Week One – Kmart Accounting Scandal
During the past two decades there have been many accounting related scandals and fraud that have changed the landscape of the financial community and accounting professionals.
Unfortunately accounting is more visible in times of scandal. Fortunately these scandals can be interesting learning opportunities.
Your assignment is to research an accounting, scandal, fraud, misappropriation, or whatever it might have been called. The paper should include the following:
1. A brief narrative of the issue. What happened, how was it caught, etc.
2. What accounting principles, assumptions, estimates and biases played a role in the scandal ?
3. What was the aftermath of the issue ? How did the accounting profession and regulatory bodies respond ? What happened to the individuals and companies involved ?
4. Consider the individuals involved, Could that be you ? Where in the circumstances for these individuals would you have made different choices and why ?
Please pick a specific company that was involved in a scandal and write a 3-5 page paper addressing these questions.
I've provided a link to an article in Forbes that highlights some of the more prominent scandals. There are others out there.
After winning some gains in the late 1990's, Kmart faced some intense competition from companies like Walmart. As profits began to fall a new CEO, Charles Conway, was hired to breath new life into the organization. Despite Conway's efforts at cleaning house and some creative marketing programs the losses continued to the point that major suppliers quit shipping to Kmart (fundinguniverse.com). Kmart was forced into bankruptcy in 2002. During bankruptcy investigations it became apparent that there had been some “creative accounting” going on that had inflated revenue figures by $42.3 million for the second quarter of 2001 (findarticles.com, Feds Indict). This lead to identifying similar discrepancies (more than $24 million) in the third and forth quarters as well (sptimes.com).
The improperly reported earnings were in the form of vendor “promotional allowances” (nytimes.com). These were all fees paid by Kmart vendors to secure shelf space, fund advertizing and keep their own competition off Kmart's shelves. They were recorded incorrectly, according the the legal indictment against Kmart, because they were “subject to a pay-back provision and should have been amortized over the life of the contract” (findarticles.com, Feds Indict). However, by recording them as earnings in a single quarter, Kmart was able to inflate its profit by almost 10%. That was very attractive to the new CEO and others in management who wanted to see Kmart's stock prices raise or at least quit falling.
The fraud is fairly straightforward in this case because of the way the transaction was treated. Although the revenue was received in the quarter it was reported, according to GAAP (Burman & Knight, pg 59), if the company will receive benefit for the revenue for an extended time, it must be recognized over time in the form of amortization. Now that I have a slightly better understanding of the bias and estimates in accounting I will assume that the accountants were able to have some sort of rationalization for booking the revenue as it did. This is were the problems began where the fraud is concerned. I believe it was the bias of the accountants who approved this rationalization to show profit for the company. It was this bias that likely persuaded the company to allow a less than adequate rationalization to be used on their financial statements.
This scandal was identified after the company was forced to file bankruptcy, so it cannot be contributed to financial collapse, but it delayed the inevitable and likely increased the losses of Kmart investors. The investigations that resulted in this scandal targeted eight individuals. Surprisingly, only three of them were Kmart employees. Kmart vendor employees were in the sights as well. According to cfo.com,
“The individuals are accused of helping Kmart recognize the allowances prematurely on the basis of false information provided to the company's accounting department.
The SEC asserts that a number of vendor representatives co-signed false and misleading accounting documents, executed side agreements, and, in some instances, provided false or misleading third-party confirmations to Kmart's independent auditor, PricewaterhouseCoopers LLP.”
This Securities and Exchange Commission (SEC) allegation was for representatives of Kodak, Pepsi, Frito-Lay and Coke. This lawsuit was finally dismissed from federal court because the evidence was not strong enough to convict any individual of wrongdoing (findarticles.com, Case Dismissed).
Kmart was able to come out of Bankruptcy in May 2003 as Kmart Holdings Corporation after securing financing for more than $2 Billion (fundinguniverse.com). In November 2003 the Detroit Free Press reported that the bankruptcy caused 67,000 people to loose their jobs and Kmart was forced to sell off or close 600 stores (smartpros.com). Cut down to size Kmart was able to become profitable once again and late in 2004 merged with Sears Roebuck to become Sears Holdings.
The major players in this scandal turned out to be the buyers who were looking for creative ways to improves revenue. They were accustom to getting these “promotional allowances” from vendors, but the problem came when they were allegedly trying to deceive the accountants within Kmart of what the payments were actually for. As I look at my position I find it difficult to see a situation where I would try to “hide” important aspects of information to deceive. I had an opportunity to “cover-up” a monumental problem that was discovered with one of our products. It cost our company $500,000 to perform the recall, which is nearly 10% of our annual revenue, what is worse is that it was during the worst economic period since the great depression. Fortunately, my organization is focused on long term growth and what is best for the customers, so there was support internally for fixing the problem.
If I had been the account representative for Kmart with the purchasing authority, I would have made sure all the critical information was passed onto the accounting department. The more difficult job to do in an “upright” manner would be the sales representative of Kmart's vendors. They were asked, by Kmart reps, to sign false documents. In that situation you need a customer service mindset, that means doing what the customer needs. Even if I were in this position I would have refused to falsify any documentation, but it may have cost me my job.
Burman & Knight (2006). Financial intelligence: A Managers guide to knowing what the numbers really mean. Boston, Mass: Harvard Business School Press.
(cfo.com) Kmart Vendors Hit with Fraud Charges. Retrieved January 15, 2010 from: http://www.cfo.com/article.cfm/3464986
(findarticles.com) Feds indict former Kmart execs: alleged accounting errors could put merchants behind bars. Retrieved January 15, 2010 from: http://findarticles.com/p/articles/mi_m0FNP/is_5_42/ai_98998090/
(findarticles.com) Case dismissed: former Kmart execs cleared. Retrieved January 15, 2010 from: http://findarticles.com/p/articles/mi_m0FNP/is_22_42/ai_110805535/
(fundinguinverse.com) Kmart Corporation, History. Retrieved January 15, 2010 from: http://www.fundinguniverse.com/company-histories/Kmart-Corporation-Company-History.html
(nytimes.com) S.E.C. Names 8 in Kmart Accounting Case. Retrieved January 15, 2010 from: http://www.nytimes.com/2004/12/03/business/03kmart.html
(smartpros.com) Fired From Kmart, Ex-CFO Is Key Figure in Lawsuits. Retrieved January 15, 2010 from: http://accounting.smartpros.com/x41496.xml
(sptimes.com) SEC says 8 took part in accounting fraud at Kmart. Retrieved January 15, 2010 from: http://www.sptimes.com/2004/12/03/Business/SEC_says_8_took_part_.shtml