U.S. Foodservice: A Case Study in Fraud and Forensic Accounting

Maria H. Sanchez

Christopher P. Agoglia^[1]

Aholds audit committee ordered investigations at the parent company and at 17 Ahold operating and real estate companies to look for accounting errors, irregularities, and other issues as well as assess internal controls and management integrity (Ahold, 2003a). After a forensic audit, Ahold eventually reported that the overstatement of U.S. Foodservices earnings was more than $850 million (Ball, 2003). A large component of the overstatement resulted from improper recognition of promotional allowances. Several U.S. Foodservice employees and vendors either admitted to or were convicted of playing a role in the fraud. In this case, students will gain insights into the proper accounting for and disclosure of promotional allowances and also the risk of over-reliance on third party confirmation as an audit procedure. Students will also distinguish between a financial statement audit and a forensic audit.

Accounting for cash consideration from vendor rebates, also known as promotional allowances, was at the center of the U.S. Foodservices earnings restatement. Rebates of this type are common in the grocery and foodservice industries and are frequently material in amount, sometimes exceeding 5% of sales. Vendors can offer rebates to customers in exchange for favorable display space in stores, or they may give volume rebates to provide an incentive to a retailer to increase sales of the vendors products, with the rebate percentage increasing as the retailers sales volume increases. However, these rebates are problematic in several respects. At the time of U.S. Foodservices accounting irregularities, there was no standardized accounting treatment of these rebates. Companies have accounted for them differently, and there have been differing levels of disclosure regarding their amounts. The investigation at U.S. Foodservice revealed that determination of rebates receivable can be problematic.

WHAT HAPPENED AT U.S. FOODSERVICE

U.S. Foodservice was acquired by Ahold in 2000. Prior to this, U.S. Foodservice used KPMG as their auditor. After the acquisition, U.S. Foodservice was audited by Deloitte &

Touche, Aholds auditor. During their 2002 audit of Aholds financial statements, as part of their confirmation process at U.S. Foodservice, Deloitte discovered that certain accrued vendor allowance receivable balances were overstated. Deloitte uncovered a series of accounting irregularities at U.S. Foodservice and other Ahold subsidiaries and also improper accounting for certain of Aholds joint ventures (Parker, 2003). Deloitte immediately withdrew their audit opinions for 2000 and 2001 and suspended work on the 2002 audit.

There appeared to be a confluence of economic conditions, managerial inventiveness, and failures of internal controls that led to the accounting irregularities at U.S. Foodservice.

Company sales for the year 2002 had been decreasing. In last quarter of 2002, upper management held a conference call with its divisional managers advising them that their annual bonuses were at risk if sales were not boosted. According to testimony provided by those inside the company, in that conference call, the companys chief operating officer described an

initiative that would increase the likelihood of managers receiving their bonuses and help the company achieve its sales target for the year. Quite simply, the strategy was to order large amounts of inventory and immediately recognize the vendor rebates that accompanied them. The rebates were in many cases substantial and, according to some sources, ranged from 8.5% to 46% of the purchase price. Divisional managers stated that they were told by upper management that if they did not place orders for additional inventory, then it would be done for them. These managers reported that it was made clear that if they did not go along with the initiative, not only were their bonuses in jeopardy, but perhaps their jobs were as well (Stecklow, Raghavan, & Ball, 2003).

Soon the warehouses at U.S. Foodservice were overflowing with inventory of foodrelated items and paper products. The amount of inventory the company purchased was so large that it had to rent additional space and refrigerator trucks to store it. As purchases increased, the vendor rebates to which U.S. Foodservice were entitled also increased. Supplier rebates increased from approximately $125 million in 2000 to about $700 million in 2003 (Bray, 2006). These rebates were recognized immediately as products were purchased in an attempt to boost earnings. The excess inventory was so immense, however, that even after the announcement of the earnings restatement, it was questionable whether the company would be able to sell it. In an effort to unload the massive amount of product in its warehouses, the company had to reduce its selling price below its original cost in some cases (Stecklow, Raghavan, & Ball, 2003).

During the audit of U.S. Foodservice, third party confirmations of rebates receivable had been provided by the vendors salespeople, not their accounting departments. According to complaints filed by the SEC, employees at U.S. Foodservice urged their vendors to complete and return to the auditors false confirmation letters with dollar amounts intentionally overstated, sometimes by as much as millions of dollars. Some vendors were pressured, some were provided with secret side letters assuring the vendors that they did not owe the amounts listed on the confirmations (Securities and Exchange Commission, 2006b).

