The audit committee of the American car rental company, Hertz Corporation, announced through a filing this past Friday, June 6, that some accounting errors will require them to restate their 2011 financial reports, and potentially their 2012 and 2013 financial reports as well. As no surprise, this has made some people (i.e. investors) very upset and the stock price of Hertz’s shares have taken a hit as a result. Hertz claims that errors were discovered related to “allowances for uncollectable amounts with respect to renter obligations for damaged vehicles and restoration obligations at the end of facility leases.” What investors are probably asking now is whether PWC, Hertz’s external auditors, and Hertz’s managers should have had reasonable awareness of the problems earlier, and how the problems were discovered in the first place.
“Hertz said it needed to do more work related to evaluating the capitalization and depreciation timing for “certain non-fleet expenditures.” The company said adjustments, including for allowances for doubtful accounts in Brazil, would likely reduce its 2011 net income by as much as $9.8 million, to $174 million” (http://in.reuters.com/article/2014/06/06/hertz-restatement-idINL3N0ON2ZA20140606).
If capitalization versus expensing is the root cause here, the impact of choosing one over the other can have a profound impact on a company’s financials. The biggest issue relates to net income and timing. In a general sense, a company that capitalizes costs will show higher profitability in the early years as opposed to expensing costs. On the other hand, if that same company had expensed their costs in the early years, they would show a higher profitability in the later years, assuming all other financial factors remain stable. In other words, the accounting treatment of a significant purchase can sometimes mean the difference between a year-end income statement that’s in the black and one that’s in the red.
Distinguishing between whether to capitalize or expense is no day at the beach either. While there are a number of criteria that go in to determining whether to capitalize or expense costs, the key objective is to distinguish the expenditures that produce future benefits (capitalize) from those that produce benefits only in the current period (expense). The accountants and auditors of Hertz may have potentially used poor judgement in determining the classification of some of their costs. At this point, we will have to wait until more facts come out.