and accurately
reflected TruServ’s assets and financial results.
4. As early as 1997, senior TruServ managers, who are now no longer employed with the
company, were aware of internal control problems. In 1997, TruServ’s predecessor company’s
internal audit department provided senior management with a report that accurately described
many deficiencies in internal controls that led to the company’s failure to report losses. Despite
receiving notice of significant problems with inventory management and accounting, TruServ
management failed to take any actions to address internal control deficiencies.
The Discovery and Size of Misstatements
5. TruServ’s financial misstatements surfaced when TruServ’s accounting staff attempted to
close its books for fiscal year 1999. After reviewing these errors, TruServ reported a loss of
more than $131 million for fiscal year 1999. The year-end adjustments resulted primarily from
deficiencies and weaknesses in the accounting practice and internal controls at TruServ. The
largest component of the previously unreported loss, $74.5 million, represented adjustments to
inventory and merchandise payable.1
6. Even though TruServ assigned the entire $131 million loss in the fourth quarter of 1999, the
expenses actually had occurred over the past several quarters. Accordingly, TruServ filed
erroneous Forms 10Q for the first, second and third quarters of 1999 and 1998, and an
erroneous Form 10K in 1998. Because the problem was caused by systemic flaws in inventory
management, computer data input and accounting systems for a period of at least two years,
TruServ is not able to restate any of its previous filings with the Commission.
Accounts Misstated as a Result of Internal Control Problems
7. Unbilled Merchandise. As TruServ closed its accounting records for 1999, TruServ’s
accounting staff reviewed the accruals for unbilled merchandise made in 1997 and 1998, and
determined that the accruals had been understated by $5.7 million in 1997 and by $19.8 million
in 1998. These errors in turn caused TruServ’s income to be misstated in 1997, 1998 and 1999.
8. TruServ routinely made an accrual for expected merchandise payable, that is, for
merchandise it had received but for which it had not yet been billed. TruServ estimated the
amount of the accrual for merchandise payable by using a report it called the Open Receiver
File. The Open Receiver File reflects merchandise that TruServ had ordered and received but for
which it had not yet received a bill. When TruServ received a bill from a vendor for
merchandise, the amount owed for the merchandise was removed from the Open Receiver File
and included in TruServ’s merchandise payable account.
9. TruServ should have been able to estimate the amount of the merchandise payable accrual
simply by looking at the amount in the Open Receiver File. However, the Open Receiver File was
not accurate, because TruServ’s distribution center and warehouse employees were not keeping
accurate records of the merchandise that it received, nor was the accounting staff using
procedures to investigate and resolve inaccuracies.
10. Starting in 1997, TruServ’s accounting staff realized that the accruals for unbilled
merchandise were too large, in that the amount TruServ accrued was always more than what it
ultimately had to pay its vendors. Rather than recommending that TruServ improve its internal
controls and establish accountability for the Open Receiver File, the accounting staff began a
practice of adjusting the accrual for unbilled merchandise by a multiplier they called a “factor.”
The factor purportedly represented the historical relationship between each month’s payments
and accruals, and was intended to refine the amount that TruServ could expect to have to pay.
However, this adjustment method was imprecise and as a result, reduced the accrual to the
point that the accruals for merchandise payable in 1997 and 1998 were understated. This
resulted in an overstatement of income.
11. Although TruServ’s books were in error because the accounting staff underestimated the
accrual for merchandise payable, the underlying problem was that TruServ failed to correct the
errors in its Open Receiver File. Therefore, although TruServ’s accounting staff was aware that
procedures were flawed, they did not fix the errors or notify anyone that procedures needed to
be improved.
12. Claims for Returned Merchandise. Approximately $20 million of the 1999 merchandise
payable adjustment related to claims for returned merchandise and allowances. If merchandise
returned by the member could not be resold due to damage or some other reason, the
accounting entry should have been made to remove the merchandise from inventory and charge
the cost of the merchandise to costs of goods sold. TruServ failed to make these entries.
Instead, TruServ removed the merchandise from inventory and reduced the amount of its
merchandise payable by the same amount.
13. Additional Stock Adjustments. In 1999, TruServ wrote off approximately $16.6 million
concerning stock adjustments TruServ made to account for lost and found merchandise,
damaged goods, and the closing of two RDCs. TruServ should have written off these stock
adjustments to cost of goods sold as necessary throughout the year, but it did not do so.
