ROYAL AHOLD The European ENRON

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ROYAL AHOLDThe European ENRON
Corporate Financial Reporting AnalysisAlvaro
ARGÜELLESIan MCKERROWJuan SIERRAAbhishek
AGRAWAL
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Agenda
? What is Ahold today? ? Royal Aholds
strategy 1997-2003 ? Differences between Dutch
GAAP and US GAAP ? Accounting irregularities ?
the European Enron ? Corporate Governance
issues
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What is Ahold today?
Ahold is international group of quality
supermarkets and foodservice operators based in
the United States and Europe.
It is committed to offering its customers the
best value, the highest quality and healthy
choices, while building value for Aholds
shareholders. Aholds main financial figures
are as follows
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Royal Aholds strategy 1997-2003

• Family owned company until 1989 when professional
  management hired
• Aholds strategy in the late 1990s was basically
  based on
• ? Aggressive international expansion plan
• ? To challenge Wal-Mart Carrefour as top
  international retailer
• ? 15 annual growth target in EPS 10 internal,
  5 external growth (earnings pre goodwill
  effect!)
• ? Expansion to be financed largely through debt
  and outside equity ? not internal cash generation
• ? Improve investor relations
• ? Emphasis on growth, rather than shareholder
  value ? Pressure on management to achieve earnings

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Royal Aholds strategy 1997-2003

• Focus on fragmented, US retail grocery market
• Their major acquisitions up to the late 1990s
  were in the North-East of the US Tops Markets
  (NY/Buffalo), Mayfair (New Jersey), Stop Shop
  (New England) and Giant Food (Maryland). By 1996,
  Ahold was close to being the largest supermarket
  chain on US East coast. The success of their
  strategy up to this point is from making
  pragmatic acquisitions and from taking advantage
  of low competition from local retailers.
• From late 1990s, strategy loses direction
• From 1998, Ahold suffered a number of setbacks.
  In 1999, the FTC blocked the acquisition of
  Pathmark due to market concentration concerns.
  The profitability of their US operations suffered
  and they started to acquire companies in the
  South.
• Reckless expansion
• From 1996-2000, Ahold tried to expand into Asia
  and Latin America with no coherent strategy.
  Their desire for short-term growth was not
  conducive to success and their expansion into
  these regions was a failure. In March 2000, Ahold
  entered the large US food service industry with
  purchase of US food service. Given their lack of
  experience in the food service industry this was
  an unexpected change of direction.It is evident
  that by 2000, Ahold was a company struggling to
  hit the 15 growth targets it had set itself and
  its growth by acquisition strategy had run its
  course.

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Differences between Dutch GAAP and US GAAP

• Since Ahold is cross-listed on the NYSE and the
  Dutch Stock Exchange since 1993, Ahold has to
  reconcile its financial statement under Dutch
  GAAP to US GAAP 20-F
• It was not until 2001 that the investor community
  recognized Aholds aggressive home country
  accounting and questioned the quality of reported
  earnings under Dutch GAAP
• A striking fact is the late discovery of the
  large differences between Dutch and U.S. GAAP
  numbers per the 20-F reconciliation.
• AHOLDs major differences between Dutch GAAP and
  US GAAP were the followings for the period
  1997-2003

