Solution Manual Auditing Case 8.2 Royal Ahold, N.V

Synopsis

Royal Ahold, N.V., is a large multinational company based in The Netherlands that was founded in 1877 by Albert Heijn. Three generations of the Heijn family oversaw the company’s retail grocery business. In 1989, the company hired a professional management team. The new management team expanded Royal Ahold’s operations by purchasing grocery chains around the globe, resulting in the company becoming the third largest food retailer in the world. In 2000, the company diversified into the wholesaling segment of the huge food industry when it purchased U.S. Foodservice, a large food wholesaler based in Columbia, Maryland.

Royal Ahold’s professional management team established aggressive earnings and revenue goals for the company each year and pressured their subordinates to achieve those goals. An incentive compensation plan awarded large year-end bonuses to managers of operating units that met or surpassed their financial goals. Royal Ahold’s decentralized operations when coupled with the strong incentives to achieve unrealistic earnings and revenue goals created an environment in which fraud often flourishes.

In early 2003, Royal Ahold’s independent auditors suspended their fiscal 2002 audit of the company when they discovered numerous potential irregularities in the company’s accounting records. Subsequent investigations documented that the company had improperly included the operating results of foreign joint ventures in its consolidated financial statements, had accounted improperly for initial acquisition costs related to several of those joint ventures, and had materially overstated “promotional allowances” due from company vendors. The disclosure of the massive accounting fraud resulted in criminal and civil lawsuits being filed against the company and its top executives in both Europe and the United States. Three former Royal Ahold executives, including the company’s former CEO and CFO, were found guilty by a Dutch court. The three executives were fined and given suspended prison sentences. Fraud charges filed against the company were settled by the payment of a fine of 8 million euros. Several lawsuits stemming from the Royal Ahold case are still pending.

This case examines accounting, auditing, and control issues pertinent to multinational companies. In addition, the case examines recent controversies arising between and among international regulatory agencies and rule-making bodies within the accounting and auditing disciplines. Finally, the case illustrates important risk factors commonly associated with financial statement fraud.

Royal Ahold, N.V.—Key Facts

1. Royal Ahold was controlled by members of the Albert Heijn family until 1989 when a professional management team was hired. 
2. The new management team aggressively pursued an international expansion plan that eventually resulted in Royal Ahold owning retail grocery chains in 27 countries and a large food wholesaling operation in the United States.
3. Differences in cultural norms and expectations adversely impacted Royal Ahold’s ability to manage its global business operations.
4. The new management team pressured their subordinates to achieve unrealistic earnings goals and rewarded them with large year-end bonuses if they reached those goals.
5. In early 2003, Royal Ahold’s Deloitte auditors suspended their fiscal 2002 audit after discovering potential irregularities in the company’s accounting records.
6. Deloitte’s suspension of its 2002 audit caused significant financial problems for Royal Ahold, including sharp drops in the prices of its outstanding securities and its credit rating. 
7. Investigations of Royal Ahold’s accounting records revealed that the company’s previous financial statements had been materially misstated.
8. The three principal sources of Royal Ahold’s financial statement misrepresentations were the improper inclusion of financial data for foreign joint ventures in its consolidated financial statements, improper accounting for purchases of foreign joint ventures, and improper accounting for “promotional allowances” by the company’s food wholesaling subsidiary.
9. Among the parties blamed for the Royal Ahold scandal were the company’s top executives, the company’s Deloitte auditors, and international oversight and rule-making bodies in the accounting and auditing disciplines. 
10. The Royal Ahold case refocused attention on the lack of cooperation between international oversight and rule-making bodies in the accounting and auditing disciplines.

Suggested Solutions to Case Questions

1. The equity method is the proper accounting method for U.S. companies to apply to investments representing a 20–50% ownership interest in an investee company. U.S. GAAP generally does not permit full or proportional consolidation of a joint venture company in which the “parent” owns a 50 per cent interest.

In arriving at the U.S. GAAP-based net income figures shown in the reconciliations presented in Exhibit 3, Royal Ahold fully consolidated the operating results of the joint ventures in which it had a 50 per cent ownership interest. Since these entities were operating profitably, the result was to overstate the U.S. GAAP-based net income figures shown in Exhibit 3.


2. There isn’t a universally-accepted definition of “earnings quality,” but, generally, that phrase refers to the degree of correlation between a company’s reported earnings and its “true” earnings. The term “earnings quality” is also often used when referring to the degree to which a given entity’s reported earnings can be used to predict its future earnings. Because of the pervasive conservatism principle within the U.S. accounting profession, reported earnings figures that are conservative, that is, that tend to be understated, are often considered to be of high quality. However, consistently understated or overstated earnings are of low quality given the general definition of earnings quality just presented. So, in comparing the earnings produced by two competing sets of accounting principles, such as IFRS and U.S. GAAP, the key issue is which set of accounting principles produces net income figures that are more highly correlated with the given entity’s stream of actual earnings. Granted, determining “actual earnings” for purposes of this comparison is a difficult assignment.