Instead, TruServ removed the merchandise from inventory, and reduced the amount of its
merchandise payable by the same amount.
14. The claims for returned merchandise and allowances and the other stock adjustments
involved TruServ’s complicated computer system for merchandise tracking, which required
warehouse and RDC employees to enter one of many stock adjustment codes that were to
reflect the reason for the returned merchandise and movement of inventory in its warehouses
and RDCs. This system was meant to provide TruServ personnel with a comprehensive picture
of the status of its inventory. However, from at least 1997 forward, RDC and warehouse
personnel did not consistently or correctly use stock adjustment codes, which caused major
errors in TruServ’s inventory records. As a result, the monthly reports which summarized the
stock adjustments made by the distribution centers and warehouses were highly inaccurate.
15. In addition to the stock adjustments described above, TruServ did not perform monthly
reconciliations between its perpetual inventory records and its general ledger. Instead of making
accurate entries to resolve discrepancies between the perpetual record and general ledger,
TruServ forced its inventory records to agree by recording the discrepancies to its merchandise
payable account.
16. TruServ’s accounting staff was aware that the stock adjustment reports were inaccurate.
However, TruServ had no internal controls in place that required accounting staff to investigate
large stock adjustments such as claims for returned merchandise as identified in Section III.12.,
or for other stock adjustments identified in Section III.13., and charge them to cost of goods
sold on a timely basis. Instead, the accounting staff incorrectly recorded stock adjustments into
the wrong account, merchandise payable, throughout the year. Historically, the accounting staff
corrected the error by writing off the adjustments to cost of goods sold only at year-end. As a
result, due to mistakes related to member claims and other stock adjustment codes, TruServ
understated its merchandise payable by $36.6 million, which resulted in a corresponding
overstatement of net income.
The February 1997 Internal Audit Report
17. TruServ’s predecessor company’s senior management had notice of the company’s internal
control problems as early as February 1997, through a report prepared by the internal audit
department (the “1997 Report”). Virtually all of the company’s senior management, including
TruServ’s chief financial officer, received the 1997 Report. The 1997 Report noted several
specific, recurring problems in data entry concerning use of receiving codes, prices, and stock
codes that caused significant discrepancies between the perpetual inventory records and the
general ledger. These deficiencies were the same ones that later caused the 1999 adjustments.
No one acted on the 1997 Report, even though the report concluded that the stock adjustments
were seriously flawed and that the company did not have adequate internal controls over its
inventory systems.
TruServ’s Action in 2000
18. In Spring 2000, after it closed the 1999 books, TruServ began to investigate the causes of
the $74.5 million adjustment, and to correct the accounting weaknesses that caused the
problems. TruServ adopted several changes in procedure, including:

TruServ began to reconcile the inventory records maintained by the distribution centers
and warehouses each month and to investigate all reconciling items so that inventory
and accounts payable are properly stated.
TruServ streamlined and synchronized procedures to manage inventory among the
distribution centers and warehouses.
TruServ reduced the number of stock adjustment codes, and redefined and standardized
their use.
TruServ instituted procedures to review stock adjustments made by the distribution
centers and warehouses, and established staff accountability for these adjustments.
TruServ instituted procedures to manage the Open Receiver File and merchandise
returned by members.
TruServ stopped entering expenses and inventory-related write-offs into merchandise
payable and began to recognize those write-offs in each month’s operating results.
TruServ improved its internal audit function by making internal audit report directly to
the Audit Committee and by establishing that TruServ managers are accountable for
recommended changes.
TruServ Violated Section 15(d) of the Exchange Act and
Rules 12b-20, 15d-1 and 15d-13 Thereunder
19. Section 15(d) of the Exchange Act and Rules 15d-1 and 15d-13 require issuers that have
filed registration statements for securities under the Securities Act with the Commission to file
annual and quarterly reports. The obligation to file such reports embodies the requirement that
they be true and correct. SEC v. Savoy Industries, 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert.
denied, 440 U.S. 913 (1979). Rule 12b-20 requires the inclusion of any additional material
information that is necessary to make required statements, in light of the circumstances under
which they were made, not misleading.
20. As a result of the conduct described above, TruServ violated Section 15(d) of the Exchange
Act and Rules 12b-20, 15d-1 and 15d-13 thereunder by filing false and misleading annual and
quarterly reports with the Commission that misrepresented TruServ’s financial results.
