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INDIANA CHEMICAL ARGENTINA, S.A. (ICASA)

Juan M. Rivera, Professor
University of Notre Dame, Notre Dame, Indiana
Douglas K. Osthimer, Partner
Kruggel, Lawton & Company, LLC, South Bend, Indiana
THE PARENT COMPANY. BRIEF HISTORY AND BACKGROUND
Indiana Chemical, Inc. (ICI) is a privately owned business engaged in the production, distribution and sale of oil-based liquid pigments for the general industrial market in the United States. Prior to starting this company in1968, Charles (Chuck) Honeywell, a chemical engineer, had worked five years in coatings and dying processes in the paint industry. Mr. Honeywell is still the sole stockholder of the corporation, which is located in South Bend, Indiana. In addition to producing chemical pigments, Indiana Chemical, Inc. is an exclusive distributor of vegetable-based powder pigments that are manufactured by two separate and unrelated companies located in the eastern U.S.

ICI has its only manufacturing facility on 10 acres of a 25 acre site located in South Bend, Indiana. The facility occupies approximately 90,000 square feet that comprise production area, raw material storage, finished goods storage, maintenance, quality control, and general administration. The production area houses several small reactors and revolving tanks with a combined capacity to produce 300,000 pounds of chemical pigments annually. All of the bulk stored oils and solvents are in properly diked above-ground storage tanks. The entire facility is securely fenced with night lighting and 24-hour manned security staff.

ICI employs 100 people, 80 in the production process and 20 in sales, finance and administration. The current general manager, Shelton Miles, a corporate lawyer by profession, has been with the company for approximately ten years. Other key members of the company’s directorship are the owner, Charles Honeywell, who is in charge of production; Michael Still, director of finance; and Bob Pendergast, director of sales and development. Annual sales of the company were $19 million in the most recent year, and the business has an outstanding loan of $2.9 million with a local bank. A summary of ICI’s audited Financial Statements and selected Footnotes for 1996 and 1995 are presented in Schedule 1.

ICI’S ARGENTINE BUSINESS VENTURE
Chuck Honeywell and Shelton Miles, owner and general director, respectively, of Indiana Chemical, Inc., were attending an industry sales convention in Orlando, Florida in mid-February of 1996. During their flight to Orlando, they went back to their thoughts and conversations about expanding sales of chemical and organic pigments abroad. The market for their products in the US had become very competitive, highly saturated and there was always the increasing concerns of environmental hazards and clean air requirements associated with their manufacturing process. Up to then, their company had sporadically exported small shipments to Mexico and Brazil at good margins, but they felt it was time to embark in a stronger sales effort abroad.

It was then only by coincidence that Luis Perez, an Argentine-born, U.S.-citizen and alleged businessman entered the picture. He was introduced to Chuck and Shelton by Fritz von Bertrand, one of ICI’s sales representatives who lived in Miami and was Luis Perez’s neighbor and bowling pal. Mr. Perez related that he came from a very prominent family in Argentina that had been in the textile industry. He was a mechanical engineer who left his native country during the “troubled years,” relocating first in Germany and then in Miami where he had married and resided for the past five years. He then talked about the very attractive business and economic conditions in Argentina, where inflation had been reigned in, the peso was at par with the U.S. dollar and the government was pretty serious about privatizing state enterprises. On top of that, the implementation of Mercosur as a free-trade zone among Argentina, Brazil, Uruguay and Paraguay would increase the opportunities for successful business ventures in the area.

Luis expressed his eagerness to go back and do business for ICI in Argentina. He was a promoter and a salesman and he stated that he did not need, nor was he seeking, a salaried position. He only needed reimbursements for expenses and his compensation would be taken as a partial ownership of the new business. Fritz von Bertrand, his friend at ICI, vouched for his credibility.

Not having any contact whatsoever with Argentina, the company had no way to verify Luis’ statements concerning his family’s history and could only conduct a credit check on his Miami address. The report contained nothing to alert the company to any character defects or criminal behavior. The company advised him that it would consider his proposal very seriously and encouraged him to refer potential customers to the company as a goodwill gesture of his ability to “open” markets. Within two weeks of the initial meeting in Orlando, Luis proved himself by bringing approximately $6,200 in cash sales from two customers, one in Costa Rica and the other in Argentina. There was another sales prospect in Nicaragua, but that did not materialize because of that country’s economic and monetary instability and the unwillingness of the customer to provide an irrevocable letter of credit. Through all these transactions, Luis did not request any commission or bonus for the recorded sales.

