Koninklijke Ahold NV How a lack of controls led to a $1B charge

Koninklijke Ahold NV

 Royal Ahold acquires US Foodservice for $3.6B in April 2000  Fraud revealed in February 2003  Players: Mark Kaiser and Timothy Lee  Scheme: Exploit lack of controls to over-accrue for vendor rebates  Results: Overstatement of acquisition balances $90M, 2000 earnings $110M, 2001 earnings $260M, 2002 earnings $510M Overview

Aftermath  Fired – Mark Kaiser, Chief Marketing Officer  Fired – Timothy Lee, Exec. VP Purchasing  Resigned – James Miller, CEO  Resigned – Cees van der Hoeven, Ahold CEO  Resigned – Michael Meurs, Ahold CFO  Stock drops 61% on 2/24, 17% on 2/25  Earnings overstated $880M, Pre-Tax Charge $1B ''It is a very disappointing result,'' said Dudley Eustace, Royal Ahold's interim chief financial officer

How Was It Detected?  ConAgra Late January/Early Feburary, accounting dept found unqualified sales representatives verifying inaccurate US Foodservice rebates Alerted US Foodservice and Deloitte & Touche  Ahold Internal Investigation Discovered irregularities in February  Deloitte & Touche Discovered irregularities during its 2002 audit Gave Ahold a clean bill of health in 2001 (~$250M in fraud)

What Went Wrong?

Cause 1: Company Culture  Acquisition Race  CEO, Hoeven, spent $19 billion over 10 yrs to buy companies in 30 countries  Opening balances at the US Foodservice was reduced by $90 million due to the fraud  Due diligence conducted by Merril Lynch and Ahold  Pressure to Increase Profit  “go-go” atmosphere gone too far

Cause 2: Personal Gain  Inflate earnings to increase bonuses  Sales representatives at suppliers may have been paid off

Cause 3: Shady Industry Practice  Lack of Transparency  Improper acceleration of revenue recognition  Rebates for volume/time/shelf-space sales  False inflation of retailer's profits  Explains the magnitude and the duration of the fraud

Cause 4: Weak Control Mechanism  At acquisition, US Foodservice warned Ahold that internal control systems on promotional allowances were “not good at all”  Efforts were made to improve control systems but no significant improvements

HOW COULD THIS FIASCO BEEN PREVENTED?

Due Diligence & The Issue of Fraud  The Financial Times, dated 5/9/03, reported that Dudley Eustace, Ahold then interim CFO, commented that “the fraud should have been detected during the process of due diligence.”  Eustace further comments that “The company [Ahold] has been flying blind with inadequate control systems. Once you added collusion to create fraud, you had a recipe for disaster.”  “When you are doing due diligence, you are not looking for fraud.”

If Conducting Due Diligence, Then Questions To Be Asked Consist Of…  What is the company’s current policy for tracking and accruing for rebates receivable?  Are rebates receivable currently tracked or estimated?  How does your company currently ensure that rebates receivable are monitored by the internal audit function for adequacy?  What are the current procedures for approving rebate programs?

Financial Statement Analysis  Examine & compare the ratio of rebate income to gross sales to previous year and budget  Examine & compare the ratio of gross sales to rebates receivable to previous year and budget

In General, Questions To Consider  Company receive rebates from vendors? If so, in what capacity?  Vendor rebates based on complex & opaque formulas linked to specified volume targets?  Company accrue for rebates receivable?  An unexplained increase in rebate income?  Rebate income increased as a percentage of gross sales?  Rebates receivable increased as a percentage of gross sales?