The fraud was simplicity itself. Food manufacturers frequently pay a fee to supermarket operators such as Ahold to encourage them to buy in bulk and then to promote the products to the ultimate consumers. These promotional allowances typically are a function of the volume purchased. The company then aggressively accounted for these promotional allowances, especially at their affiliate U.S. Foodservice, but did not have the volume to justify their recognition. Prematurely and incorrectly recognizing these promotional allowances of course increased their profits.
 
Three aspects of this story are especially noteworthy. First, Deloitte & Touche uncovered this fraud during its audit of the 2002 results for Ahold. While some commentators assert that D&T should have discovered this fraud at least one year earlier, we have no evidence upon which to make this judgment. Whether or not it turns out to be true, we at least should congratulate the auditing firm for revealing this fraud as soon as the firm learned of its existence. Recall that one of the problems in Arthur Andersen's misguided culture was that when it found a fraud, such as at Waste Management, the auditors perpetuated the deception by proposing to reverse the charges over a 10-year period. Whereas Arthur Andersen aided and abetted the accounting fraud at Waste Management, I am happy to see D&T do its duty with respect to Ahold.
 
Second, Floyd Norris points out that the Emerging Issues Task Force looked at the accounting for promotional allowances last year but did not issue any bulletin. He states that "some accountants expected it would change the accounting rules to require companies to take the discounts only after they had earned them rather than reporting discounts that they expected to receive but had not yet qualified to get." I am bothered about this statement. Why does the FASB or one of its arms have to get involved with every accounting minutiae that is possible? What ever happened to professional judgment? Of course, business enterprises can report these discounts only if they are earned! That's generally accepted accounting principles. Anything else is a lie. I would flunk one of my intermediate accounting students if he or she said otherwise.
 
Third, this new episode drives home the point that professional analysts are failing to do their jobs. They continue to focus on earnings, which are easily manipulated by management. If they had looked at free cash flows instead, then analysts would not need to know whether a fraud was occurring. They would have realized that Royal Ahold was distributing cash left and right. Consider the following comparison between Ahold's earnings and their free cash flows (in millions of euros):

 

	2001	2000	1999
Net income	1,113	1,116	752
Free cash flow	(2,366)	(7,340)	(570)

 

Over the three-year period, Royal Ahold claims earnings of 2.98 billion euros, but free cash flow are negative 10.2 billion euros! I don't need to know they are cooking the books in a red hot oven. As long as I know that financially they are hemorrhaging to death, I do not invest in this company. Analysts must start doing their jobs. In the mean time, maybe average investors should quit listening to the so-called pros.
 
Ahold reminds us that accounting frauds have not stopped despite passage of Sarbanes-Oxley. Let's maintain our vigilance in the fight against white-collar, red-ink-masquerading-as-black-ink crimes.

 

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of the forthcoming Hidden Financial Risk, which explores the causes of recent accounting scandals.