Oh, look. Another accounting enforcement action from the SEC, where poorly designed internal controls led to management’s abuse of estimates. Everyone put on your shocked face.
The SEC settled a case on Monday with Conn’s, a rent-to-own retailer based in Texas with $1.55 billion in annual sales. Conn’s agreed to pay $1.1 million in a civil penalty for low-balling its allowances for bad debt in the mid-2010s, which had the effect of overstating the company’s income for more than two years. Michael Poppe, Conn’s chief operating officer at the time, also agreed to pay a $50,000 personal penalty for his role in the mess.
What happened? From mid-2012 into 2014, Conn’s used a faulty “roll rate” to estimate possible losses on loans it extended to customers. Businesses use that rate as they monitor which customers are current on payments, which ones are 30 days past due, or 60 days overdue, and so forth. The rate tracks how many customers “roll” from one category of delinquency into the next.
Precisely what that roll rate is can vary widely from one firm to the next, but firms usually calculate their estimated roll rate for future periods based on historical data about actual roll rates in prior periods.
That’s not what Conn’s did. Instead, Conn’s executives set the roll rate manually, “reflecting then current management’s unduly optimistic future expectations,” the SEC said in its complaint, and in its usual dry style. “Those expectations were not reasonable in light of Conn’s operations and results at the time.”
Those operations included an expansion of lending to customers with bad credit and no particular loyalty to Conn’s. The company’s loan portfolio rose from $647 million in mid-2012 to $1.1 billion by mid-2014. Charge-offs of uncollectible debt jumped from $53.2 million to $120.1 million in the same period.
As actual delinquency rates rose, that should have triggered an increase in Conn’s roll rate, to set aside enough allowances for bad debt to cover those larger losses. Except that didn’t happen, because Conn’s executive team set the roll rates manually and low-balled them for years. Even when actual charge-offs exceeded roll rate estimates for 14 consecutive quarters, management kept the roll rates low.
Poppe was instrumental in all of this. As CFO in the early 2010s he created the model, manual roll rates included. Then as COO, Poppe guided other executives on what that roll rate should be.
Conn’s finally confronted its issues in late 2014. First management updated the roll rate, which led to higher allowances for doubtful accounts, which led to Conn’s slashing its guidance for 2015 and share price dropping 30 percent in one day.
Then executives redesigned the roll rate to rely on historical data — which led to an immediate $20 million increase in loan loss reserves, which cut $0.08 off earnings per share for the quarter, which led to another share price drop of 41 percent. Investor dismay and SEC enforcement follow, and here we are today.
Adventures in Estimates
Look, the internal control issue here is that Conn’s used a manual process for a key operating metric when it shouldn’t have. That’s the whole thing, really.
For a company of its size and complexity, Conn’s should have had its financial systems calculate the roll rate automatically, based on historical data on customers’ payments. Sure, management should still have authority to change the roll rate, based on special circumstances — but management should not have been allowed to set the rate based on gut feeling.
That was the error. The process was designed to rely on management estimates of a good roll rate, rather than on hard, proven data. We don’t know what financial management software Conn’s used at the time, but there’s no reason for a large firm to use an approach like that today. Properly calibrated software can automate that opportunity for abuse out of existence.
This enforcement action is only the latest we’ve seen that involves management manipulating important estimates, because internal control systems allowed them to manipulate those estimates. In April the SEC filed civil charges against a trucking company and its former management for fudging liabilities during an acquisition spree. In December the SEC whacked Hertz Corp. with a $16 million fine for sloppy accounting practices that led to a restatement, where management changed estimates about allowances for litigation losses and about the value of aging vehicles.
When financial systems generate estimates automatically, based on historical data, management can then only change those estimates by overriding the control — which is (or at least, should be) a big deal. You can have policies and procedures that dictate when management overrides a key estimate. You can have meeting minutes and other documentation available for subsequent audit and review. You can have other executives required to co-sign an override decision.
In contrast, when managers set critical estimates themselves, the process can be much more loosey-goosey — and loosey-goosey, gut feelings are harder to verify or challenge. Little surprise, then, that the SEC also said that “insufficient documentation was kept to reflect or explain the rationale behind the specific changes.”
The PCAOB did recently update its standard for auditing management’s use of estimates. That new standard takes effect for fiscal years ending on or after Dec. 15, 2020. That’s good news, sand let’s hope more firms embrace strong internal control that will seal off chances for shenanigans like this.