Accounting Games in the Grocer's Aisle

Loose rules on supplier payments give chains lots of discretion

On the face of it, there's no simpler business than a supermarket. Draw customers into the store as often as you can and sell as many products as possible for more than you paid. That's what most customers see. Below the surface, though, is a murky world of incentive payments that pass quietly from manufacturers to the stores. These payments go toward winning prized shelf space, subsidizing promotions, or funding rewards for selling a lot of a particular brand of soap or soup.

Trouble is, these payments, unlike what goes through the cash registers, don't need to be clearly accounted for under current rules. That allows management to engage in perfectly legal accounting ploys to prop up earnings. In some cases, the payments are even used as tools of outright fraud. The issue gained attention after recent allegations that Dutch supermarket operator Royal Ahold (AHO ) overstated profits by $500 million because it loaded up on inventory to collect supplier payments. "What investors don't know could hurt," Credit Suisse First Boston analyst Jack Murphy recently warned clients. He calls the payments a "black hole" in income statements.

These incentive payments aren't chump change; in fact they can tally in the billions of dollars and make the difference between a giant chain losing money and posting a healthy profit. Companies are tight-lipped about the payments, but fragments of information revealed in March by grocers Albertsons Inc. (ABS ) and Kroger (KR ) indicate that the two chains booked payments of $2 billion to $3 billion apiece last year. That was more than either company's entire operating profit, analysts at CSFB figure. Safeway Inc. (SWY ) reported $2.1 billion in supplier money in 2002, equaling 6.5% of sales, while its operating-profit margin was 5.2% of sales. Supermarkets aren't the only ones in this game. Express Scripts Inc. (ESRX ), a prescription-benefits manager, said on Apr. 1 that it got nearly $1 billion in payments from drugmakers last year -- three times its operating income. The company says it passes along more than half of those payments by granting discounts to its corporate customers, but it isn't specific.

With that much money at stake and so little disclosure required by regulators, there's great temptation for chains to finesse the numbers. For instance, grocers can take a quarterly earnings pick-me-up by booting one supplier in favor of another to get a big up-front payment for shelf space. A greater risk for investors is that under the rules, companies can book rebates in advance for hitting suppliers' targets. That's allowed when there's a "probable and reasonably estimable" chance that they will meet this goal. Translation: Companies can count their chickens before they hatch. But if the targets aren't met, investors get hit with a nasty charge to earnings. "The only reason people want to use this approach is to accelerate earnings to make their numbers," says Lynn E. Turner, former chief accountant at the Securities & Exchange Commission. "Anticipating if targets will be met has failed miserably in financial reporting."

Information is starting to dribble out, but it's short of what investors want. Safeway, for example, divulges more than most of its rivals in its annual reports, but it doesn't disclose quarterly incentive payments, leaving investors to wonder whether they're being parceled out to boost weak quarters. Nor does Safeway say what part of its supplier money comes from short-term deals, which allow less room for earnings management, and what comes from long- term arrangements, where there's less certainty that volume targets will be hit and the money collected.

For their part, the companies defend their practices. They say many of the payments don't help their profits because they are spent on promoting products. The companies say the payments they record don't fluctuate markedly. Kroger says it doesn't count "most" of its payments until it meets suppliers' goals, while Safeway says it always waits until it meets the goals.

Many loopholes could have been plugged last year. A unit of the Financial Accounting Standards Board took up the issue but made only some changes. The panel specifically left the door open to counting payments before goals are met. That leaves investors praying those chickens will hatch.

By David Henry in New York

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