TruServ Violated Section 13(b)(2)(A) of the Exchange Act
21. Section 13(b)(2)(A) of the Exchange Act requires every issuer who must file reports
pursuant to Section 15(d) of the Exchange Act to “make and keep books, records, and accounts,
which, in reasonable detail, accurately reflect the transactions and dispositions of the assets of
the issuer . . .”
22. As a result of the conduct described above, TruServ violated Section 13(b)(2)(A) of the
Exchange Act by failing to keep books, records and accounts that accurately and fairly reflected
TruServ’s assets and financial results.
TruServ Violated Section 13(b)(2)(B) of the Exchange Act
23. Section 13(b)(2)(B) of the Exchange Act requires every issuer which must file reports
pursuant to Section 15(d) of the Exchange Act to both devise and maintain a system of internal
accounting controls to provide reasonable assurances that preparation of financial statements is
in conformity with generally accepted accounting principles (“GAAP”). As set forth above,
TruServ’s internal accounting controls were inadequate, and TruServ therefore violated this
24. As a result of the conduct described above, TruServ violated Section 13(b)(2)(B) of the
Exchange Act by failing to devise and maintain adequate internal accounting controls.
TruServ’s Remedial Efforts
25. In determining to accept the Offer, the Commission considered remedial acts promptly
undertaken by Respondent and cooperation afforded the Commission staff.
TruServ undertakes to:
26. Continue to maintain the procedures that it has adopted since Spring 2000 as enumerated
in paragraph III.18. above, in order to comply with, and take steps to effect further compliance
with, Sections 15(d), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act.
27. Continue to employ as a member of its management, during fiscal years ending December
31, 2002, 2003 and 2004, a Director of Internal Audit who will be responsible for executing
TruServ’s internal audit plan. TruServ also will engage a public accounting firm with appropriate
qualifications and expertise to assist the Director of Internal Audit in performing certain internal
audit procedures.
28. In the event that TruServ’s current Director of Internal Audit is no longer employed by
TruServ, any successor shall be an individual with appropriate qualifications and experience for
the position, and shall be hired after consultation with and approval by the Audit Committee.
The Director of Internal Audit shall report to the Audit Committee as well as management.
29. TruServ shall require its Director of Internal Audit to prepare a confidential business report,
and deliver the report within 90 days after the close of each of the aforementioned fiscal years,
to the Audit Committee, with copies to the Commission, TruServ’s independent auditors, and
TruServ’s public accounting firm engaged to assist the Director of Internal Audit in performing
certain internal audit procedures. The report shall include (a) a description of the scope of the
Audit Plan during the preceding year, (b) confirmation that the Audit Plan was carried out, (c)
an overview of the significant control weaknesses identified which require improvement, and (d)
a review of the steps taken to improve the system of internal controls.
In view of the foregoing, the Commission deems it appropriate to accept the offer of settlement
submitted by TruServ and to impose the sanctions specified therein.
Accordingly, IT IS ORDERED that:
A. Pursuant to Section 21C of the Exchange Act, TruServ shall cease and desist from committing
or causing any violations and any future violations of Sections 15(d), 13(b)(2)(A) and
13(b)(2)(B) of the Exchange Act and Rules 12b-20, 15d-1 and 15d-13 promulgated thereunder;
B. TruServ shall comply with the undertakings enumerated in Section III paragraphs 26-29
By the Commission.
Jonathan G. Katz
TruServ’s inadequate internal controls also caused two other material year-end 1999
adjustments. First, in 1998 and 1999, TruServ failed to perform timely bank account
reconciliations. Once these reconciliations were completed in the fourth quarter 1999, it became
apparent that TruServ had to write off approximately $4.3 million to balance its cash and other
accounts. Second, TruServ also wrote off $8.2 million in vendor rebates. This adjustment
related to an accrual made at year-end 1998 which, according to TruServ’s accounting staff,
proved to be overly optimistic.
TruServ also made other material accounting adjustments in the fourth quarter of 1999 to write
off items including, among others, losses on sales, severance and vacation pay, costs of closing
certain regional distribution centers (“RDCs”) and costs improperly capitalized in inventory, and
the write-off of a deferred tax asset. Finally, TruServ experienced operating losses as well,
which contributed to the $131 million total loss in 1999.

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