Kmart Case

Introduction

Financial reporting malpractices cause most of the corporate scandals in the United States (Bowie, 2013). The misconducts are in the form of omissions of critical facts or misrepresentation of the financial conditions of organizations. In such cases, the shareholders do not have access to credible information to assist them in investment decisions. Companies involved in such accounting misconduct eventually file for bankruptcy, causing distress to its stakeholders. Misrepresenting information is both fraudulent and unethical (Gibson, 2012). It is fraudulent because it deceives the users of the information. The manifestation of the unethical aspect is through the managers of the firms. The management has a duty to act in the best interests of the shareholders. Failure to provide them with accurate information is a sign of unethical decision-making. This research paper will prove that misleading financial information is fraudulent and unethical by analyzing the Kmart’s accounting scandal, the result of the Securities and Exchange Commission’s (SEC) investigation and Kmart’s response.

The Origin of the Scandal

Kmart was one the number two discount retailer in the United States before it filed for bankruptcy in 2002.The problem started when Kmart’s newly promoted Chief Operating Officer (COO) purchased an extra stock of supplies without the knowledge of other senior executives. Normally, Kmart bought increased stock near the festive season. However, the COO purchased the stock one and a half months earlier than the usual period. The management acknowledged that the stock was excess and estimated it to be worth $ 400 million. The executives later realized that its value was $ 800 million. The implications of such a massive purchase would be a decrease in the cash flow and the inability of the company to meet its short-term financial obligations. Kmart’s leadership took several steps to reduce the cash flow impact that would emerge from the stock build-up. Some of the actions they took included lowering capital expenditure and accelerating the collection of allowances from vendors. Despite the efforts, the company could not consolidate enough money to solve the liquidity crisis.

Project SID

SID was an acronym for “slow it down”, which Kmart managers used to delay the payment of vendors and suppliers (Securities Exchange and Commission, 2005). The management realized that the first initiatives to improve the cash flow problems were ineffective. Kmart leaders decided to change the period within which they could pay the suppliers unilaterally. The change was both unethical and illegal because Kmart and the suppliers had entered into a binding contract. In such an agreement, neither party could change the conditions without the consent of the other. As a result of delays in paying the suppliers, the company lost the vendors trust, and most of them stopped supplying products. The suppliers’ action to halt their business relationships with Kmart was a clear indication of the importance of ethical conduct in business. The company’s internal auditors provided the management with a cash flow analysis that indicated that irrespective of project SID, the organization could not solve its liquidity problems. The Chief Financial Officer (CFO) CFO warned Charles Conaway (Chief Executive Officer) about the seriousness of the cash problems and suggested that the company should file for bankruptcy. However, Conaway was not pleased with the suggestion and fired the CFO and replaced him with John McDonald. Conaway’s decision showed that he was aware of the crises that faced Kmart, yet he did not take the legal action recommended by the former CFO.

Project eLMO

In anticipation for confrontations with the suppliers, the management created a fictitious story to explain the suppliers’ payment delays. Project eLMO was a cover-up story that masked the real reason for the vendor crisis. The managers used the project to show that Kmart was in the process of converting its payables and inventory software to track its “soft” and “hard” products. As such, Kmart’s leadership created the perception that the implementation of the software changes was the cause of the payment delays (Securities Exchange and Commission, 2005).

The Results of the SEC Investigations

Letters from Kmart employees that the workers sent anonymously to the SEC prompted the agency to initiate investigations. After the investigations, SEC identified several activities undertaken by Charles Conaway (Chief Executive Officer) and John McDonald (Chief Financial Officer) that amounted to either fraud or unethical behavior.

Misleading Management’s Discussion and Analysis (MD&A) in Form 10-Q

The SEC requires publicly traded companies to fill form 10-Q for its quarterly reporting (Greuning, 2009). The report in the form contains unaudited financial information, which provides a continuous view of an organization’s financial conditions throughout the year. The management should discuss the financial status of the company because shareholders use the analysis to understand the corporation’s activities from the management’s perspective. The management’s discussion and analysis (MD&A) section of the quarterly report contains the analysis. Every public entity should provide its shareholders with an accurate analysis of its financial position so that they can make objective investment decisions (ICAA, 2012). The management should discuss and analyze the company’s finances in a manner understandable to the equity owners.

Part of the information that a corporation should provide in Form 10-Q is any material changes in the company’s financial condition since the last reported financial period (Ketz, 2006). The organization should then describe the reasons for the changes. Kmart’s leadership failed to provide the reasons for the increase in accounts payable that related to the money the company owed its suppliers. Additionally, Kmart’s executives did not provide an explanation in Form 10-Q about the unusual changes in its inventory that resulted from the “inventory overbuy”. Therefore, SEC found that the failure to provide an explanation for the existence of Project SID rendered the information in the MD&A inaccurate and incomplete.

Under the Securities Exchange ACT of 1934, a public corporation should describe trends and uncertainties that are likely to cause changes in its liquidity. Secondly, the firm should indicate the action it would take in case there is liquidity deficiency and the sources of external liquidity. SEC investigations discovered that by October 31st, 2001, Kmart had not paid $570 million to its vendors through Project SID. The money withheld from vendors was a material deficiency that Kmart should have reported in form 10-Q, yet Kmart did not. Moreover, Project SID was a source of external liquidity that the management should have described in detail in the MD&A section of their quarterly report. Despite these being essential facts, Kmart did not provide explanations regarding them. Consequently, SEC found the company in breach of the provisions of the law.

