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Ethics and Compliance Failures Underlie Hertz’s Restatement of Financial Statements

November 25, 2014

Hertz Restatements due to Inadequate Internal Controls and Faulty Audit by PricewaterhouseCoopers

 

On November 14, 2014, Hertz confirmed that it would restate its financial statement results for 2012 and 2013, adding to the already announced restatement for 2011. The disclosure led to a 14% drop in the share price of Hertz stock on top of a previous decline of 23% since the first announcement in June. Hertz does not expect to conclude its internal investigation until mid-2015, so the final amount of the restatements will not be known until that time.

 

The questions from an ethical perspective revolve around the issue of what led to the restatement. How could such a failure occur in the post-Sarbanes Oxley era? What role did management play? Why didn’t the internal controls identify the problems in accounting right away? And, where were the auditors?

 

When a company restates its financial statements it informs investors that those statements should no longer be relied on. Back in June, Hertz identified a material weakness in internal controls over financial reporting as the culprit. Now, however, a variety of improper accounting has come to light including: 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 essence of the accounting problems for Hertz relate to the methods they used to estimate potential expenses and liabilities. In accounting, many estimates are required to identify potential expenses and liabilities that have not occurred at the date of the financial statements but may occur pending the outcome of certain future events. The most baffling of the misstatements is that of capitalization and depreciation. The rules for capitalizing expenditures as assets instead of immediate expensing are quite clear. If future value exists at the time of acquisition, then the expenditure is recorded as an asset and depreciated over its useful life. Otherwise, it is expensed immediately and matched against current revenues. Likewise, current estimates of depreciation should not cause restatements later on.

 

The allowance for doubtful accounts is based on an estimate of collectability and should be guided by past experience. Here again, so long as the estimate is reasonable in amount it is acceptable. The problem may be that the receivables in an emerging market like Brazil may have caused some problems that can explain the need for restatement in this area.

 

Judgments are numerous and complex around renter obligations for damaged vehicles and can lead to contingent liabilities if the renters do not meet their obligations. Once again, a company like Hertz should have enough experience to develop reliable estimates.

 

Estimating the cost of restoring leased property at the end of the lease term is a complicated area. Tom Selling, a well-known commentator on financial fraud issues and visiting professor at Southern

 

Methodist University, puts it this way:

“Estimating the cost of restoring leased property at the end of a lease term is another complicated area. 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. 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.”

 

From a compliance perspective, the company’s internal controls over financial reporting failed to identify the accounting problems; the internal audit did not detect the improper accounting; the audit committee either wasn’t aware of the problems or did nothing; and the external auditors, PwC, failed in their obligations to identify material misstatements in the financial statements.

 

Back in June, the Hertz audit committee disclosed the problems with the internal controls and first announced the financial statements should not be relied upon. Then, PwC withdraw its audit report for the affected years and announced they were restating the financial statements. Hertz stated that it intends to amend its “Management Report on Internal Control over Financial Reporting and Disclosure Controls,” a required document under section 404 of Sarbanes-Oxley. It also announced it expects PwC to issue an adverse opinion on the internal control as of December 31, 2013.

 

Underlying these announcements is the question of whether top management signed the certification of financial statements as being accurate and reliable, as required under section 302 of Sarbanes-Oxley, and whether they knew of the existence of the accounting problems during the affected periods. If so, the CEO and CFO are in for hard times as the SEC will come down hard on them and perhaps seek to “clawback” any incentive compensation received during the period of restatements. You can bet that legal action will be taken against top management and, of course, PwC, in the inevitable class-action lawsuit.

 

There is no excuse for Hertz’s accounting and internal control failures other than to say management was either complicit or failed in its fiduciary obligations to protect investor interests. The audit committee failed in its obligations as well to oversee internal controls and financial reporting.

 

As for PwC, this isn’t the first time the firm has come under scrutiny by the SEC for its audits. The Public Company Accounting Oversight Board previously criticized the firm and said it wasn’t not doing enough to ensure its audits were properly carried out. In particular, the PCAOB questioned the firm’s quality control practices in its audit procedures as part of inspections conducted of the firm’s audit process.

 

The Hertz situation is likely to get worse as additional evidence is gathered. I believe it will be the biggest accounting scandal since the era of Enron and WorldCom. Ethically, the restatements at Hertz point to an ineffective compliance system and faulty audit by PwC. However, the real underlying cause of the problems is the failure of top management to set an ethical tone at the top that would ward off accounting and financial irregularities, and a failed audit and auditors that missed obvious red flags such as the resignation of two CFOs in a six-month period.

 

Blog posted by Steven Mintz, aka Ethics Sage, on November 25, 2014. Dr. Mintz teaches in the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: www.workplaceethicsadvice.com.

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