Kmart Executives Manipulate the Contract Process

Story Kmart Corporation is a US discount retailer and a general merchandise retailer. The company operates in the general merchandise retailing industry through 1,829 Kmart discount stores with locations in all 50 states, Puerto Rico, the United States Virgin Islands and Guam. On January 22, 2002, Kmart and 37 of its US subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the federal bankruptcy laws. Just prior to the bankruptcy, two executives lied to Kmart accounting personnel and concealed a side letter relating to the $42 million payment from one of Kmart's vendors in order to improperly recognize the entire amount in the quarter ended August 1, 2001. Those deceptions caused Kmart to understate losses by the material amount of $0.06 per share, or 32 percent. (Merrick 2003) The Securities and Exchange Commission (SEC 2003) filed civil charges against the two men responsible for this misstatement - Joseph A. Hofmeister and Enio A. Montini Jr. Montini and Hofmeister negotiated a five-year contract for which American Greetings paid Kmart an "allowance" of $42,350,000 on June 20, 2001. The contract was for, among other things, exclusive rights to sell their product - greetings cards - in Kmart stores. American Greetings was to take over the 847 stores that were formerly supplied by Hallmark, the major competitor of American Greetings, at a rate of $50,000 per store. Under the terms of its 1997 contract with Hallmark, Kmart was obligated to repay a portion of certain prepaid allowances and other costs, and accordingly Kmart paid Hallmark $27,298,210 on or about June 4, 2001.

Accounting Makes a Difference in Bonus

Kmart classified these vendor allowances as a reduction in cost of goods sold in its statement of operations. One of the primary measures of performance for Montini and Hofmeister was contribution to gross margin. Because vendor allowances were generally accounted for as a reduction of cost of goods sold, this could help the two make their gross margin numbers and their bonuses. Montini also received an additional $750,000 forgivable cash loan after the deal was closed.

Secret Negotiations

Montini and Hofmeister conducted their negotiations with American Greetings in secret, excluding from the process key finance and accounting personnel. Since the accounting people had been frozen out of the negotiations, they depended on the two men to give them the details. Montini assured the Finance Divisional VP that there were "no strings attached" to the $42 million. In fact, American Greetings had insisted that any and all up front monies be covered by a payback provision. American Greetings worried that, given Kmart's shaky financial condition, the retailer might not survive the contract term. (SEC 2003) Montini had made two agreement letters with American Greetings. One agreement letter appeared to exclude the $42,350,000 from any repayment obligation. A second letter (the side letter) obligated Kmart to pay American Greetings "liquidated damages" for early termination of the agreement. Montini and Hofmeister provided a copy of the signed "No Strings Attached" letter, but not the "Liquidated Damages" letter, to the Finance DVP and Internal Audit. GAAP, as well as the company's own accounting policies and practices, required that the $42 million be recognized over the term of the agreement. Instead, Kmart improperly recognized the entire $42 million allowance during the quarter ended August 1, 2001; $27 million as an "offset" to the payment to Hallmark and $15 million in "incremental" merchandise allowances.

Discussion Questions

¦ What procedures can Kmart's independent auditor use to uncover the side agreement?

¦ What circumstances should have alerted Kmart's management and internal auditors to possible problems?