Oh, Gee: Fraud Case Involving Estimates

We have a fresh case of accounting fraud to mull this week, this time with a Wisconsin trucking firm where three senior executives cooked the books for years and eventually drove $245 million of shareholder value over the cliff. Yet again, poor internal control over management estimates and use of spreadsheets played a starring role in the scheme.

The company in question is Roadrunner Transportation Systems, a $2 billion trucking firm formerly based in Cudahy, Wisc. (The business has since relocated to Chicago.) This week the feds brought civil and criminal charges against the company’s former CFO, Peter Armbuster, as well as Mark Wogsland, the company’s former controller in the early 2010s; and Bret  Naggs, who succeeded Wogsland as controller in the later 2010s.

What happened? According to SEC and Justice Department complaints, Armbuster orchestrated accounting shenanigans at Roadrunner from 2010 into 2017, mostly by devaluing liabilities on the company’s balance sheets and stowing away those monies to inflate income in later periods.

He, Wogsland, and Naggs also kept inflated assets on the balance sheet despite clear evidence that those assets were nearly worthless; misled the company’s external auditor (Deloitte) with false documents; and sold company stock during the good times at a tidy profit, before the company finally barfed up an accounting restatement in 2017 that wiped out nearly half the company’s value for shareholders.

This is the third enforcement action we’ve seen recently that revolves around management estimates: senior executives altering their judgments about important metrics or values, without sound basis for doing so. We saw it with a $16 million fine the SEC slapped against Hertz in December, and with a $28.5 million penalty the owners of Bankrate.com paid in March.

So far, Roadrunner itself has not faced any criminal or civil charges, although at least one board director at the firm is implicated in the fraud. So let’s take a closer look at what Armbuster, Wogsland, and Naggs (they sound like a folk band) are accused of doing.

Estimates in a Time of Acquisition

Roadrunner was a highly acquisitive in the 2010s, scooping up more than 20 businesses since 2010. Armbuster and his henchmen would then establish contingent earnouts for each deal: additional money Roadrunner would pay to the seller, if the acquired business unit later met certain performance goals.

Unto themselves, contingent earnouts are a routine part of the M&A world. Armbuster is accused of lowering the reported liabilities of those earnouts on Roadrunner’s’ balance sheet by millions of dollars, to create a cushion of funds he could use to inflate the company’s performance in later quarters. (Hence this maneuver is known in anti-fraud circles as cushion accounting.)

According to the Justice Department complaint, in 2013 a board director (only identified as ‘Individual 1’) specifically told Armbuster in 2013 that the finance team could reduce an earnout “if we need a little more cushion” and divert the money to “wherever we may be short.” Several days later Armbuster did exactly that, reducing a liability by $495,000 and diverting that amount to pay for other operating expenses.

There’s more. The three men also delayed recognizing certain items, such as accruals for bonuses to be paid or expenses for bad debt that had to be written off. As the years passed, the misstated accounts added up.

By November 2016 the discrepancies were north of $20 million, and a meeting of senior financial executives (including new employees not party to the original frauds) was convened. Questionable accounts were listed on a whiteboard, the most serious issues were grouped under a column titled “Worry.”

The wheels finally came off in January 2017, when Roadrunner announced a restatement. By the time the restatement was completed one year later, the company discovered net income had been overstated by $66.5 million from 2011 through 2016.

Tying Down Loose Data

This was a problem of weak control over management estimates and financial data. So ultimately, it was a problem of accounting systems that couldn’t tie estimates back to underlying data or allow outsiders (that is, the auditors) to see the original, untampered data themselves.

For example, Roadrunner would advance money to its drivers, and then carry those advances as receivables on the balance sheet, presuming those drivers would pay the money back. One of Armbuster’s moves was to keep carrying those receivables at full value even when he knew they were probably worthless, to avoid tripping debt covenants with Roadrunner’s banks.

As the criminal complaint said, “A large portion of this receivable was uncollectible because many drivers who owed Roadrunner money had left the company, and thus were unlikely to repay the funds.”

That strikes me as a data analysis shortcoming. In some future world were internal accounting controls are seamless and automated, the departure of any employee should trigger an automatic reevaluation of his debts, so receivables stay accurate.

Along similar lines, Armbuster would circulate a spreadsheet to staff that listed misstated accounts totaling more than $10 million. When he circulated the spreadsheet to the auditors, however, that tab of misstated accounts was omitted.

For that, I’ll just repeat what I said in March about Bankrate.com’s fraud:

You want accounting systems designed to make unusual transactions stick out like a sore thumb, plainly visible to all. Those systems should rely on a single source of financial transaction data, not spreadsheets; with strong access controls and audit trails. Thankfully, technology today makes those goals much easier to achieve.

The PCAOB is already stepping up its auditing standards for management estimates. We’ll also start seeing audit firms disclose Critical Audit Matters in their audit reports later this summer, and CAMs are defined as items of “especially challenging, subjective, or complex auditor judgment.” A client tinkering with allowances or estimates with scant supporting evidence can certainly qualify.

As we can see, that attention is necessary.