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Differences between Dutch GAAP and US GAAP
(contd)
GOODWILL FROM ACQUISITIONS Under Dutch GAAP
(in the 90s) goodwill from acquisitions was
immediately charged against stockholders equity,
thus not affecting the income statement However,
U.S. GAAP (until 2001) required goodwill to be
capitalized and amortized over 40 years, thus
affecting the income statement. From 2001, the
goodwill generate from acquisitions is not
amortized but is annually subjected to an
impairment test, with impairments charged to the
income statement. Ahold relied on acquisitions
to achieve the objective of 15 growth in
earnings excluding extraordinary items, currency
conversions and amortization of goodwill The
requirement that Ahold reconcile its Dutch
accounting numbers to US GAAP forced the firm to
amortize goodwill in its income statement
reported in the 20-F filing with the SEC. As the
number and size of acquisitions increased, and as
Ahold paid more and more for its acquisitions
relative to the book value of the companies, the
gap between Dutch GAAP earnings and US GAAP
earnings at Ahold widened.
Impairment testing Impairment is the inability
of a company to realize fully the expected
benefits of owning an asset To test goodwill
for impairment, companies must first assign the
recorded goodwill to reporting units. Then,
SFAS No. 142 prescribes a two-step process to
determine whether goodwill is impaired Step 1
Compare fair value of reporting unit to its
carrying amount, incl. related goodwill. When
fair value is less than book value, goodwill
shall be impaired, and the company goes to Step
2. Step 2 Compare implied fair value of
reporting units goodwill to its carrying amount.
When fair value is less than book value, the
company must record an impairment write-off equal
to the difference.
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Differences between Dutch GAAP and US GAAP
(contd)
? Major changes that took place in US GAAP
goodwill treatment, caused following
adjusments - 2001 ? impairment of 728m
(lower valuation of Disco JV in Argentina) -
2002 ? impariment of 1.85Bn (lower valuation of
US Food Service)
? It seems that Ahold overpaid in order to
achieve its growth in earnings
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Differences between Dutch GAAP and US GAAP
(contd)
JOINT VENTURES Up to 2000, under Dutch GAAP
impairment losses did not have to be recognized
and all goodwill relating to joint ventures was
charged directly to shareholders equity upon
acquisition. After 2000, goodwill must be
amortized over its useful life with a maximum of
20 years. FINANCING ? Sale and lease back
operations Ahold entered into sale and leaseback
arrangements with various financial institutions,
whereby the Company sells various retail
properties and simultaneously leases them back
from the purchaser. Dutch GAAP ? if a sale and
leaseback transaction transfers substantially all
risks and rewards of ownership to the buyer and
the transaction is established at fair value, the
gain or loss on the sale is recognized
immediately in the consolidated statements of
operations. US GAAP ? gains are recognized
based on the degree to which the seller retains
the right to use the real estate through the
leaseback. Where the seller retains substantially
all of the use of the property, the gain on the
sale transaction is required to be deferred and
amortized over the lease term. Where the seller
retains only a minor use of the property, any
profit or loss generally is recognized at the
date of sale. Losses are recognized immediately
upon consummation of the sale. As a result of
the aforementioned difference between US GAAP and
Dutch GAAP, certain gains that were recognized at
the date of sale and leaseback transactions under
Dutch GAAP were deferred under US GAAP.
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Differences between Dutch GAAP and US GAAP
(contd)
FINANCING (contd) ? Derivative
instruments Under Dutch GAAP, gains and losses
from derivative financial instruments that are
designated and qualify as hedges are deferred and
recognized in the consolidated statement of
operations in the same period in which the
underlying hedge exposure affects earnings. US
GAAP (adopted by Ahold as of January 1, 2001)
requires that all derivatives be recognized as
either assets or liabilities in the consolidated
balance sheet and measured at fair value.
Depending on the documented designation of a
derivative instrument, any change in fair value
is recognized either in income or shareholders
equity (as a component of accumulated other
comprehensive income). RESTRUCTURING
PROVISIONS Under Dutch GAAP, Ahold recorded
provisions when it entered into plans for store
and distribution center closures or sales.
Effective January 1, 2001, restructuring
provisions are recorded for expected costs of
planned reorganizations only if certain specified
criteria are met. Under US GAAP (through
December 31, 2002) the criteria that had to be
met in order to record a restructuring provision,
including a requirement to communicate terms of a
restructuring plan to employees prior to
recognition of the related provision.
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Accounting irregularities ? JV consolidation