Another piece of inaccurate information that Kmart’s managers provided in the MD&A section of their quarterly report related to the working capital. The analysis indicated that the sources of the working capital were borrowing under the company’s credit facility and operations. However, SEC investigators identified millions of dollars in the working capital that came from Project SID, which Kmart did not disclose to the shareholders.

In a conference that Kmart officials called to respond to analysts and investors’ concerns, they made false claims regarding the reasons the retailer had a conflict with its vendors. Both MacDonald and Conaway explained during the conference that some of the accounts payable encountered problems because the software “dropped” some of them. The “drop” meant that the processing software accidentally left out some of the invoices unprocessed. However, SEC concluded that project eLMO had nothing to do with the vendors’ withheld funds. Conaway also lied to the investors by insinuating that the vendors complaining represented a small number while in reality, the main suppliers had issues with the company.

Kmart’s Response

After anonymous employees had sent letters to the SEC, Kmart responded by initiating internal investigations. Additionally, it informed the SEC about the letters and promised to comply with government investigators. The company also filed for bankruptcy at the same time it launched its investigations. Kmart’s board of directors hired Deloitte & Touche LLP, Skadden, Slate Meagher & Flom, and Arps to ensure that the fact-finding was independent. The concurrent filing for bankruptcy and internal investigations were indications that the claims made in the letters could have been valid. In the aftermath of the SEC investigations, the company acknowledged that it had erroneously accounted for some of the vendor transactions (Shafer-Landau, 2012). For instance, it had recorded vendor allowances as up-front instead of waiting to recognize them over the contract’s lifetime. Kmart improved the appearance of its liquidity by acknowledging future vendor allowances before collecting them. The action made the stakeholders view the company’s performance as healthy when it was almost collapsing. The misinformation denied the shareholders an opportunity to salvage their investment.

Fraud and Unethical Behavior from SEC Investigations

Most of the findings by SEC indicate that the executives at Kmart collectively or individually led to unethical behavior or fraud. First, the failure by Conaway and MacDonald to adhere to the Securities Exchange Act was immoral. According to Schneider & Norman (2011), ethics refer to a set of rules and regulations that guide the conduct of a group of people. The Securities Exchange Act was a guideline that Kmart management should have followed without exception. The misleading information that the company fed to the analysts and shareholders was fraudulent. The investors who had an interest in the performance of the company relied on the analysis of financial information to make decisions. Moreover, the public that continued to purchase the shares of the company would have made alternative decisions had they been aware that the retailer was experiencing liquidity problems. Therefore, by supplying false and inaccurate information to the shareholders, Kmart fraudulently enticed them to continue investing in its operations.

Apart from the collective unethical conduct by Kmart’s management, both Conaway and MacDonald were unethical individually. Before the Kmart’s bankruptcy filing, MacDonald received $1.75 million cash payment from the company, which was an addition to the $ 750 000 he had received earlier. Conaway received about $20 million as compensation for his service to the organizations for 20 months. The amount paid to the two officials should have reflected the financial performance of the company. Therefore, the two compensation packages were fraudulent and unethical since they were inconsistent with the efforts of the two leaders to improve performance. Kmart gave Macdonald the amount on the eve of the bankruptcy filing. According to the agency theory, the management, which is hired to represent the interests of the shareholders, may act to support its interests at the expense of the shareholders (Simpson & John, 2013). The managers at Kmart should have tried to minimize the financial impact that the shareholders would experience by not allocating allowances to the executives in times of financial crisis. Since their reckless decisions had led to the liquidity problems, they should have declined any compensation as a sign of being accountable. However, they did not care about the consequences of their actions and the shareholders. The consequentialist theory of ethics claims that an action is morally acceptable when its consequences are desirable (Timmons, 2012). According to the theory, both MacDonald and Conaway acted unethically because their actions would lead to the suffering of Kmart’s stakeholders. The employees of the company would lose their jobs, vendors the money Kmart owed them and shareholders would forgo their investment.

Therefore, the misleading financial information culminated to all the problems that the company faced. Had the information been accurate, SEC would have intervened at the right time to save the shareholders. The vendors would have reduced their losses by halting their supply to Kmart at the appropriate time while the public would have refrained from purchasing Kmart’s shares. The intervention by SEC would have prevented the two executives from receiving compensation packages by demanding their resignation and charging them in a court of law before their planned exit.

Conclusion

The misleading information that Kmart provided to the public was the source of all the unethical and fraudulent activities. The violation of the contractual agreements with suppliers about payment timelines in project SID laid the foundation for the dissemination of inaccurate information. Project eLMO gave the leaders at Kmart an opportunity to lie to the shareholders and the public about the vendors’ unpaid dues. The omission of information about SID in the MD&A resulted in fraud as vendors were denied their pay for goods supplied. Conaway and MacDonald’s failure to comply with the Securities Exchange Act was unethical because it provided guidelines on how to write financial reports. The inaccurate information defrauded the shareholders because it encouraged them to continue investing while the company was collapsing. The misrepresentation of information denied the vendors a chance to stop supplying Kmart in good time and thus their losses. Additionally, the misleading information encouraged the public to continue buying Kmart shares. The public would have avoided the shares and the losses that followed if it had the right information. Therefore, the misrepresented information led to both fraud and unethical activities.

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