Subsequently, Luis Perez felt that it was time to embark on ICI’s efforts in Argentina, where he had many business relations and was ready to settle back. Thus, in May of 1996, Indiana Chemical, Inc. provided him with funds for his initial trips and expenses aimed to start a new business unit in Buenos Aires and thus attend to the promising market.

INDIANA CHEMICALARGENTINA, S.A. INITIAL PHASE
Luis Perez was invited first to ICI’s corporate headquarters in South Bend, Indiana, where he was shown the facilities and was introduced to key administrators and personnel. While meeting with the Directorship of the company, Luis was instructed to contact potential customers to start taking orders for the chemical pigments line as soon as feasible. He was provided with a list obtained from the American Chamber of Commerce in Buenos Aires, with about 30 firms that were in the paint, solvent, textile and plastic industries as potential customers. Mr. Perez asserted that he already had done some homework and had contacted two or three of his old business buddies in Buenos Aires with sales targets in mind. He told the Board of Directors that he would work on setting up shop as soon as he arrived in Buenos Aires, but that he needed full support and company representation from Indiana Chemical, Inc. in order to do a good job.

In a Board of Directors meeting, Luis was given ample powers of attorney and company’s representation to charter an affiliate of ICI in Argentina. After the power-of-attorney papers were notarized and validated by the Argentine consulate in Chicago, Luis Perez was ready to relocate with his family to Buenos Aires, Argentina. Before departing from South Bend, he reiterated that there was no need for him to have an assigned salary as long as the company provided funds for his moving expenses and the start-up costs ofthe Argentine affiliate.

Funding for Mr. Perez’s reallocation and business organizational expenditures were made through direct personal checks or wire transfers to Luis in both Buenos Aires and Miami. In Buenos Aires, Luis found a combination office and storage facility that rented for $5,000 a month. He hired some local lawyers to register Indiana Chemical Argentina, S.A. (ICASA) as a fully owned affiliate of Indiana Chemical, Inc. of Indiana. He also hired the professional services of an Argentine Public Accountant, Flavio Weber, who would do the compilation and reporting of ICASA’s local transactions based on documentation that Mr. Luis Perez would provide on a monthly basis. A checking account for Indiana Chemical Argentina with
Luis Perez as the only authorized signatory was opened by Mr. Perez himself in Banco Latino at a branch conveniently close to the offices of ICASA. Mr. Perez also hired a secretary and two salespeople who were to start with the company in July or August of 1996. The sales employees were to double-up as delivery and account collection people since the expected initial level of operations did not call for additional personnel. Between May and July, Luis made payments to buy a delivery truck and also purchased a desk computer, a copy machine, a laser printer, a fax machine and office furniture for the new Argentine corporation. The transmittals of cash to fund all these expenditures are reflected on Schedule 2. Luis Perez
provided receipts and documentation for all these pre-operation expenditures, as listed in Schedule 3, some of which represented his personal travel and moving expenses from Miami to Buenos Aires.

INDIANA CHEMICALARGENTINA. BUSINESS CONDITIONS AND INITIAL SALES
Shelton Miles, the General Manager of ICI in Indiana, was present for the ribbon-cutting ceremonies signaling the start of operations of ICI’s affiliate in Buenos Aires in mid-August. During this visit Shelton met Alberto Marino, one of Luis’ friends, who owned Coltex, S.A., a company that produced textiles for the apparel industry in Argentina. Coltex was already using vegetable-based pigments and was ready to place purchase orders of this product with Indiana Chemical Argentina if a constant supply could be guaranteed. Mr. Marino had already tested the product and had found it of excellent quality for the coloring of the textile materials that his company produced. Shelton assured him that the supply would be no problem since Indiana Chemical, Inc. was the exclusive distributor of Vortec®, a patented organic pigment produced in the USA.
During the following months of 1996, ICI kept pumping funds and shipping inventory of Vortec® pigment to ICASA for sale to Coltex, S.A. and other smaller customers in Argentina. Schedule 4 reports the dollar value of cash and inventory channeled to Indiana Chemical Argentina from September to December of 1996. In total, there were $396,419 of fresh new resources syphoned out to the Argentine unit between September and December of 1996.

