How Wheels Came Off of Hertz’ Accounting

It’s an experience almost anyone can appreciate: your car seems to perform so well for so long—then, suddenly, all the little things go at once. And you’re stuck on the side of the road.

So seems to be the case with $10.7 billion Hertz, the auto rental company that warned on June 6 of a massive financial restatement yet to come. In a Form 8-K filing, Hertz warned that its current quarterly filing would be late and that its financial statements for 2011 should no longer be relied upon. Even worse, the 2012 and 2013 annual statements might be called into question too before Hertz completes its investigation into what went wrong.

The company also disclosed it has identified at least one material weakness in internal control over financial reporting and that disclosure controls and procedures were ineffective as of Dec. 31, 2013. Its share price promptly dropped, and plaintiff lawyers have already begun filing shareholder lawsuits.

So what happened?

Hertz foreshadowed the errors in its 2013 year-end Form 10-K, reporting that it had discovered in the fourth quarter “certain out-of-period errors” totaling $46.3 million. In its 10-K, Hertz says the errors are not material in any given period, but if aggregated to the fourth quarter of 2013 when discovered, would be material to that quarter. As such, the company would be reaching back to revise earlier periods.

Hertz’s 8-K filing did not quantify the magnitude of its mistakes, but said the company had identified accounting errors in four areas: capitalization and timing of depreciation for certain non-fleet assets; allowances for doubtful accounts in Brazil; allowances for uncollectible amounts with respect to renter obligations for damaged vehicles; and restoration obligations at the end of facility leases. The company has not provided any further detail so far.

Layered onto the accounting errors, a personnel change in the CFO’s office also has observers buzzing. CFO Thomas Kennedy assumed his duties last December, two months after his predecessor, Elyse Douglas, resigned on Oct. 1. Hertz had announced in May 2013 that it was relocating its headquarters from New Jersey to Florida, a move Douglas said she could not make for personal reasons.

Bloomberg now lists Douglas as president, CFO, and treasurer of a Hertz subsidiary, Thrifty Insurance Agency. Meanwhile at the parent offices, Hertz says the new CFO Kennedy is being assisted by a new chief accounting officer and a new vice president in charge of Sarbanes-Oxley compliance, both hired earlier this spring.

The timing of the personnel change along with the discovery of accounting errors doesn’t look good for the former CFO, says Randy Wilson, a partner with investigative accounting firm RGL Forensics. “It probably means there’s more there than what is on the surface,” he says, although any suggestion of fraud or other deliberate wrongdoing is premature. “If [Douglas] moved to another division in the company, there’s less of a chance of fraud,” Wilson says.

Steve Hazel, another partner at RGL Forensics, says any investigation into possible intentional mis-statement would focus on whether the former CFO somehow benefitted personally from the mistakes. “There’s a lot of estimation and guesswork here,” he says. “There’s probably some degree of concern whether there was intent to commit fraud or just bad estimation or a bad thought process. But there’s not enough information in this case to make a judgment call on those things.”

Back to the Numbers

On the four specific accounting issues that tripped up Hertz, some are more common themes in restatements than others, says Peter Bible, a partner with EisnerAmper. Doubtful accounts, uncollectible amounts, and future costs associated with restoring leased property are all areas steeped in estimates and uncertainty, he says, and as such are classic areas for error.

The depreciation issue, however, is more straightforward. “Usually when you see an asset put into place and a depreciation method selected, that’s something you don’t see missed or not accounted for correctly very much,” he says.

RESTATEMENT EXPLANATION

The following excerpt from Hertz Global’s Form 8-K explains why the company needs to restate financials.

On May 13, 2014, each of Hertz Global Holdings Inc. and The Hertz Corp. delayed the filing of its Form 10-Q for the period ended March 31, 2014 (the “First Quarter 10-Q”). During the preparation of the First Quarter 10-Q, errors were identified relating to Hertz’s conclusions regarding the capitalization and timing of depreciation for certain non-fleet assets, allowances for doubtful accounts in Brazil, as well as other items. Hertz continued its review and recently identified additional errors related to allowances for uncollectible amounts with respect to renter obligations for damaged vehicles and restoration obligations at the end of facility leases.