In a span of several months, the initiative proposed by the companys COO unraveled. Rather than helping the company out of its economic doldrums, the scheme instead resulted in earnings restatements, plunging stock price, several high-level managers losing their jobs, regulatory investigation of the companys accounting practices, and allegations that officials in both the U.S. and Dutch offices had criminal intent to deceive and defraud the investing public

(Stecklow, Raghavan, & Ball, 2003). In July 2003, Dutch officials raided Aholds headquarters and began a criminal probe (Sterling, 2003). One year later, in July 2004, U.S. officials announced that two former U.S. Foodservice executives were being formally charged with conspiracy, securities fraud, and making false filings. Prosecutors also announced at the same time that two other U.S. Foodservice managers had admitted to their roles in the same alleged scheme of overstating earnings (McClam, 2004).

THE FORENSIC AUDIT

After the irregularities were uncovered by the external auditors, a criminal investigation was launched by the U.S. Department of Justice. In addition, Ahold appointed a team of forensic accountants from PricewaterhouseCoopers to work alongside the SEC. The forensic accountants had to sort through tens of thousands of documents (Datson, 2003). A U.S. federal grand jury issued subpoenas for Ahold documents for as far back as January 1, 1999 (Buckley and Chaffin, 2003).

The forensic audit revealed fraud at U.S. Foodservice totaling over $850 million, with over $100 relating to 2000, over $200 million relating to 2001 and the rest relating to 2002. The fraud related to fictitious and/or overstated vendor allowance receivables and improper or premature recognition of vendor allowances and an understatement of cost of goods sold (Ahold, 2003a). Numerous U.S. Foodservice employees were involved in the fraud, and it was discovered that the fraud went back as far as 2000. U.S. Foodservice employees were found to have been using inflated recognition rates for vendor allowances and intentionally misapplying both Dutch and U.S. GAAP. Deloittes audit testing using third party confirmations failed to detect managements misrepresentation of the reduction in cost of sales resulting from these manufacturer rebates (Bryan-Low, 2003).

The probe of U.S. Foodservice expanded to investigate several of the companys suppliers, including Sara Lee and ConAgra Foods, to determine if they might have been complicit in U.S. Foodservices intent to misrepresent certain financial statement assertions. The investigation revealed that U.S. Foodservice employees asked salespeople at their vendors to sign false documentation for Deloitte and that some vendors cooperated with this fraudulent scheme. Three salespeople at Sara Lee admitted that they had signed off on, and forwarded to

U.S. Foodservices external auditors, erroneous documents that reflected inflated amounts owed to the company by Sara Lee (Callahan, 2003b). Similarly, at ConAgra Foods two salespeople also admitted to signing off on inflated amounts for manufacturer rebates due to U.S. Foodservice. ConAgra Foods claimed, however, that the erroneous confirmation amounts were discovered and that U.S. Foodservices external auditor was notified before news of the accounting scandal broke (Callahan, 2003a). The forensic examination at U.S. Foodservice also revealed numerous weaknesses in internal controls, including failure to properly record and track vendor allowances, inadequate accounting and financial reporting systems for vendor allowances, and failure to follow GAAP (Ahold, 2003a).

The investigation revealed fraud at not only U.S. Foodservice, but also at several other Ahold subsidiaries and the parent company. It was discovered at one subsidiary that fictitious invoices were used to conceal payments, and in some cases, payments were improperly capitalized rather than expensed. It was also discovered that the consolidation of certain joint ventures into Aholds financial statements was in error and that secret side letters had been concealed from Aholds audit committee and external auditors. Further, accounting irregularities and earnings management were uncovered at other subsidiaries and at the parent company.

Overall, more than 750 separate items related to internal control weaknesses and accounting issues were identified at Ahold and its subsidiaries (Ahold, 2003a). This extensive forensic examination led to a lengthy delay in the announcement of 2002 audited earnings numbers. Aholds 2002 annual report was released October of 2003, which included restatements for the years 2000 and 2001.

The total fraud at Ahold was revealed to be over $1 billion. Of this, approximately $856 million related to U.S. Foodservice. Upon conclusion of the forensic investigation, Ahold announced the creation of a task force reporting to the audit committee to address the internal control weaknesses and improper accounting practices uncovered during the investigation. (Ahold, 2003b). Ahold announced in their 2002 annual report that the internal audit department would now report directly to the CEO and the audit committee, rather than solely to the CEO, as was the case previously (Ahold, 2002a).