AFFILIATE’S REPORT. MIXED RESULTS AND LIMITED ACCOUNTABILITY
During the first months of operation, the Argentine unit of Indiana Chemical showed a lot of promise but not encouraging results. Luis Perez, its manager, kept asking for inventory shipments with the promise of future sales, always arguing that the Argentine customers expected not only a diverse spectrum of pigments, but also continuity in the flow of merchandise from ICI. When called to supply information about purchase orders, bank statements, sales collections, or expense reports, Mr. Perez became evasive and apologetic. He said that Mr. Flavio Weber, the external accountant hired to keep the books, was behind
in processing the information that Mr. Perez had supplied to him.

Luis Perez frequently referred to the way business operations were conducted in Argentina. He argued that, as was common in many Latin American countries, businesses do not record all their transactions in the “official” company accounts. For instance, he explained, even though there was a secretary and two salesmen working in the affiliate, only the secretary was kept on the payroll. The other two employees were being paid “under the table” or, as it was called in Argentina, were “in the black.” He related that everybody played the tax evasion game in Argentina. Employees preferred to be paid off-the-records so as to avoid tax and social security withholdings. Luis added that he was inclined to continue with this practice because it helped the affiliate to save on worker compensation and other employee-related expenses. He added that there were many other service expenses that were not to be recorded, under the same principle of “tax avoidance.”

The management of Indiana Chemical, Inc. in South Bend was increasingly concerned because the importation of US pigment products into Argentina was an onerous affair, as they had already experienced. First, there were freight and insurance expenditures for the material transported in special containers. Secondly, there were 14% import duties and a 3% statistical tax applied on the CIF (cost, insurance and freight) value of the imported product. Thirdly, the value added tax (VAT) system in the country had been adjusted in 1991 to prevent tax evasion. Thus, a pre-payment of VAT and income taxes was required before the imported merchandise could be introduced into Argentina. The prepayment is equivalent to 30% of the merchandise’s total landed cost, and an additional 3% on landed cost is a prepayment for the expected income tax. The corporation can recoup those taxes only when it has sales, at which time a 21% VAT is computed and collected by the vendor. The 3% prepaid income tax is compensated as a credit to the company’s Argentine income tax for the year.

All the funds and merchandise remitted to ICASA in Argentina had been reported in ICI’s accounting books as part of the inventory, as shown in the financial statements in Schedule 1. The prepaid VAT tax credits from the imported merchandise were kept in a separate current asset account.

After insisting for several weeks for the financial statements of ICASA, these were faxed to ICI in South Bend in the middle of March 1997 by Mr. Flavio Weber, the external public accountant retained by the affiliate in Argentina. These statements and their selected Footnotes are found in Schedule 5. Mr. Weber reiterated that not all the actual transactions of the business were actually recorded, but only those that had been submitted with proper documentation by Mr. Luis Perez. Since he had been retained for a compilation and minimal review service, and not as an external auditor, he could not provide an opinion on the completeness and reasonableness of the financial accounts of ICASA, nor on the administrative effectiveness of its management. Also in March, upon Shelton’s insistence, Luis faxed a list of typical actual monthly expenses incurred in the affiliate. These are reported on Schedule 6.

INDIANA CHEMICALARGENTINA. SECOND PHASE: 1997.
ACCOUNTING AND MANAGEMENT NIGHTMARES
At the beginning of 1997 some sales of pigment inventory in Argentina started to materialize. Unfortunately, the cash flow to ICI headquarters was only a trickle compared to the infusion of more funds that the Argentine unit demanded and received, as evidenced from remittances listed on Schedule 7. Sales of vegetable-based pigments to Coltex S.A. stabilized at an average of $30,000 per month, and there were other small sales of chemical-based pigments that oscillated between $10,000 and $15,000 monthly. Unfortunately, the terms of credit extended to customers were normally 90 days, and the Argentina affiliate was still hungry for cash from ICI. Chuck Honeywell in South Bend was constantly asking Luis Perez when the additional sales, and more importantly, the cashing of prior sales would materialize.

