U.S. Foodservice: A Case Study in Fraud and ForensicAccounting

Maria H. Sanchez

Christopher P.Agoglia^[1]

Ahold’s audit committee orderedinvestigations at the parent company and at 17 Ahold operating andreal estate companies to look for accounting errors,irregularities, and other issues as well as assess internalcontrols and management integrity (Ahold, 2003a).   Aftera forensic audit, Ahold eventually reported that the overstatementof U.S. Foodservice’s earnings was more than $850 million (Ball,2003). A large component of the overstatement resulted fromimproper recognition of promotional allowances. Several U.S.Foodservice employees and vendors either admitted to or wereconvicted of playing a role in the fraud. In this case, studentswill gain insights into the proper accounting for and disclosure ofpromotional allowances and also the risk of over-reliance on thirdparty confirmation as an audit procedure. Students will alsodistinguish between a financial statement audit and a forensicaudit.

Accounting for cash consideration fromvendor rebates, also known as “promotional allowances,” was at thecenter of the U.S. Foodservice’s earnings restatement. Rebates ofthis type are common in the grocery and foodservice industries andare frequently material in amount, sometimes exceeding 5% of sales.Vendors can offer rebates to customers in exchange for favorabledisplay space in stores, or they may give volume rebates to providean incentive to a retailer to increase sales of the vendor’sproducts, with the rebate percentage increasing as the retailer’ssales volume increases. However, these rebates are problematic inseveral respects. At the time of U.S. Foodservice’s accountingirregularities, there was no standardized accounting treatment ofthese rebates. Companies have accounted for them differently, andthere have been differing levels of disclosure regarding theiramounts. The investigation at U.S. Foodservice revealed thatdetermination 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, Ahold’s auditor. Duringtheir 2002 audit of Ahold’s financial statements, as part of theirconfirmation process at U.S. Foodservice, Deloitte discovered thatcertain accrued vendor allowance receivable balances wereoverstated. Deloitte uncovered a series of accountingirregularities at U.S. Foodservice and other Ahold subsidiaries andalso improper accounting for certain of Ahold’s joint ventures(Parker, 2003). Deloitte immediately withdrew their audit opinionsfor 2000 and 2001 and suspended work on the 2002audit.  

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

Company sales for the year 2002 hadbeen decreasing. In last quarter of 2002, upper management held aconference call with its divisional managers advising them thattheir annual bonuses were at risk if sales were not boosted.According to testimony provided by those inside the company, inthat conference call, the company’s chief operating officerdescribed an

“initiative” that would increase thelikelihood of managers receiving their bonuses and help the companyachieve its sales target for the year. Quite simply, the strategywas to order large amounts of inventory and immediately recognizethe vendor rebates that accompanied them. The rebates were in manycases substantial and, according to some sources, ranged from 8.5%to 46% of the purchase price. Divisional managers stated that theywere told by upper management that if they did not place orders foradditional inventory, then it would be done for them. Thesemanagers reported that it was made clear that if they did not goalong with the “initiative,” not only were their bonuses injeopardy, but perhaps their jobs were as well (Stecklow, Raghavan,& Ball, 2003).

Soon the warehouses at U.S.Foodservice were overflowing with inventory of foodrelated itemsand paper products. The amount of inventory the company purchasedwas so large that it had to rent additional space and refrigeratortrucks to store it. As purchases increased, the vendor rebates towhich U.S. Foodservice were entitled also increased. Supplierrebates increased from approximately $125 million in 2000 to about$700 million in 2003 (Bray, 2006). These rebates were recognizedimmediately as products were purchased in an attempt to boostearnings. The excess inventory was so immense, however, that evenafter the announcement of the earnings restatement, it wasquestionable whether the company would be able to sell it. In aneffort to unload the massive amount of product in its warehouses,the company had to reduce its selling price below its original costin some cases (Stecklow, Raghavan, & Ball, 2003).

During the audit of U.S.Foodservice, third party confirmations of rebates receivable hadbeen provided by the vendors’ salespeople, not their accountingdepartments. According to complaints filed by the SEC, employees atU.S. Foodservice urged their vendors to complete and return to theauditors false confirmation letters with dollar amountsintentionally overstated, sometimes by as much as millions ofdollars. Some vendors were pressured, some were provided withsecret “side letters” assuring the vendors that they did not owethe amounts listed on the confirmations (Securities and ExchangeCommission, 2006b).

