The deals that led to a major accounting scandal at Royal Ahold NV's food-service subsidiary this week have been a widespread practice -- and a vulnerability -- in the cutthroat food-distribution business for about three decades.
The vulnerability has taken center stage this week as Ahold revealed that Columbia, Md.-based U.S. Foodservice Inc. overstated its earnings by at least $500 million in the past two years. Yesterday, Fleming Cos. of Lewisville, Tex., the nation's largest grocery distributor, said the Securities and Exchange Commission formally opened an investigation into its accounting practices. Earlier this month, the SEC also began an inquiry into bookkeeping at Nash Finch Co., a food retailer and wholesaler in Edina, Minn.
At the heart of the accounting irregularities is an industry convention in which a supplier makes special payments to a distributor for doing business. A problem arises when the distributor fails to account properly for the payments.
Gary M. Giblen, an analyst with C.L. King & Associates Inc. in New York, said there's nothing improper about the payments themselves, which are used by manufacturers to entice food distributors to buy their products.
But companies can run into accounting difficulties because the rules governing how these payments are booked are "loosey-goose," Giblin said. "There are virtually no defined reporting regulations for these allowances."
A task force of the Financial Accounting Standards Board took a stab last year at detailing how companies should book their allowances. But the effort yielded only general guidelines.
Writing comprehensive accounting rules for the payments is difficult because the deals come in so many forms. Often a supplier provides a payment to a distributor with the ultimate goal of winning prime shelf space or a price advantage at a retailer.
For instance, a soft-drink company might offer a rebate to its distributor fully expecting the distributor to work out a deal on its behalf with the supermarket where the drinks are sold. The distributor might pass on some of the rebate to ensure that the supermarket marks down the soft drink's price and prominently features it in newspaper circulars sent to consumers.
Mia Kirchgaessner, a food retail analyst at Sanford C. Bernstein, said manufacturers spend billions of dollars a year on these "promotional allowance" programs.
Using the payments, manufacturers can push the products they want to push, Kirchgaessner said. The rebates also give manufacturers some leverage as they try to outprice their competitors and win new customers.
"These payments are very, very commonly used," Kirchgaessner said. "I would be extremely surprised if there is a [retailer or wholesaler] out there that doesn't use any."
Richard Kochersperger, director of the Food Marketing Group, a consulting firm, said the food wholesalers and the grocery retailers are under tremendous pressure to perform.
"The pressure from Wall Street to show positive sales and positive profits is like nuclear heat," Kochersperger said. "So many companies are stretching beyond their capabilities."
Kochersperger said the payment allowances became the norm soon after the Nixon administration lifted the wage and price controls it imposed during an era of high inflation.
At the time, manufacturers were barred from raising their prices even though the cost to produce their product was going up, Kochersperger said. Once the price controls were lifted, manufacturers started raising their prices and then negotiating them back down through allowances.
"They concluded they never wanted to be in that situation [imposed by price controls] again," Kochersperger said.
In the case of U.S. Foodservice, analyst Kirchgaessner speculated that the company may have agreed to receive payments for moving a certain volume of merchandise for its suppliers, booked the payments, then failed to deliver the volume. If the payments never materialized, the company should not have recorded the revenue. Executives at U.S. Foodservice and Ahold have declined comment on the details of the accounting irregularities.
Ahold, under stiff pressure in an increasingly competitive grocery-store environment, was relying on its food-distribution unit to provide a steady stream of profits by selling food to restaurants, schools and other institutions.
Ahold is the world's third-largest food retailer and has six supermarket chains in this country. The company is battling shifts in the industry. Wal-Mart, the world's largest grocer, has made it tough for its rivals to compete in a climate where food prices have fallen with low inflation. Add to that the introduction of traditional grocery-store staples such as bottled water in retail outlets like gas stations and office supply stores and the chains feel even more squeezed.
Against this backdrop, Ahold was hoping to pare its debt, cut back on acquisitions and focus on its core business, which includes -- in addition to U.S. Foodservice -- Stop & Shop, Tops, Bi-Lo, Bruno's, Internet grocer Peapod, and the Giant chains in Landover, Md., and Carlisle, Pa.
In November, Ahold outlined its challenges to analysts and announced plans to sell some of its businesses. Company executives have said since that the Giant chains and U.S. Foodservice were not on the chopping block.
Rick Abraham, vice president of industry affairs for the Grocery Manufacturers of America, said the industry has since consolidated. Today, there are fewer food and non-food manufacturers and fewer customers for them to serve.
"With fewer players, it's become more competitive," Abraham said.