In January of 1997, Luis Perez conveyed assurances of good business prospects with two new
customers that he had taken away from the competition. One of them was a manufacturer of plastic components who used chemical pigments on a big scale. This business had made lab tests of the ICI’s product line with excellent results and had placed an order for $125,000 of the pigments shipped by ICI as part of the October 2 dispatch (see Exhibit 4). The merchandise had arrived in Buenos Aires and Luis informed ICI that all duties and taxes had been paid and delivery to the customer was about to start. The $125,000 sales order represented a two-month demand for the interested client and the only inconvenience was that Indiana Chemical Argentina had to keep the inventory and do partial weekly deliveries during the span of two months. On account of this expected inventory movement, Luis Perez had gone ahead and bought a used forklift to facilitate product deliveries. He had purchased the forklift without any consultation with the company’s headquarters, but again, it was not the first time that he had made decisions on his own. On account of all this, Luis requested more funds from ICI in Indiana.

The other prospective client was a pharmaceutical company in Buenos Aires that needed the chemical pigments to coat pills and tablets that they were producing in Argentina. This company had requested specially formulated pigments that had been shipped from the ICI’s plant in Indiana on December 2, 1996. The CIF cost of this material was $85,845 and the sales price was $205,000. In January 1997, Luis advised ICI that the material had arrived in Buenos Aires and he needed about $70,000 to prepay the VAT, import duties and other customs charges. The customer was going to need this material in March. In addition, he had to pay $30,000 for the forklift that he had purchased. ICI reluctantly agreed to send more cash to Luis Perez — as the list on Schedule 7 referred to earlier shows — in the hopes of tying up long-term sales contracts with those new Argentine customers.

When the 1996 financial statements of Indiana Chemical Argentina arrived in ICI’s headquarters in mid-March of 1997, there were big concerns from both the directors of the company and the company’s external auditors. The reported numbers from ICASA did not match with its counterpart’s accounts at ICI. The financial statements of the Argentine affiliate were not really audited because the Argentine CPAsigning them had been hired to do only the record keeping and reporting on behalf of the Argentine unit. Flavio Weber, the local external accountant, asserted that he had recorded those transactions for which Mr. Luis Perez had submitted proper and valid documentation, and nothing else. He was aware that the Argentine affiliate had other transactions that were unreported, or “in the black,” but that was a choice taken by Mr. Perez. In one instance related to the lift truck that Mr. Perez claimed he had purchased for $30,000, there was really no invoice to support that acquisition and the asset was missing from ICASA’s balance sheet.

Additionally, more worrisome management problems began to surface in mid-March of 1997.
Mr. Perez related to Shelton Miles, the general manager of ICI, that the $125,000 sale of pigments to the plastic company in Buenos Aires was made in January, but the customer was delinquent in making the first $40,000 payment as originally agreed. Luis Perez had to cover up the problem and had remitted $40,000 to ICI using his own personal funds. The customer had become evasive and unwilling to discuss further payments with Luis Perez. In addition, the $205,000 promised sales to the pharmaceutical company had been suspended. After the pharmaceutical business tested the material shipped to them, they found out that the chemical specifications were not those that they had requested. Consequently, they were reluctant to accept the merchandise without its proper reformulation to comply with their written specifications. Luis claimed that he had advised ICI’s quality control department at headquarters about those detailed specifications. However, there was no evidence of a fax or any other document to substantiate Luis’ statement. It would be very costly to reformulate the chemical pigments using somebody else’s facilities in Buenos Aires, and bringing the product back to South Bend was out of the question.

Given all these new developments, Chuck Honeywell instructed Shelton Miles to go down to Buenos Aires to sort things out and initiate corrective action. Since some issues involved financial matters, Shelton decided to take along a junior accountant from their local CPA auditors, and a trip to Argentina took place in April, 1997. Upon arrival in Buenos Aires on April 14th, Shelton Miles, the general manager, and Frank Martinez, the junior accountant from the CPA firm in South Bend took two different approaches to the Indiana Chemical Argentina situation. Shelton was to concentrate on visiting the customers and try to salvage any business relations for future sales. Frank Martinez was to do some forensic accounting on the operations and controls — or the lack thereof — of the Argentine affiliate and its general manager, Luis Perez.

