Kmart accounting scandal

Kmart is a Corporation headquartered in Troy, Michigan since 1899 by Sebastian S. Kresge.

The company went public on the New York Stock Exchange in 1925 under the symbol KM,
and during the 70’s the company officially changed its name to Kmart, standing for quality
products and low price. On January 22, 2002, Kmart filed a voluntary petition for
reorganization relief under Chapter 11 of the Bankruptcy code. The company's common stock
is registered with the Commission pursuant to 12(b) of the Exchange Act [15 U.S.C. § 78l (b)]
and traded on the New York Stock Exchange until December 19, 2002, when it was delisted.
Kmart fiscal year ends the last Wednesday in January. Before filing for bankruptcy, Kmart
operated approximately 2,100 stores throughout the United States and employed
approximately 250,000 workers. Kmart's annual sales averaged $37 billion, and the company
was the nation's second largest discount retailer and third largest general merchandise retailer.
Its direct competitors were Wal-Mart and Target.

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. [CITATION fundinguinversecom \l 1033 ]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.[CITATION fin20 \l 1033 ]. This lead to identifying similar discrepancies (more than $24
million) in the third and forth quarters as well[ CITATION spt20 \l 1033 ].

The improperly reported earnings were in the form of vendor “promotional allowances”
[CITATION SEC20 \l 1033 ]. 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” [CITATION
fin20 \l 1033 ].On the balance sheet, vendor allowances effectively reduce the cost of goods,
which in turn inflate the profit margin. However, under generally accepted accounting
principles, allowances should only be recorded in the period that they are earned and with the
corresponding income for the period related to them. The SEC charges claim that Kmart used
an accrual method to account for the allowances.

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
[ CITATION Kni06 \l 1033 ], 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.”[ CITATION cfo20 \l 1033 ]
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
[CITATION fin20 \l 1033 ] 

Kmart was able to come out of Bankruptcy in May 2003 as Kmart Holdings Corporation after
securing financing for more than $2 Billion [ CITATION fundinguinversecom \l 1033 ]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 . Cut down to size Kmart
was able to become profitable once again and late in 2004 merged with Sears Roebuck to
become Sears Holdings.
References
cfo.com, n.d. Kmart Vendors Hit with Fraud Charges. [Online]
Available at: Harvard Business School Press.
[Accessed 12 12 2020].

fundinguinverse.com, n.d. Kmart Corporation, History.. [Online]

Available at: http://www.fundinguniverse.com/company-histories/Kmart-Corporation-
Company-History.html
[Accessed 12 12 2020].

Knight, B., 2006. Financial intelligence: A Managers guide to knowing what the numbers
really mean. In: Boston: Harvard Business School Press, p. 29.

marketwatch.com, 2004. Kmart execs, vendors charged with fraud. [Online]

Available at: https://www.marketwatch.com/story/sec-charges-8-in-24-million-kmart-fraud-
from-2001
[Accessed 12 12 2020].

nytimes.com, n.d. S.E.C. Names 8 in Kmart Accounting Case.. [Online]

Available at: http://www.nytimes.com/2004/12/03/business/03kmart.html
[Accessed 12 12 2020].

sptimes.com, n.d. SEC says 8 took part in accounting fraud at Kmart. [Online]
Available at: http://www.sptimes.com/2004/12/03/Business/SEC_says_8_took_part_.shtml
[Accessed 12 12 2020].