The audit committee of the board of directors has consulted with management and analyzed the adjustments. The audit committee has concluded that the financial statements for 2011 should no longer be relied upon, and Hertz must restate them. Hertz also needs to correct the 2012 and 2013 financial statements to reflect these errors. However, because of the above mentioned errors, the audit committee has directed the company to conduct a thorough review of the financial records for fiscal years 2011, 2012 and 2013, and this review may require Hertz to make further adjustments to the 2012 and 2013 financial statements. If these further adjustments to the 2012 and 2013 financial statements are determined to be material adjustments individually or in the aggregate, Hertz will need to also restate and withdraw reliance on those financial statements. Hertz will make a decision on 2012 and 2013 financial statements after the work described in Item 7.01 below is completed.

The financial statements for 2011 were most recently included in the Form 10-K for the year ended Dec. 31, 2013. As soon as practicable, Hertz expects to amend the 10-K to correct the errors identified and related disclosures. Hertz will file the First Quarter Form 10-Q, and issue the first quarter earnings release, at the same time it files the 10-K amendment. Consequently, the company will not hold the conference call scheduled for June 9, 2014.

The chairman of the audit committee of the board of directors has discussed this matter with PricewaterhouseCoopers, the independent registered public accounting firm for Hertz.

In light of the above, management, in consultation with the audit committee, has determined that at least one material weakness existed in Hertz’s internal control over financial reporting and that disclosure controls and procedures were ineffective at Dec. 31, 2013. Hertz intends to amend its Management’s Report on Internal Control Over Financial Reporting and Disclosure Controls and Procedures and expects to receive an adverse opinion on the internal control over financial reporting as of Dec. 31, 2013 from PricewaterhouseCoopers.

Hertz is in the process of implementing new procedures and controls, and strengthening the accounting and finance departments through the addition of new personnel. Leading this process is Thomas (Tom) C. Kennedy, who was appointed senior executive vice president and chief financial officer of the company, effective Dec. 9, 2013. He is being assisted by the company’s new chief accounting officer (CAO), Robin Kramer, who was hired in mid-May, and its new vice president of SOX/compliance, Randy Walford, who was hired in late April. Kramer comes to the company with over 25 years of experience in both public accounting and as CAO for another Fortune 500 company. Mr. Walford comes to Hertz with over 13 years of experience in public accounting. The company also recently expanded its accounting and finance departments with additional key new personnel to further strengthen the technical and managerial expertise in these departments.

Source: Hertz.

For Tom Selling, a visiting professor at Southern Methodist University and a frequent blogger, the capitalization versus depreciation issue creates a sense of déjà vu. “WorldCom was about the mischaracterization of maintenance expenditures as capital expenditures,” he says. “So if there were things that were capitalized and shouldn’t have been, income would be overstated, just like at WorldCom.”

On allowances for doubtful accounts in a single country, Scott Univer, general counsel for WeiserMazars, says the accounting is complex and can differ across jurisdictions—and emerging markets can always be difficult. “In many countries, the process for collecting past due accounts is difficult, and I suspect Brazil is one of them,” he says. “When can you consider an account still collectible? When can you write it off? It can depend a lot on the legal environment.” Applying all of those country-specific legal judgments to financial statements based on U.S. Generally Accepted Accounting Principles adds yet another layer of complexity to the analysis, he says.

Judgments are numerous and complex around renter obligations for damaged vehicles, says Kelley Wall, a director at consulting firm Rose Ryan. “It all gets back to having to measure each period your contingent liabilities,” she says. “It’s a concern not just for Hertz but for every company.”

At the end of the reporting cycle, companies need to identify any contingencies (often unresolved uncertainties tied to legal claims of some kind), and make adjustments for them, she says. “If anything changes or becomes different, you have to have a process in place to identify it and account for it in that period. It’s a high-risk area, and one the Securities and Exchange Commission is still heavily commenting on.”

Estimating the cost of restoring leased property at the end of a lease term is another complicated area, Selling says. “When you build out a leased facility you have to estimate how much it’s going to cost to tear it down and add the present value of that cost estimate to the value of the asset,” he says. “Over time, if you estimate correctly, you have an increase in depreciation and a component of interest cost.” Companies might make mistakes in estimating the cost or the discount rate, either of which would skew the reported figures.

Univer says restatements generally fall into one of three causation buckets: fraud, misapplication of accounting rules, or clerical or bookkeeping errors. It’s too soon to say definitively in the Hertz case, but the facts so far likely suggest misapplication of accounting rules. “The accounting rules get pretty complicated,” he says. “It can get technical and tricky.”