• What Ahold did
• In order to fully consolidate revenues and
  earnings from subsidiaries, Ahold claimed
  effective control over 5 South American JVs where
  it owned only 50 of the shares by providing
  control letters signed by top executives of these
  JVs
• Ahold hid from its auditors secret comfort
  letters destined to the other shareholders of
  these JVs, where it denied that it held effective
  control of the company
• Result
• Ahold overstated net sales by approximately EUR
  4.8 billion (5.1 billion) for fiscal year 1999,
  EUR 10.6 billion (9.8 billion) for fiscal year
  2000, and EUR 12.2 billion (10.9 billion) for
  fiscal year 2001
• Ahold overstated operating income by
  approximately EUR 222 million (236 million) for
  fiscal year 1999, EUR 448 million (413 million)
  for fiscal year 2000, and EUR 485 million (434)
  for fiscal year 2001
• What Ahold should have done
• According to Dutch and US GAAP, revenues and
  earnings should have been consolidated following
  the Equity Method, that is, in proportion to the
  stake owned (50), and not fully consolidated

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Accounting irregularities ? Contingent liabilities

• What Ahold did
• Ahold did not disclose a contingent liability
  derived from the obligation of buying out its
  partners in the Argentinean Joint Venture Disco,
  in case this subsidiary were to default on the
  payment of its debt
• In 2001 Ahold estimated that the probability of
  this event triggering the liability was remote,
  even though Argentina was already heading towards
  a major financial collapse, and thus did not
  disclose the liability neither on its Balance
  Sheet nor in the Footnotes
• Only in 2002 did Aholds management judge the
  likelihood of a default as reasonably possible,
  but not probable
• Result
• As a result of Disco defaulting on one of its
  payments, the partners exercised their put
  option, and the transaction resulted in an
  overall loss to Ahold of 372 million in 2002
• What Ahold should have done
• Contingent liabilities are conditional on a
  certain event taking place in order to
  materialize
• According to US GAAP, contingent liabilities
  should be disclosed
• On the Balance Sheet if the management estimates
  as probable the likelihood of the event on which
  the liability is contingent
• In the Footnotes if the event is judged to be
  possible but not probable
• No need to disclose if the likelihood of the
  event occurring is considered remote

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Accounting irregularities ? Vendor rebates

• What Ahold did
• Aholds subsidiary US Foodservices (USF), as most
  food retailers, received a large number of vendor
  rebates (promotional allowances) if USF purchased
  certain merchandise volumes. These rebates
  accounted for the majority of US Foodservices
  income during 2001 and 2002
• These rebate contracts generally included
  prepayments for multi-year contracts, which were
  recorded as current period earnings
• USF managers systematically booked rebates to
  compensate for any shortfall in projected
  earnings, therefore meeting their target earnings
  (and thus receiving their generous bonuses)
• To do so, they induced vendors to confirm false
  promotional allowance income, manipulated
  accounting entries, forged cash receipts, and
  made false and misleading statements to the
  companys auditors
• Result
• The USF rebate fraud resulted in Ahold
  overstating its earnings from 2000 to 2003 by
  more than 800 million
• What Ahold should have done
• The matching principle establishes that revenue
  should be recognized when two basic criteria are
  met
• Earned the company has substantially performed
  the service or delivered the good
• Realizable payment collection is reasonably
  assured
• In this case, the rebates were prepaid, but were
  only earned when Ahold actually bought the
  merchandise from its vendors at the end of the
  specified period
• Ahold should not have recognized revenues until
  the period for which the rebates were given
  expired and the purchase volumes required were met