Shelton’s meeting with the representatives of the pharmaceutical company confirmed that they were not willing to accept any pigment products without proper reformulation to comply with their requested specifications. According to Luis, the imported inventory was at the customs agent pending some paperwork after he had paid the import duties and other taxes required for its release. Regarding the other major customer, the plastic manufacturing firm that supposedly owed $125,000 to ICASA, Luis was very opposed to Shelton visiting them. Luis related that he had to use a lot of diplomacy and sales tact to assure collection, but that they should pay pretty soon. Furthermore, Luis explained to Shelton that because the sales to new customers had not progressed as expected, he was not generating enough cash to sustain the operations in Argentina. There were always the “special commissions” to customs inspectors to get the merchandise processed rapidly at the Port of Buenos Aires, plus promotional expenses to seek sales, and trips to the interior of the country to try to open new markets. He advised Shelton that effective that April he would cancel the lease contract on the office and storage facility to save expenses. He had already given an indefinite leave to his secretary and the two salesmen, and he was doing what he could to keep expenses to a minimum. The bulk of the inventory of the affiliate had been transferred to a warehouse owned by his friend, Alberto Marino of Coltex, S.A., the one company that remained a loyal customer. Luis complained to Shelton that ICI headquarters had not come through with good financing to propel ICASA into a more prominent presence in Argentina. He said that oftentimes he had to use his own personal funds to pay for the company’s expenses and that ICI should compensate him with stock in lieu of the salary that he never received. Luis complained that there was barely one penny left in the company’s bank account.

Frank Martinez’s inquiries painted a different picture. After visiting ICASA’s facilities and finding an empty warehouse and a scantily equipped office, Frank found the location of Alberto Marino’s warehouse facility. There Frank found the inventory of imported pigments that belonged to ICASA, although the people in charge at that storage building did not allow him to take a detailed physical count. At Banco Latino, Frank Martinez found out that ICASA had not one, but two checking accounts, and the balance of both at April 15th amounted to $27,530. He also visited at length with Flavio Weber, the Argentine accountant who had kept the books for ICASA. Mr. Weber revealed that he had recorded invoiced sales of $84,515 for the first three months of 1997 ending on March 31st, and that did not include the sale of $125,000 to a plastic manufacturing company because Mr. Perez had not provided the corresponding invoice. He had not recorded operating expenses for that period other than the rent and the secretary’s salary, which were $2,500 and $1,650 per month, respectively. While he knew that the rent of the leased facilities was $5,000 per month, Luis had apparently arranged for the landlord to invoice the company only $2,500 to thus help the owner save some income taxes. Mr. Weber recorded on the books only what could be substantiated with valid tax-supported documentation. Another example was the delivery van, which he had not recorded in ICASA’s reported assets because the invoice had been issued in the name of Luis Perez and not the company’s. For all practical purposes, Mr. Perez was the owner of that van and its special equipment.

Mr. Weber acknowledged that Luis had supplied him with a list of expenditures for the first quarter of 1997 that had been allegedly paid with the company’s funds at Banco Latino. However, there was no supporting documentation to record and classify these expenditures which apparently included advances to custom agents, purchases of supplies and several miscellaneous expenses. Frank Martinez annotated the total amounts paid, which were $52,405, $45,172 and $41,284 for the months of January, February and March of 1997, respectively. Also, by discerning the type of accounts that the amounts were tentatively allocated to, Frank could sum the estimated expenses of each month as follows: $15,364 for January, $22,411 for February and $15,793 for March. He was nevertheless intrigued when he observed items like the following in the list of business expenditures:
Travel and Entertainment Expenses:
Date Description Amount
01/13 Amazon Tours $1,270
01/21 Casino Club Hotel 1,546
02/04 Airplane tickets 989
02/07 Marriott USA 582
03/01 Unclassified 444
TOTAL $4,831
AICPA Case Development Program Case No. 98-06: Indiana Chemical Argentina u 7
Miscellaneous Expenses:
Date Description Amount
01/21 General expenses $ 1,388
02/28 American Express (no details) 3,662
03/15 American Express (no details) 6,164
TOTAL $11,214
When Luis was confronted with Frank’s findings over a dinner meeting in Buenos Aires, he became ostensibly upset and responded that “he was not a crook” and that he had given a lot of his time and resources to make Indiana Chemical stronger in the long-run in Buenos Aires. Afterwards, Shelton and Frank met alone to assess the whole situation and they both concurred that there was enough evidence to relieve Luis Perez from his management responsibilities and, upon lawyers’ counsel, to initiate a criminal process against him.