In a span of several months, the“initiative” proposed by the company’s COO unraveled. Rather thanhelping the company out of its economic doldrums, the schemeinstead resulted in earnings restatements, plunging stock price,several high-level managers losing their jobs, regulatoryinvestigation of the company’s accounting practices, andallegations that officials in both the U.S. and Dutch offices hadcriminal intent to deceive and defraud the investing public

(Stecklow, Raghavan, & Ball,2003). In July 2003, Dutch officials raided Ahold’s headquartersand began a criminal probe (Sterling, 2003). One year later, inJuly 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 alsoannounced at the same time that two other U.S. Foodservice managershad admitted to their roles in the same alleged scheme ofoverstating earnings (McClam, 2004).

           

THE FORENSIC AUDIT

After the irregularities wereuncovered by the external auditors, a criminal investigation waslaunched by the U.S. Department of Justice. In addition, Aholdappointed a team of forensic accountants fromPricewaterhouseCoopers to work alongside the SEC. The forensicaccountants had to sort through tens of thousands of documents(Datson, 2003). A U.S. federal grand jury issued subpoenas forAhold documents for as far back as January 1, 1999 (Buckley andChaffin, 2003).  

The forensic audit revealed fraud atU.S. Foodservice totaling over $850 million, with over $100relating to 2000, over $200 million relating to 2001 and the restrelating to 2002. The fraud related to fictitious and/or overstatedvendor allowance receivables and improper or premature recognitionof vendor allowances and an understatement of cost of goods sold(Ahold, 2003a). Numerous U.S. Foodservice employees were involvedin the fraud, and it was discovered that the fraud went back as faras 2000. U.S. Foodservice employees were found to have been usinginflated recognition rates for vendor allowances and intentionallymisapplying both Dutch and U.S. GAAP. Deloitte’s audit testingusing third party confirmations failed to detect management’smisrepresentation of the reduction in cost of sales resulting fromthese manufacturer rebates (Bryan-Low, 2003).

The probe of U.S. Foodserviceexpanded to investigate several of the company’s suppliers,including Sara Lee and ConAgra Foods, to determine if they mighthave been complicit in U.S. Foodservice’s intent to misrepresentcertain financial statement assertions. The investigation revealedthat U.S. Foodservice employees asked salespeople at their vendorsto sign false documentation for Deloitte and that some vendorscooperated with this fraudulent scheme. Three salespeople at SaraLee admitted that they had signed off on, and forwarded to

U.S. Foodservice’s externalauditors, erroneous documents that reflected inflated amounts owedto the company by Sara Lee (Callahan, 2003b). Similarly, at ConAgraFoods two salespeople also admitted to signing off on inflatedamounts for manufacturer rebates due to U.S. Foodservice. ConAgraFoods claimed, however, that the erroneous confirmation amountswere discovered and that U.S. Foodservice’s external auditor wasnotified before news of the accounting scandal broke (Callahan,2003a). The forensic examination at U.S. Foodservice also revealednumerous weaknesses in internal controls, including failure toproperly record and track vendor allowances, inadequate accountingand financial reporting systems for vendor allowances, and failureto follow GAAP (Ahold, 2003a).

The investigation revealed fraud atnot only U.S. Foodservice, but also at several other Aholdsubsidiaries and the parent company. It was discovered at onesubsidiary that fictitious invoices were used to conceal payments,and in some cases, payments were improperly capitalized rather thanexpensed. It was also discovered that the consolidation of certainjoint ventures into Ahold’s financial statements was in error andthat secret side letters had been concealed from Ahold’s auditcommittee and external auditors. Further, accounting irregularitiesand earnings management were uncovered at other subsidiaries and atthe parent company.

Overall, more than 750 separateitems related to internal control weaknesses and accounting issueswere identified at Ahold and its subsidiaries (Ahold, 2003a). Thisextensive forensic examination led to a lengthy delay in theannouncement of 2002 audited earnings numbers. Ahold’s 2002 annualreport was released October of 2003, which included restatementsfor the years 2000 and 2001.

The total fraud at Ahold wasrevealed to be over $1 billion. Of this, approximately $856 millionrelated to U.S. Foodservice. Upon conclusion of the forensicinvestigation, Ahold announced the creation of a task forcereporting to the audit committee to address the internal controlweaknesses and improper accounting practices uncovered during theinvestigation. (Ahold, 2003b). Ahold announced in their 2002 annualreport that the internal audit department would now report directlyto the CEO and the audit committee, rather than solely to the CEO,as was the case previously (Ahold, 2002a).