In addressing this question, your students will likely focus on the large differences between the Dutch GAAP-based and U.S. GAAP-based net earnings figures shown in Exhibit 3. Notice that easily the most significant factor accounting for the difference in Royal Ahold’s Dutch GAAP-based

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Solution Manual Case 2.6 Kansayaku

This case focuses on Japan’s accounting profession and independent audit function. As this case documents, the accounting profession and independent audit function within the United States and Japan are very similar in many respects but very dissimilar in others. Similar to the United States, Japan’s accounting profession has historically been dominated by a small number of large accounting firms. In fact, each of Japan’s four largest accounting firms is affiliated with one of the Big Four accounting firms that are principally domiciled in the United States. The overall role and nature of the independent audit function in the two major industrialized countries are also very similar. One of the major differences between the accounting profession in Japan and the United States is the relatively small number of Japanese CPAs. On a per capita basis, the United States has more than ten times as many CPAs as Japan. Likewise, there is a large disparity in audit fees between the two countries. The annual audit fee for a U.S. company is typically ten times the size of the audit fee for a comparable Japanese company. Finally, the nature and structure of the regulatory function for the accounting profession and financial reporting system have historically been very different between the two countries.

Similar to the United States, Japanese auditors have faced mounting criticism in recent years as a result of a series of high profile accounting and auditing failures. Much of this criticism stemmed from revelations that several of the large “mega banks” that have dominated Japan’s post-World War II economy were technically insolvent despite the fact that those banks had received unqualified audit opinions each year on their financial statements. As a result of the major financial crises within Japan’s banking industry, pervasive changes were made in the country’s regulatory infrastructure for its financial reporting system. Many of these changes directly impacted Japan’s accounting profession and independent audit function. The first major test of this new regulatory framework was posed by an accounting and auditing scandal involving a large cosmetics and apparel company, Kanebo Ltd. In fact, the Kanebo affair is often referred to by the Japanese press as “Japan’s Enron.”

Kansayaku—Key Facts

1. Similar to the United States, the public accounting profession and independent audit function in Japan are dominated by a small number of large accounting firms.

2. On a per capita basis, Japan has significantly fewer CPAs than any other industrialized country, including the United States; likewise, independent audit fees in Japan have historically been a small fraction of those in the United States.

3. A severe financial crisis that struck Japan’s banking industry during the late 1990s triggered a major credibility crisis for Japan’s accounting profession and independent audit function.

4. The criticism of Japan’s independent audit function focused on allegations that the close relationship between auditors and client management undermined the independence and objectivity of auditors.

5. Allegedly, independent auditors in Japan routinely subordinated their professional judgment to the wishes and demands of client executives.

6. In response to the widespread criticism of independent auditors, Japan’s federal government overhauled the regulatory structure for the nation’s financial reporting system.

7. The first major test of this new regulatory framework was posed by an accounting and auditing scandal involving Kanebo, Ltd., a large cosmetics and apparel company.

8. Kanebo’s top executives goaded the company’s accounting staff to misrepresent Kanebo’s financial statements throughout the late 1990s and beyond.

9. Kanebo’s independent auditors not only ignored the material misrepresentations in Kanebo’s financial statements but also suggested additional methods for improving the company’s apparent financial condition and operating results.

10. Despite the fact that Kanebo’s top executives and the company’s independent auditors either pled guilty or were convicted of various fraud charges, none of the individuals served any time in prison since each received suspended sentences.

11. Among the most significant results of the Kanebo scandal was the two-month suspension imposed on the company’s independent audit firm, ChuoAoyama.

12. The unprecedented suspension of ChuoAoyama signaled that Japan’s regulatory authorities were seriously committed to reforming the nation’s financial reporting system, including its independent audit function.
Question

Question and Answer

1. Research online news services to identify recent developments impacting the accounting and auditing profession in Japan. Briefly summarize these developments in a bullet format.

There have been recent developments in Japan that have impacted the accounting and auditing profession. Two of these developments are the Kanebo scandal of 2004 and the 2011 fraud scandal at Olympus Corp.
The Kanebo scandal of 2004 involved ChuoAoyama PricewaterhouseCoopers, a leading auditor in Japan. It was discovered that ChuoAoyama's monitoring systems failed to show that its employees had been cooking the books for Kanebo for five years. After this scandal was uncovered, the Japanese Financial Service Agency revised auditing standards, the CPA Law and the Financial Instruments and Exchange Law. The FSA also introduced the Internal Control Report and Audit and quarterly financial statement reviews. In addition, the CPAAOB was formed and was to become an independent regulator under the FSA. Further reforms include requiring auditors to rotate client teams every seven years, with a two year interval before they return.

Another development was the Olympus Corp. fraud of 2011. Olympus Corp. admitted to hiding large securities losses by using payments to merger advisers and venture capital funds. The two auditing firms that were under investigation were KPMG ASZA and Ernst & Young ShinNihon. With each firm, there was a failure to obtain sufficient, competent evidence to support the auditors' opinion on the financial statements. Based on this scandal, the PCAOB was given more international freedom. The PCAOB and Japanese regulators reached an agreement that allows the two countries to carry out joint inspections of auditing firms in Japan and the US. As a result, the PCAOB conducts inspections of international firms that audit public companies whose shares trade on US exchanges, which includes on-site visits and sharing of confidential information under certain circumstances.


2. As noted in this case, Japanese companies typically rely more heavily on debt capital than US Companies. Explain how this fact may cause the independent audit functions in the two countries to differ.

In any economy, the parties that are the principal source of capital for business organizations will obviously be among the principal stakeholders in that economy’s financial reporting process. Not surprisingly, individual audit firms, rule-making authorities, and professional organizations will likely feel some pressure or need to cater (or kowtow) to the information needs of those principal stakeholders. No doubt, this pressure will influence decisions made on individual audit engagements, influence the nature of accounting and auditing pronouncements, and influence the agendas and policy initiatives pursued by professional accounting and auditing organizations.

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