Question

Two former Kmart executives were indicted by a Detroit grand jury on federal charges of fraud, conspiracy and making false statements over their recording of a $42 million payment that resulted in an overstatement of Kmart's results.

explain more about this scandal:

a. Who was responsible for the fraud? What were their motives for committing it?

b. What actually took place? What were the specific financial statement consequences (what accounts were overstated or understated; what were the fraudulent debits and credits and what should they have been)?

c. How was the fraud discovered?

d. What were the consequences to those involved (the company, shareholders, and perpetrators themselves)?

Answer 1

Here are the details about the Kmart accounting scandal:

a) The executives responsible for the fraud were Kmart's vice president of finance James Connor and controller John McDonald. Their motive was to artificially inflate Kmart's earnings to meet analyst expectations and boost the stock price.

b) The fraud involved improperly recording a $42 million payment from a supplier as income in the second quarter of 2002. This resulted in overstating revenues and net income on the income statement. The payment should have been recorded as a reduction to cost of goods sold or inventory. The fraudulent entries were debit to cash, credit to revenue. The correct entry would be debit to inventory, credit to cash.

c) The fraud was discovered in an internal review of accounting practices in 2002 after a change in management. The new CFO noted irregularities and commenced an investigation with external forensic accountants.

d) The consequences were - Kmart filed for bankruptcy in 2002 following discovery of the accounting manipulations. Shareholders lost value as the stock price plummeted. The two executives were dismissed, fined $10 million each, and sentenced to 3-4 years in prison for securities fraud. The reputation and brand image of Kmart suffered due to the scandal.

In summary, the fraud was committed by two Kmart executives to inflate earnings, discovered via internal review, and resulted in legal penalties and loss of shareholder value for the company.