According to press releases from Ahold, after the accounting scandal, U.S. Foodservice made substantial improvements in the companys financial systems and controls, as well as its financial organization, to strengthen financial monitoring and reporting (Ahold, 2004). They also established a new office of governance, ethics and compliance.

LESSONS LEARNED: AUDIT CONFIRMATIONS

In designing the tests to be performed during an audit, an auditor must obtain adequate assurance to address audit risk. The greater the risk of a particular financial statement assertion (e.g., the existence and amount of vendor rebates), the more evidence an auditor should gather to support the assertion. Statement on Auditing Standards (SAS) No. 67 states that, confirmation is the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions (AICPA, 1992, SAS 67.06, AU 330). According to SAS No. 67, confirmation from an independent source is generally viewed as having greater reliability than evidence obtained solely from client personnel. Confirmation with a third party helps the auditor assess the financial statement assertions with respect to all five of managements assertions: existence or occurrence, completeness, rights and obligations, valuation or allocation, and presentation and disclosure. The auditor may design a third party confirmation to address any one or more of these assertions (AICPA, 1992). However, existence is usually the primary assertion addressed by confirmation of receivables.

Even though evidence obtained by a third party confirmation is generally viewed as being more reliable than evidence provided by the entity being audited, SAS No. 67 cautions that an auditor should maintain a healthy level of professional skepticism. The auditor should consider information from prior years audits and audits of similar entities. Further, an auditor has an obligation to understand the arrangements and transactions between the audit client and the third party so that the appropriate confirmation request can be designed. SAS No. 67 states that [i]f information about the respondents competence, knowledge, motivation, ability, or willingness to respond, or about the respondents objectivity and freedom from bias with respect to the audited entity comes to the auditors attention, the auditor should consider the effects of such

information on designing the confirmation request and evaluating the results, including determining whether other procedures are necessary (AICPA, 2002, SAS 67.27). The statement allows for the possibility that the party responding to the confirmation may not be completely objective or free from bias and requires the auditor to use other evidence to confirm financial statement assertions in such cases (AICPA, 1992).

Confirming accounts receivable is a generally accepted auditing procedure and is required unless the amount involved is immaterial, a confirmation would be ineffective, or if the auditor can substantially reduce the level of audit risk of the financial statement assertion through the use of other substantive and analytical tests. Accounts receivable, for the purpose of SAS No. 67 (AU 330), represent claims against customers that have arisen in the normal course of business and loans held by financial institutions (AICPA, 1992). The Statement does not specifically address confirming a receivable that arises when a vendor owes a rebate to a reseller, a situation that differs substantially from the typical trade accounts receivable from a customer. Confirming vendor rebate receivables give rise to different risks that likely were not envisioned when the Statement was adopted in 1992.

In adopting SAS No. 67, two (of the seventeen) Board members, while assenting to the Statement, expressed a reservation that the language used in the Statement usurped the freedom of the auditor in exercising professional judgment in how best to confirm accounts receivable and that the language might also lead auditors to place undue reliance on third party confirmation when circumstances might suggest that the auditor choose a more effective test (AICPA, 1992). With the benefit of hindsight it is clear that the auditors of U.S. Foodservice could have, and should have, designed a more effective test, one that would have helped overcome the inherent weakness that existed in this situation where parties providing the confirmation may have either been uninformed about the existence and/or amount owed to the retailer or may have had a vested interest to overstate the amount that was owed to U.S. Foodservice. While some practitioner literature has made reference to biases of confirmation respondents (e.g., Simunic 1996), scant attention has been given to this particular concern regarding responses to auditor confirmations by vendors sales personnel.

THE AFTERMATH

In 2004, Timothy J. Lee and William F. Carter, both former purchasing executives for U.S. Foodservice, pleaded guilty to participating in the scheme and to conspiring with suppliers to mislead the companys auditors. They later agreed to pay approximately $300,000 in civil penalties (Reuters, 2005).

More than a dozen U.S. Foodservice vendors pleaded guilty from 2003 to 2006 to criminal charges related to the fraud, admitting that they submitted false confirmations to the auditors (Bloomberg, 2006). Many other U.S. Foodservice employees and vendors have faced civil charges from the SEC, and most have agreed to pay fines without admitting guilt (Sterling, 2007).

In 2009, the SEC dropped the charges against the two former KPMG auditors charged with having engaged in improper conduct during the 1999 audit of U.S. Foodservice (SEC, 2009).

The auditors had been charged by the SEC in 2006 (SEC, 2006b).

read the above REAL WORLD AUDITING case study and provide an overview of the facts of the case (in your own words); discuss the theoretical principles applicable to the case.