Question: The Kraft Heinz Co. case was discussed
The Kraft Heinz Co. case was discussed in the chapter. To refresh your memory, on May 6, 2019, Kraft Heinz disclosed that it would restate its financial statements due to faulty procurement practices. The financial statements for 2016, 2017, and the first three quarters of 2018 were misstated because of inappropriate timing of the recognition of when certain cost and rebate elements associated with supplier contracts were initially recorded and then recognized through corresponding decreases to costs of products sold in future financial periods. The Form 8-K Report was filed with the SEC on May 2, 2019 pursuant to Items 2.02 and 4.02 of the Securities Exchange Act of 1934. The information in Exhibit 1 is taken from the Report. Due to the findings above, the company said it would not be able to timely file its quarterly report for the period ended March 30, 2018. Exhibit 1 Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review On May 2, 2019, the Company, in consultation with the Audit Committee of its Board of Directors reached a determination that the Company’s consolidated financial statements and related disclosures for the years ended December 30, 2017, and December 31, 2016, included in its Annual Reports on Form 10-K, and for each of the quarterly and year-to-date periods in 2017 and the quarterly and year-to-date periods for the nine months ended September 29, 2018, should no longer be relied upon because of certain misstatements contained in those financial statements. The Company does not believe that such misstatements constitute a quantitatively material misstatement to any individual period presented in the Company’s prior annual or interim financial statements, but due to the qualitative nature of the matters identified in the investigation, including the number of years over which the misconduct occurred and the number of transactions, suppliers, and procurement employees involved, the Company has determined that it is appropriate to correct the misstatements in the Company’s previously issued financial statements through restating such financial statements. As previously disclosed in the Company’s press release as furnished with its Current Report on Form 8-K filed on February 21, 2019 (the "Earnings Release"), the Company received a subpoena in October 2018 from the SEC related to the Company’s procurement area, more specifically the Company’s accounting policies, procedures, and internal controls related to its procurement function, including, but not limited to, agreements, side agreements, and changes or modifications to its agreements with its suppliers. Following receipt of this subpoena, the Company, together with external counsel and forensic accountants, and under the oversight of the Audit Committee, initiated an investigation into the procurement area, which is now substantially complete. As a result of the findings from the Company's investigation, which identified that several employees in the procurement area engaged in misconduct, the Company has recorded adjustments to correct prior period misstatements that increase the total cost of products sold in prior financial periods, which the Company does not believe constitute a quantitatively material misstatement to any individual period. These misstatements principally relate to the incorrect timing of when certain cost and rebate elements associated with complex supplier contracts and arrangements were initially recognized, and once corrected for, the Company expects to recognize corresponding decreases to costs of products sold in future financial periods. The findings from the investigation did not identify any misconduct by any member of the senior management team. Additionally, the Company has implemented and continues to implement certain remedial actions, including employee personnel actions and certain improvements to its internal controls, to mitigate the likelihood of this occurring in the future. The Company also continues to cooperate fully with the SEC. In connection with the internal investigation described above, the Company also conducted a comprehensive review of significant supplier contracts to identify other potential misstatements in the timing of the recognition of supplier rebates, incentive payments, and pricing arrangements. The review identified additional misstatements, which may or may not have resulted from the misconduct noted above, primarily related to certain supplier contracts and arrangements where the allocation of value of all or a portion of rebates and up-front payments to contractual elements in the current period should have been deferred and recognized over an applicable contractual period. These misstatements will be corrected for in the same manner as those noted above. The Company corrected these misstatements to defer the up-front consideration from suppliers when the retention or receipt of that consideration was contingent upon future events and to correctly recognize the consideration as a reduction of cost of products sold over the terms of the arrangements with the suppliers. The misstatements arising from the contract review relate to the timing of recognizing certain cost and rebate elements, and the Company thus expects to recognize corresponding decreases to costs of products sold in future financial periods. The Company's investigation and review described above identified required adjustments of approximately $208 million, of which approximately $27 million was recorded in the previously furnished fourth quarter 2018 cost of products sold. As a result, the cumulative net misstatements to the previously furnished or reported annual and interim financial statements were approximately $181 million, which, when reflected over the relevant periods, resulted in misstatements that are not quantitatively material to any prior year or quarter, but would have been significant to the fourth quarter of 2018 if corrected in that period. The impact of these corrections to previously reported financial statements is an increase to cost of products sold of approximately $25 million in 2015, $26 million in 2016 and $100 million in 2017. The impact to the previously furnished financial statements in 2018 is an increase in cost of products sold of approximately $30 million. These misstatements were also not quantitatively material to any quarter, with the largest correction being a $38 million increase to cost of products sold in the third quarter of 2017. In addition, the Company evaluated other elements of these complex supplier contracts and arrangements, including the classification of leases embedded in supplier arrangements as capital or operating. As a result of the review, the Company identified certain arrangements that were improperly classified as embedded capital leases. The correction of this error did not impact previously reported 2017 net income and resulted in a decrease to previously furnished 2018 net loss of approximately $2 million. The correction reduced previously reported 2017 Adjusted EBITDA by approximately $2 million and previously furnished 2018 Adjusted EBITDA by approximately $33 million. The Company will also correct for these misstatements in connection with the restatement. The effect of the restatements in prior periods on both Adjusted EBITDA and Adjusted EPS is expected to be less than two percent in each year and less than four percent in each quarter. The misstatements also had less than one percent impact on total assets or total liabilities at December 30, 2017. Exhibit 2 shows the preliminary estimated impact of misstatements for supplier rebates, capital leases, impairments and other misstatements described in Exhibit 1. The tables illustrate the impact to net income/(loss), Adjusted EBITDA, diluted earnings per share ("diluted EPS") and Adjusted EPS for 2016 and 2017 as compared to the previously reported financial statements as well as the impact of these metrics for 2018 as compared to the previously furnished financial statements in the Earnings Release issued on February 21, 2019. These misstatements and illustrated restated numbers are preliminary, unaudited, and subject to further change in connection with the completion of the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2018. SEC Issues Two Subpoenas In February 2019, buried in a press release announcing its 2018 Quarter 4 results, the company stated that it had received a subpoena from the SEC associated with an investigation into the company’s procurement area. It said the SEC was investigating its “accounting policies, procedures, and internal controls related to its procurement function, including, but not limited to, agreements, side agreements, and changes or modifications to its agreements with its vendors.†At that time Kraft Heinz said it was recording a $25 million increase to costs of products sold as an out of period correction as the Company determined the amounts were immaterial to the fourth quarter of 2018. In the most recent SEC filing, the company also said it has received a second subpoena associated with its assessment of goodwill and intangible asset impairments, and that this subpoena also included document requests related to the procurement area. “The Company is taking action to improve our policies and procedures and will continue to strengthen our internal financial controls,†said Michael Mullen senior vice president of corporate affairs at Kraft Heinz. “The findings from the investigation did not identify any misconduct by any member of the senior management team. We are pleased to report that the investigation is now substantially complete.†
Questions. 1. Given the discussion in the chapter about reporting restatements of the financial statements to the SEC, explain why Kraft did not follow all the rules in reporting the numbers in Exhibit 2. 2. Comment on how the company addressed operational issues in its Form 8-K. What role did they play in deciding to restate the financial statements? 3. Are there any conclusions you can draw about the cause of misstatements at Kraft Heinz during the affected periods with respect to ethical leadership? Explain.
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