According to press releases fromAhold, after the accounting scandal, U.S. Foodservice made“substantial improvements in the company’s financial systems andcontrols, as well as its financial organization, to strengthenfinancial monitoring and reporting” (Ahold, 2004). They alsoestablished a new office of governance, ethics and compliance.

LESSONS LEARNED: AUDIT CONFIRMATIONS

           In designing the tests to be performed during an audit, an auditormust obtain adequate assurance to address audit risk. The greaterthe risk of a particular financial statement assertion (e.g., theexistence and amount of vendor rebates), the more evidence anauditor should gather to support the assertion. Statement onAuditing Standards (SAS) No. 67 states that, “confirmation is theprocess of obtaining and evaluating a direct communication from athird party in response to a request for information about aparticular item affecting financial statement assertions” (AICPA,1992, SAS 67.06, AU 330). According to SAS No. 67, confirmationfrom an independent source is generally viewed as having greaterreliability than evidence obtained solely from client personnel.Confirmation with a third party helps the auditor assess thefinancial statement assertions with respect to all five ofmanagement’s assertions: existence or occurrence, completeness,rights and obligations, valuation or allocation, and presentationand disclosure. The auditor may design a third party confirmationto address any one or more of these assertions (AICPA, 1992).However, existence is usually the primary assertion addressed byconfirmation of receivables.

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

information on designing theconfirmation request and evaluating the results, includingdetermining whether other procedures are necessary” (AICPA, 2002,SAS 67.27). The statement allows for the possibility that the partyresponding to the confirmation may not be completely objective orfree from bias and requires the auditor to use other evidence toconfirm financial statement assertions in such cases (AICPA,1992).

Confirming accounts receivable is agenerally accepted auditing procedure and is required unless theamount involved is immaterial, a confirmation would be ineffective,or if the auditor can substantially reduce the level of audit riskof the financial statement assertion through the use of othersubstantive and analytical tests. Accounts receivable, for thepurpose of SAS No. 67 (AU 330), represent claims against customersthat have arisen in the normal course of business and loans held byfinancial institutions (AICPA, 1992). The Statement doesnot specifically address confirming a receivable thatarises when a vendor owes a rebate to a reseller, a situation thatdiffers substantially from the typical trade accounts receivablefrom a customer. Confirming vendor rebate receivables give rise todifferent risks that likely were not envisioned when the Statementwas adopted in 1992.

In adopting SAS No. 67, two (of theseventeen) Board members, while assenting to the Statement,expressed a reservation that the language used in the Statementusurped the freedom of the auditor in exercising professionaljudgment in how best to confirm accounts receivable and that thelanguage might also lead auditors to place undue reliance on thirdparty confirmation when circumstances might suggest that theauditor choose a more effective test (AICPA, 1992). With thebenefit of hindsight it is clear that the auditors of U.S.Foodservice could have, and should have, designed a more “effectivetest,” one that would have helped overcome the inherent weaknessthat existed in this situation where parties providing theconfirmation may have either been uninformed about the existenceand/or amount owed to the retailer or may have had a vestedinterest to overstate the amount that was owed to U.S. Foodservice.While some practitioner literature has made reference to biases ofconfirmation respondents (e.g., Simunic 1996), scant attention hasbeen given to this particular concern regarding responses toauditor confirmations by vendors’ sales personnel.

THE AFTERMATH

In 2004, Timothy J. Lee and William F. Carter, both formerpurchasing executives for U.S. Foodservice, pleaded guilty toparticipating in the scheme and to conspiring with suppliers tomislead the company’s auditors. They later agreed to payapproximately $300,000 in civil penalties (Reuters, 2005).

More than a dozen U.S. Foodservice vendors pleaded guilty from2003 to 2006 to criminal charges related to the fraud, admittingthat they submitted false confirmations to the auditors (Bloomberg,2006). Many other U.S. Foodservice employees and vendors have facedcivil charges from the SEC, and most have agreed to pay fineswithout admitting guilt (Sterling, 2007).

In 2009, the SEC dropped the charges against the two former KPMGauditors charged with having engaged in improper conduct during the1999 audit of U.S. Foodservice (SEC, 2009).

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

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