Ace reveals $154 million accounting error

In a surprise announcement that was both shocking and familiar, Ace Hardware revealed on Sept. 5 that it discovered a $154 million “accounting error” in the company’s financial statements. The Oak Brook, Ill., co-op is now in the process of reviewing several years of financial records to determine the cause of the discrepancy, how far back it goes and exactly how much money is involved.

Ace is being assisted in the effort by Protiviti, a forensic accounting firm. The process could take several months to complete.

In an interview with HCN, Ace president and CEO Ray Griffith stressed that there was no evidence of theft or missing inventory. The error came to light, he said, when Ace was assembling its proposal to become a for-profit corporation. Financial reporting requirements by the Securities and Exchange Commission (SEC) caused Ace to closely examine its past revenue streams and other historical financial records.

Griffith said he first learned of the accounting discrepancy at about 5 p.m. on Aug. 16, when Ron Knutson, Ace’s vp-finance, and Art McGivern, senior vp-general counsel and secretary, came into his office. Griffith informed Ace’s board of directors the next day, and coop employees worked throughout the weekend trying to find the mistake. But they could not reconcile a $154 million difference between the company’s general ledger balance (record of financial transactions) and its “perpetual inventory” (actual inventory records) for 2006.

The shortfall seems to have accumulated over a period of at least five years.

As a result of the accounting error, Ace understated the cost of goods sold and overstated the company’s gross profit and net income for the years 2002 to 2006, and possibly before that.

“We have reason to believe that a portion of that [shortfall] is in the import area,” Griffith said, singling out “freight and duties [more] than actual inventory.” Because the percentage of imported merchandise has ramped up in recent years —Ace brought in $325 million worth of direct imports in 2006 —the losses may be more concentrated in the past couple of years, he acknowledged.

One week after he learned of the accounting error, Griffith stood in front of 250 Ace group leaders in Schaumburg, Ill., and pitched the idea of changing the organization over from a co-op to a for-profit corporation. That proposal has since been shelved.

“I was in a state of denial,” said Griffith, explaining why he pushed forward with the presentation. The CEO said he also hoped the issue would resolve itself. “I was thinking it was a balance sheet issue, that we [would] find the error.”

Ace members learned of the shortfall in several ways. Some larger dealers got phone calls from board members, and everyone received a four-page letter from Griffith on Sept. 6. A copy of that same letter was posted on Acenet, the co-op’s intranet, on Sept. 5.

The letters were followed by several open-ended conference calls with Griffith and Ace board chairman Tom Glenn, who allowed dealers to phone in with questions and concerns. The Hardlines Forum (www.hardlines.org), an online discussion group of independent hardware store owners, has also been ablaze with postings on the topic.

Member reaction varied from incredulous to philosophical. Some dealers experienced a déjà vu, having lived through a $131 million loss at True Value. The Chicago co-op, then called TruServ, announced the “accounting irregularity” in March 2000, when the organization could not reconcile the inventory on its books with how it was paying vendors for merchandise. The discrepancy was blamed, in part, on the long and sometimes clumsy merger and consolidation of three buying groups that preceded TruServ’s formation.

The debt remained on TruServ’s books for several years. To help offset the loss, TruServ imposed a moratorium on dealers redeeming stock in the company. Lawsuits ensued, and many dealers defected to other co-ops, affecting overall sales. One of those stores was Douglas Ace Hardware in Douglas, Wyo., which converted to Ace in 2000 and now operates two stores under the Ace Hardware banner.

Co-owner Greg Underberg doesn’t see any parallels between the Ace and TruServ accounting errors. “This is strictly an inventory issue,” Underberg said. “I think they’re going to have it straightened out and be back on track in no time.”

While not all Ace members expressed the same confidence—“Heads should roll,” said one Ace store owner—other dealers interviewed by HCN also voiced support for Ace’s management.

“If you look at this long term, it’s not a crippling thing,” said Paul Wenke, owner of Valley Ace Home Center in Westcliffe, Colo. “I think Ace is a well-managed company, [so] we will recover from this.”

Wenke did question the role of Ace’s auditors, KPMG, which examines the co-op’s financial results each year. He is not alone in wondering why Ace got a clean bill of health between 2002 and 2006, the years where the shortfall may have been accumulating.

“That is extremely distressing to the board,” said Rick Karp, an Ace board member for the past eight years. Karp, owner of Cole Hardware in San Francisco, also serves as the chairman of the audit committee. He could not comment further, he said, on what actions the board may take, if any, in connection to the accounting firm.

Because of the $154 million error, Ace will have to restate its financial results for 2004 to 2006, and possibly other years as well. While it hasn’t been determined how to make up the shortfall, “most or all of our 2007 profits/patronage dividends might be applied to offset the expected financial adjustment,” Griffith wrote in his Sept. 5 letter to Ace members.

Griffith told HCN that the co-op is currently looking at different options on how to absorb the loss, under the guidance of its board of directors. When asked about bonuses paid out to Ace executives based on miscalculated earnings, Griffith said: “I assure you our employees will participate in that pain.”

Ace’s larger dealers may feel a disproportionate sting, however. Rocco Falcone, president of Rocky’s Ace Hardware in Springfield, Mass., called the $154 million loss “a serious issue” that could have financial consequences on his chain of 32 hardware stores.

“That shortfall has to come out of somewhere,” Falcone said. “There’s a great deal of concern on the part of the dealers. It raises a question mark about Ace corporate.”

Griffith said the picture is not all that bleak. Ace’s balance sheet is sound, cash flow is strong and trucks are still rolling out of the warehouses, he said. “We’re going to take care of this issue,” Griffith stated.