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Hertz, Estimates, and Internal Controls

Who says a government shutdown means no news for internal control and compliance? On New Year’s Eve the Securities and Exchange Commission served up another juicy enforcement action, hitting Hertz Corp. with a $16 million penalty for sloppy accounting practices that led to a financial restatement in 2015.

The case is worth a look because the accounting practices in question revolved around estimates for potential losses, poor disclosure of new accounting policies, and management pressure that led to a poor control environment. Those are all sore points of financial reporting these days — and all are likely to be more inflamed this year as audit firms implement a new form of audit report that’s supposed to elaborate on exactly such tensions.

For those who might not recall the Hertz restatement: Hertz, the car rental giant, ran into trouble in early 2014 with its financial statements for the prior two years. Ultimately Hertz had to restate financials for all of 2012 and 2013, plus some of late 2011 and early 2014. The restatement cut pretax income by $235 million, a painful hit for a company that been reporting roughly $440 million in annual pretax income before the restatement.

The SEC called out larger issues afoot that made the Hertz case notable: bad management, leading to more pressure on employees, who then caused all sorts of trouble in areas with weak accounting controls.

As detailed in the SEC’s settlement order, Hertz was feeling pressure to perform in the early 2010s. To improve its financial picture, then, executives tinkered with assumptions about car rental operations that had the practical effect of pushing reported costs down, therefore causing operating income to go up. The tinkering with assumptions, however, had no solid grounding in reality.

Bad Assumptions on Allowances

For example, Hertz routinely tried to offset the cost of damaged vehicles by trying to recover those costs from rental customers or insurance companies. That also means, however, that Hertz had to set aside some allowance for damaged vehicle costs it would never recover.

Starting in August 2012, Hertz sent many more aging claims (anything larger than $5,000 and older than 120 days) to outside attorneys for collections — but Hertz did not increase its allowance for doubtful accounts like it should have. Historically, those accounts would be written off; now they stayed on the books, under the logic that collections lawyers knew how to recover old debts.

Worse, Hertz also had a policy to write off 100 percent of all claims older than 360 days. When the collections lawyer idea came along, executives pegged the losses at closer to 15 percent based on a different formula for other aging accounts.

Alas, Hertz had no evidence to justify that much lower allowance. By December 2012, it became clear that the lawyers’ recovery rate was somewhere around 2 percent — but Hertz still didn’t adjust the allowance back upward to a more reasonable level (like, say, the original 100 percent). Why not? Because that would have pushed up costs, and the department in charge of making those estimates was “under persistent pressure to meet budgets, and to generate opportunities to help close company-wide budget gaps or revenue shortfalls.”

Bad Disclosure on Depreciation

Hertz also fudged the numbers by extending the estimated lifetime of its rental fleet. The longer the estimated lifespan of a vehicle, the more Hertz could stretch out the depreciation of that vehicle — which, again, has the practical effect of lowering costs, and increasing income.

Beginning in 2013, Hertz extended the lifetime of its fleet from 20 to 24 or even 30 months. That was a change from Hertz’ own prior practice, and outside the normal holding period of other major car companies.

That’s a street legal move under Generally Accepted Accounting Principles, if you disclose it clearly to investors. Instead, in its second-quarter report that year, Hertz said this:

Depreciation rates are reviewed on a quarterly basis based on management’s routine review of present and estimated future market conditions and their effect on residual values at the time of disposal. During the six months ended June 30, 2013, depreciation rates being used to compute the provision for depreciation of revenue earning equipment were adjusted on certain vehicles in our car rental operations to reflect changes in the estimated residual values to be realized when revenue earning equipment is sold.

You might notice that the part about extending the lifetime of the vehicles to 30 months, well outside the norm for Hertz and its peers, is missing. The effect of the lifespan change cut Hertz’ depreciation costs by $15 million in the first half of 2013. Hertz, however, explained away the lower depreciation costs as “improved residual values” for its cars.

Then Hertz kept up that disclosure charade for several more quarters. Only when it finally restated results in 2015 did Hertz say that the depreciation costs were kept low by the longer lifespan maneuver.

Hertz Big Issue: Poor Control Environment

As knuckled-headed as those accounting shenanigans were, they are nothing new under the financial sun. The SEC correctly calls out the larger issues afoot that made the Hertz case notable: bad management, leading to more pressure on employees, who then caused all sorts of trouble, deliberately or not.

These included an inconsistent and sometimes inappropriate tone at the top, insufficient and inadequately trained financial personnel, unclear reporting lines, the distraction caused by multiple, conflicting business initiatives… exacerbated by problems associated with implementation of a new Oracle enterprise resource management system to manage Hertz’s day-to-day business activities.

When problems like that pollute the control environment, casting a shadow over all the business operations, then of course employees are driven to entertain whacky ideas like what we see in the Hertz settlement. People can justify all sorts of decisions when they fear that their jobs are at risk.

Specifically, a high-pressure environment can lead employees to tinker with estimates, allowances, and disclosures thereof, because those items require judgment. It’s much easier to fudge some rationale for changing an estimate than, say, fabricating the amount of inventory your company possesses. Inventory can be counted. Judgments require evidence, experience, and technical skill.

Those things were lacking among Hertz’s financial and internal audit staff, and technical skill among personnel is still one of the largest worries for financial and audit teams today. Pour on a layer of bad management, pressure to meeting financial targets, and botched IT implementations — which are also endemic at large corporations everywhere — and what we see in the Hertz restatement could be plausible at other organizations.

Maybe not many will result in financial restatements and SEC penalties, but at the least, they could result in painful annual audits and crappy work environments.

My question is how auditors might work to prevent repeat performances in the future. The PCAOB just adopted a new standard for how audit firms should look at estimates. Starting later this year, audit firms will also need to start disclosing critical audit matters (CAMs). CAMs will be anything audit firms discuss with the audit committee relevant to material accounts that involves “especially challenging, subjective, or complex auditor judgment.” A client tinkering with allowances or estimates with scant supporting evidence can certainly qualify.

What might have happened at Hertz if its audit firm (PwC) had a sharper standard for estimates and a duty to disclose CAMs? We’ll never know — but for other companies dependent on estimates and laboring under financial pressure, we’ll find out soon enough.

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