The revocation of Luis Perez’s powers-of-attorney papers, duly legalized and notarized, were received in Buenos Aires promptly after Shelton Miles had contacted and hired some Argentine lawyers to work on the case. The initial documents of a criminal process for fraud, defalcation and misrepresentation were filed at the Argentine courts, and at the end of that week, on Friday, April 18th, Mr. Perez was presented with the official forms stripping him of his power-of-attorney representation of Indiana Chemical and citing him to appear in court. That was the last time that Indiana Chemical, Inc. heard from Mr. Luis Perez.

FURTHER DEVELOPMENTS
After Mr. Flavio Weber was advised of Mr. Perez’s dismissal, he was more willing to share whatever limited financial information he had on file about ICASA’s operations. Flavio had filed the monthly tax declaration forms with the Argentine fiscal authorities and could confirm that as of April 15th the company had $82,520 in Prepaid Value Added Tax credits, which could be recovered through future sales in Argentina. He also said that Mr. Perez kept custody of the company’s sales register and checkbook, though no additional sales had been recorded after Frank Martinez’s first visit a few days earlier. He knew that a check for $15,000 had been received in February for sales to a plastic manufacturing company. Frank realized that the $15,000 deposit was the one shown on the bank statement of April 14th. At this point Banco Latino had already been advised that Mr. Perez was no longer representing the company, and the accounts of ICASA had been closed after cashing the $27,000 balance available on April 15th. All the regular customers had been contacted too. Flavio Weber was also aware that Luis Perez had withdrawn $20,000 and $40,000 from the bank in January and February, respectively, and had notified him that those funds were to pay for business expenses and that he would later bring the supporting documentation to Mr. Weber, which never occurred.

When Frank Martinez went to Coltex’s premises to try to recover ICASA’s inventory, Alberto Marino refused to deliver any of it. He said that he needed to use those pigments in his textile manufacturing operations, plus he had lent money and a lift truck to Luis to help him during ICASA’s trying times. Luis had borrowed $40,000 in December to pay some duties and VATs associated with imported merchandise, though Mr. Marino did not have a signed document from Luis because he had done this solely on good faith and because of their long friendship. Mr. Marino felt that this was just like lending money to ICASA or Indiana Chemical, Inc. and he claimed to have a valid right against the inventory under his custody. It then became evident that Mr. Perez had never purchased a lift truck, and that recovering the inventory from Mr. Marino’s warehouse would need the intervention of the appropriate authorities. With the help of the police department, a notary public prepared an official list of the company’s inventory stored at Coltex. Assigning the CIF cost and import duties to each inventory item, Indiana Chemical arrived at a total of $233,183 of vegetable-base pigment inventories at the facilities owned by Mr. Marino. On the next day, a court order forced Mr. Marino to release the inventory to Shelton Miles who then found an alternate storage space for it in Buenos Aires. However, the chemical pigments that had been shipped in December for the pharmaceutical manufacturer were nowhere to be found. As it turned out, that inventory was still held at the customs warehouse in the Port of Buenos Aires, because Mr. Perez had never paid the corresponding VATs and import duties necessary to clear customs and take legal possession of the merchandise.

Auditing and Control Issues:
1. What should Indiana Chemical, Inc. have done before entrusting funds to Mr. Luis Perez for the start of operations in Argentina?
2. What internal control weaknesses can you detect in the process of remitting cash and merchandise to Mr. Perez and the Argentine affiliate? What would you have done differently?
3. What criticism can you advance to Indiana Chemical, Inc. for the financial recording and reporting shortcomings uncovered in its Argentine affiliate? What would you have done differently?

International Accounting and Taxation Issues:
1. Which other avenues or options could Indiana Chemical, Inc. have taken to do business in Argentina?
2. What would be your final recommendation to Indiana Chemical, Inc. in regards to the current state of affairs of its Argentine affiliate?