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Accounting irregularities ? stock price
performance
FTC Blocks Pathmark acquisition
Ahold acquires US FOOD SERVICE
Earnings restatement announcement causes 60 drop
in share price
Acquisition of local retail grocery chains
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Earnings discrepancias
Ahold relied on acquisitions to achieve the
objective of 15 growth in earnings. However as
the base increased, Ahold needed larger and
larger deals to hit this target. Under Dutch GAAP
goodwill purchased was immediately charged
against the stockholders equity. Hence
acquisitions did not impact the earnings. However
under US GAAP goodwill was capitalized and
amortized over a period impacting the earnings.
As Ahold paid more relative to the book value of
the companies, the gap between Dutch GAAP and US
GAAP increased significantly. In early 2002 Ahold
reported a 16 EPS growth in Dutch GAAP but a 17
EPS decline in the US GAAP (the numbers were
restated later). While there were a lot of
unexplained gaps between the US and Dutch GAAP,
investors didnt bother to investigate these
because majority of Aholds shareholders were
Dutch. After the accounting fraud came to
light, Ahold had to restate the financials for
the years 2000 and 2001. Earnings in 2000 went
down to 442 million euro from 1.115 billion euro.
Similarly in 2001, earnings dropped from 1.113
billion profit to 254 million loss. Aholds
auditors suspended 2002 year audit pending the
completion of investigations. As a result of
these announcements Aholds stock price fell 59
in a single day. SP too downgraded Aholds
credit rating from BBB to junk.
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Corporate Governance Failure
OWNERSHIP AND CONTROL STRUCTURE Aholds founder
family owned founder/priority shares with options
to dilute 100. The CEO, Van der Hoeven,
eliminated the family oversight by convincing the
family to sell its holds to institutional
investors. Van der Hoeven then avoided
blockholder monitoring by putting the voting
controls of the institutional investors in a
foundation, which was strongly influenced by
Aholds management. This situation is best
reflected in 1997 shareholder meeting where a
single foundation, with 19 preferred shares,
controlled more than 63 of the voting rights.
Quite understandably the chairman of the
foundation decided to vote in favor of all the
management proposals. The institutional investors
agreed to this arraignment in return for
preferred dividends which secured early returns
for them. These measures decreased the
shareholders ability to control and discipline
management and the management acted without any
oversight. MANAGEMENT BOARD The management board
was dominated by the CEO. He appointed loyal
managers without consulting the board. A lot of
managers were former from recently acquired
companies and they continued to manage the
subsidiaries they previously managed. Aholds
management also successfully circumvented the
role of dividends as a disciplining device. It
initiated choice dividends which allowed
shareholders to choose between stocks or cash
dividend. The ratio of shares to cash was always
set such that shareholders chose the stock
dividend. This allowed the management to
influence the cash outflow without any dividend
reduction. The short sightedness of the
management was further encouraged because of the
incentive structure at Ahold. Managers exercised
their stock options immediately and carried very
few stocks of the company. During late 90s
managements options payouts were often 600 more
than of their cash compensation. All of these led
to poor internal control and didnt align
managements interests with long term growth of
the company.
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Corporate Governance Failure
SUPERVISORY BOARD Aholds supervisory board was
not independent due to the presence of former
managers and supervisors with conflicting
interests with the shareholders. For example,
Nelissen, a board member, was the CEO of Amro,
one of Aholds main banks. Nelissen was also on
the board of Aholds auditor, Deloitte. Although
unproven, it is widely believed that Nelissen was
the main reason why ABN-Amros analysts continued
to give a strong buy rating to Ahold even when
their numbers looked questionable. In return,
Ahold rewarded the bank by giving 16 equity and
debt underwriting projects. Conflict of the
interests was not the only problem a lot of
board member were either overcommitted or didnt
understand the business. When asked about the
misuse of accounting differences between US and
Dutch GAAP, Schneider, an art professor and a
supervisory board member mentioned that she
didnt understand the issue. She said, I dont
feel responsible, I am not a business person.
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Conclusion
Ahold initially was successful in growing
through acquiring retail stores in USA because of
the synergies and the economies of scale. However
after the anti-trust ruling against it, Ahold
couldnt come up with a coherent strategy to
drive future growth. The high equity price put
pressure on the management to continue delivering
high growth numbers. Hence they went for mergers
and acquisitions in unrelated areas leading to
greater integration problems which reduced the
earnings growth. This ultimately forced managers
to show growth by cooking the books. While there
were both internal and external monitoring
structures, these were systematically undermined
because of a dominant management. Moreover, since
management held very little of the companys
stock and since the incentive compensation was
based on earnings growth, governance shortcomings
were amplified and also provided a direct
motivation for the management fraud. Ahold shows
that the absence of a family or major blockholder
monitoring in combination with an unconstrained
management can be devastating for the continuity
of the firm and its performance.