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Fraud deconstructed: Manipulating expenses to achieve promised profits

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Introduction to the case

Kraft Heinz Company (KHC) is an American multinational food and beverage company that was formed in 2015 through the merger of Kraft Foods and H.J. Heinz Company. Following an investigation conducted by the Security Exchange Commission (SEC), KHC faced allegations of various types of accounting misconduct and was subsequently fined $62 million by the SEC. The investigation revealed that the company's procurement division allegedly manipulated expenses to meet publicly-announced costs-savings targets. Its deceptive accounting practices aimed to inflate profits by prematurely recognizing cost savings. The alleged misconduct took place from 2015 to 2018—the ‘Period of Misconduct’.

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Details of the fraud

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KHC announced to its investors that it would achieve costs savings because of its merger and tied performance targets for procurement staff to cost-savings targets.

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To meet the cost-savings expectations, KHC entered into various arrangements to obtain upfront cash payments and discounts that were tied to future commitments. KHC then prematurely recorded such benefits from suppliers as cost savings, contrary to accounting rules.

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KHC’s Chief Operating Officer, Eduardo Pelleissone, was supposedly presented with indications that expenses were being manipulated through agreements with KHC’s suppliers. Rather than addressing the apparent risks, he allegedly encouraged the procurement staff to meet unrealistic savings targets.

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In total, 59 transactions were improperly recorded by KHC, understating KHC’s cost of goods sold by approximately $50M during the Period of Misconduct.

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How did the fraudsters commit the crime?

The KHC’s procurement division entered various supplier contracts that required up front payments from suppliers for future purchasing commitments. These included:

  • upfront discounts and credits from suppliers received in exchange for future purchasing commitments;
  • payments to KHC with an agreement for repayment by KHC through future price increases or volume commitments; and,
  • agreements to reduce current prices, to be offset by future price increases.

KHC’s procurement division claimed that these supplier payments related to savings earned in the current or prior years. KHC also obscured its obligations for future consideration given in exchange for current benefits. The misleading information about contracts was provided to KHC’s finance group and caused KHC to account for these cost savings prematurely.

Notably, KHC acknowledged material control weaknesses in its 2018 annual report, including those in its procurement division. KHC disclosed that employees circumvented controls and withheld information to achieve financial targets. Additionally, KHC noted that it failed to maintain sufficient documentation of transactions to allow for the proper determination of accounting treatment.

Further, KHC’s legal department responsible for reviewing supplier contracts, whose compensation was tied to helping reduce costs, was understaffed. As a result, the staff overlooked inconsistencies between the contract documents and the negotiated transaction.

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What was the outcome?

On February 21, 2019 KHC received a subpoena from the SEC regarding the misleading transactions. As a result, KHC initiated an internal investigation that identified further misstatements. In total, including the misleading transactions, KHC identified an understatement of its costs of goods sold of $208M. In June 2019, KHC released its 2018 annual report which restated its results for the Period of Misconduct.

In September 2021, the SEC concluded that KHC had violated federal securities laws, resulting in a fine of $62 million. Additionally, Pelleissone personally received a fine of $300,000, while former Chief Procurement Officer, Klaus Hofmann, received a $100,000 fine and a five-year prohibition from assuming officer or director roles within a publicly traded company.

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How could this have been prevented?

A positive and ethical tone at the top can inspire employees to adhere to established standards of conduct and create an environment in which employees are inclined to act appropriately and reject pressures for misconduct.

Developing and implementing effective internal controls is crucial for managing risks, preventing fraud, ensuring accurate financial reporting, complying with regulations, optimizing operations, and building trust among stakeholders. While developing internal control systems, consideration should be given to how an organization’s goals may influence staff conduct. Appropriate controls should be put in place to safeguard against unwanted behaviour.

Allocating sufficient resources for the proper performance of key internal control functions is essential to ensuring that safeguards operate as intended.

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How BDO can help

Our Forensic Disputes and Investigations and Risk Advisory teams are experienced in identifying potential risks and implementing effective measures to mitigate or investigate fraud. We offer a range of services, including fraud risk assessments, compliance testing, forensic accounting, investigations, litigation support and more. Act today to protect your business from fraud by contacting our team for a comprehensive analysis of your company’s risks and potential vulnerabilities.

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