The Fraud that Changed Governance and Auditing Forever

McLeod Governance loves a great story about corporate misadventure.

They don’t get much better than this.

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Today, the McKesson Corporation – headquartered out of San Francisco – is the largest health care company in the world with 2012 sales of $US122 billion.

In December 1938, then known as McKesson and Robbins, Inc. it was the centre of what was one of the largest corporate scandals of the 20th century.

The scandal led to major corporate governance and auditing reforms.

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The mastermind of the McKesson & Robbins fraud was Philip Musica.

Although born to poor Italian immigrants and raised in poverty, Musica became a nationally recognized leader in business and politics.

At the height of his popularity, in 1937, a delegation of prominent Republicans urged Musica (who was then using the alias F. Donald Coster) to seek their party’s nomination to run for U.S. President.

Musica’s criminal career began early.

By his 30th birthday, he had been convicted of fraud twice.

The first conviction was for avoiding import tariffs by bribing customs officials to record incoming shipments at a fraction of their true weight.

The second conviction was for using forged invoices to obtain large bank loans.

In 1919, after adopting the name Frank D. Costa to conceal his criminal record, Musica founded the Adelphi Pharmaceutical Manufacturing Company. Adelphi manufactured high alcohol-content products such as hair tonic and cosmetics. Adelphi’s best customers were bootleggers who bought huge quantities of the company’s products and distilled out the alcohol to make booze.

In 1925, using the assumed name of F. Donald Coster, M.D., Ph.D., Musica used his bootlegging profits to buy McKesson & Robbins, a ninety-year-old company that sold milk of magnesia, cough syrup, and quinine.

During the next twelve years, Musica/Coster built a pharmaceutical distribution network that rivaled national chains such as Liggett, Rexall, and Walgreen.

To inflate McKesson & Robbins’ reported assets while skimming cash into his own pocket, Musica enlisted the help of his three younger brothers.

One brother, using the alias George Vernard, was placed in charge of a fictitious sales agency—W.W. Smith & Co.

The W.W. Smith office was actually a “letter-writing plant” containing seven typewriters, each with a distinct typeface and a unique supply of stationery.

Musica/Vernard’s role was to write purchase orders bearing the names of fictitious companies and mail them to McKesson & Robbins.

Another Musica brother, using the alias Robert Dietrich, was placed in charged of McKesson & Robbins’ shipping department. This brother would forge shipping documents to make it appear that inventory had been delivered by McKesson & Robbins to legitimate customers.

The fourth Musica brother, using the alias George Dietrich, was appointed McKesson & Robbins’ assistant treasurer. This brother would transfer money between numerous company bank accounts to create the appearance of cash payments for purchases and cash receipts from customers.

For each sale, McKesson & Robbins paid W.W. Smith & Co. a commission of .75 percent.

The four Musica brothers divided the Smith commissions among themselves with Philip, the oldest brother and mastermind, getting the largest share.

The McKesson & Robbins fraud was not discovered until late 1938 when the company’s treasurer, Julian Thompson, became suspicious of the large payments McKesson & Robbins was making to W.W. Smith & Co. Thompson obtained copies of the Dunn & Bradstreet (D&B) credit reports that had been used to satisfy McKesson’s auditors of W.W. Smith’s viability.

When he showed the credit reports to a D&B representative, he learned that D&B had never heard of W.W. Smith & Co. and that the credit reports in his possession were forgeries.

On December 6, 1938 the SEC opened an investigation into McKesson & Robbins’ accounting and the New York Stock Exchange suspended trading of the company’s shares.

One week later, federal agents arrested Coster, fingerprinted him, and released him on bond. The next day, investigators discovered from his fingerprints that respected businessman F. Donald Coster M.D., Ph.D. was really twice-convicted fraudster Philip Musica. They ordered Musica/Coster taken into custody, Musica put a gun to his head and took his own life.

The McKesson & Robbins fraud led to significant changes in procedures for appointing auditors and conducting audits. After four months of hearings, during which forty-six witnesses produced 3,000 pages of testimony, the SEC recommended that non-officer members of the client’s board nominate the auditors and that auditors be elected by and address their report to the shareholders.

In the summer of 1939, the American Institute of Accountants appointed its first standing committee on auditing procedures.

The committee’s first standard, Statements on Auditing Procedure No. 1, “Extensions of Auditing Procedure,” made observing inventory and confirming accounts receivable—two procedures that would have helped detect the McKesson & Robbins fraud—standard audit procedures.

Summary of McKesson & Robbins fraud based on The Greatest Frauds of the (Last) Century – a Paper by Paul M. Clikeman, Robins School of Business, University of Richmond, May 2003

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