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Accounting

How a finance trainee left a $152m hole at Ace Hardware

Written by Adrie van der Luijt

Monday, 11 February 2008

US retail co-operative Ace Hardware considered switching from being a dealer-owner co-operative to becoming a for-profit corporation, when it discovered a $152 million accounting shortfall.

The mistake came to light in August last year when executives at the hardware retail chain were preparing documents to file with the Securities and Exchange Commission (SEC).

The organisation’s management said that it accepted full responsibility for the error, in which they overstated profits repeatedly over at least five years.

Ace discovered that a mid-level employee, who had worked in the finance department at the firm’s Oak Brook, Illinois, based head quarters for at least eight years, had made an innocent but costly mistake that went unnoticed for years.

Overvalued stock

Poor training and a lack of supervision led the member of staff to make incorrect entries in Ace’s ledgers that overvalued stock and eventually created a $152 million accounting error.

The employee’s journal entries gave the impression that the general ledger and the perpetual inventory ledger were reconciled, even though they were not.

“Numbers were flowing through one of the ledgers but not flowing into the other,” Ace’s CEO and president Ray Griffith told store owners.

He added that about 25 percent of the error ($34.6 million) dated back to 1995, while the remaining $117.4 million occurred from 2002 through 2006.

Griffith said that the company expected to spend around $10 million on a five-month investigation of the errors by law firm Skadden Arps and audit firm Protiviti Inc.

Best intentions

The investigation found that there was no evidence of fraud or theft. It concluded instead that the finance department had relied too much on a single method to reconcile its books.

The mid-level employee had too much control, the investigation concluded, and was able to successfully mask the differences in number between two ledger books for years.

"Frankly, it's embarrassing," Griffith said. "There are oversight issues, lack of controls and policies in place that were not followed."

He conceded that the firm had provided the employee with insufficient training to do the job. Griffith said that the employee had acted with the best intentions.

He added that accounting systems at the company had failed to keep up with an increasingly complex and competitive situation in the hardware retail market.

Ace is importing more and more from Asia, which has resulted in complications that it did not experience ten years ago.

“We relied on systems that, in hindsight, should have been upgraded and advanced to address those issues,” Griffith said.

Tough questions

Ace Hardware received the full report of the investigation into the accounting shortfall on a Tuesday, posted it on its internal website on Friday and held conference calls with its network of around 3,600 dealers the following week.

Tough questions were asked during the conference calls about the company’s auditors, KPMG LLP, and about the shortfall’s tax implications.

Ace was forced to restate its earnings for the fiscal years 2004, 2005 and 2006 and will also correct its figures for fiscal year 2007 by February. Ace said it expects to report an $85 million profit for 2007.

Dealers receive patronage dividends, an annual profit-share payment in the form of cash and stock linked to Ace Hardware’s gross profits. The cash percentage was between 25 and 45 per cent in the past.

One of the outcomes of the investigation was the discovery that dealer-owners at Ace's 4,600 stores in the US and 70 other countries had received substantially too much in patronage dividends for years as a result of overstated profits.

Restoring equity

The Ace board said it planned to recover 60 per cent of the shortfall before the end of the fiscal year by paying its dealers just 20 per cent dividend in cash and 80 per cent in Class C stock when dividend is distributed in March.

The remaining cash dividend will be reinvested to restore the co-operative’s equity position to the $320 million stated in its 2006 accounts. Restoring Ace’s equity is vital because lenders have committed money based on that level.

A further $10 million will come from forgoing payments to dealers’ pension schemes in 2007.

Dealers who opened stores in 2007 will not be asked to contribute to the shortfall. Ace expects a complete recovery by 2009.

The Ace board was already facing much resistance from smaller stores before the error came to light, because of the cost of its Vision 21 programme, aimed to give stores a more uniform look.

Each Ace store traditionally looks different, because Ace is a co-op and not a franchise. Ace has placed a focus on Ace stores exhibiting some similar characteristics, such as signaled and core product lines.

Switch to computer accounting systems

Ace said that it is putting new checks and balances in place and hoped to both hire new auditing talent and train existing staff by the end of March. It is also looking at a switch from manual accounts to computer accounting systems to prevent similar errors happening in the future.

The unidentified employee is not the only one who is no longer working for Ace Hardware as a result of the investigation. Chief financial officer Ron Knutson resigned from his job last year after the shortfall was discovered. Other members of staff have been reassigned.

The board shelved its plans to become a for-profit corporation in September after discovering the accounting problems.

It said that it may look at restructuring the company again at a later stage, but added that a lot of hard work and thought needed to be done first.

In August 2007 computer manufacturer endured major embarrassment and damage to its reputation when it had to came clean on accounting errors and restated its accounts since 2003.

In order to meet the expectations of shareholders and Wall Street analysts Dell's finance department bent accounting rules to make up for shortfalls in certain quarters and under-reported results in others, each time ensuring that Dell did in fact hit profits targets that financial analysts were expecting.

Ironically, the computer firm that pioneered IT sales over the Internet admitted that most of its journal entry processes, including account reconciliation and documentation requirements, were done manually, increasing the opportunities for errors or omissions. Dell will now invest in the design and implementation of IT systems in order to eliminate manual processes.

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