SEC Digs Deeper Into Companies’ EPS Manipulation

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The regulator uses research-based analytics databases that detect the absence of the numeral ‘4’ in companies’ quarterly reports to detect potential law violations.

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“Three cases isn’t a huge amount, but it shows that they’re focused on it,” said David Rosenfeld, an associate law professor at Northern Illinois University and former co-chief of enforcement for the SEC’s New York Office. “It takes a long time to settle matters relating to accounting issues.”

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The SEC’s ongoing efforts to scrutinize these companies are in line with Chairman Gary Gensler’s far-reaching policy agenda, requiring stronger corporate disclosure and overhauling the business models of some Wall Street firms to better protect investors.

Investors use a company’s price-to-earnings ratio, which is calculated by dividing the share price by its EPS, to help measure a stock’s value relative to earnings.

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Companies’ EPS in the S&P 1500 has climbed substantially over the past decade, and the quarterly average EPS, as of June 30, was $1.298, up from 38 cents a year ago, when companies were dealing with the start of the coronavirus pandemic. . For FactSet Research Systems Inc.,

a data provider. Stock prices have risen faster than company profits in recent years, although corporate earnings remain the primary driver of stocks over the long term.

Analysts presented EPS estimates for companies ahead of quarterly earnings announcements based on projected future growth. It is not clear to what extent companies rely on earnings-management practices to meet or beat analyst estimates.

“Many investors suspect that EPS manipulation is more common than is the case,” said Amy Boras, executive director of the Council of Institutional Investors, which represents pension funds and other large money managers.

EPS manipulations are typically not detected by auditors conducting high-level reviews of companies’ quarterly financials. Auditors typically examine a company’s internal controls and question executives what they did during a particular period, said Dennis Usher, in charge of audit and consulting services for US-listed companies at professional-services firm Mazarus USA LLP. Why made large or unusual journal entries. He said one challenge in detecting manipulations is that accounting adjustments are usually small and do not exceed a certain materiality threshold, which auditors use to examine aspects of quarterly adjustments.

The SEC’s So-called EPS Initiative in August Charged Healthcare Services Group Inc.,

Which provides housekeeping and other services for health facilities. The agency said the Benslem, Pa.-based company failed to accrue and disclose for material loss contingencies — or potential future damages — related to the settlement of private lawsuits in a timely fashion, as generally accepted by the US. Accounting principles are required.

According to the exchanges, there are about 5,500 publicly listed companies on the New York Stock Exchange and Nasdaq combined. SEC officials use risk-based data analysis to find companies that may have been involved in manipulation, and sometimes rounding issues can lead to investigations.

The initiative’s database was created based on academic research from 2009, which examined the unusually high absence of the digit “4” in the quarterly financial numbers of companies, raising questions about whether companies misappropriate their earnings. Was increasing

Companies continue to use the digit “4” in their unreported quarterly EPS in less than 10% of cases, said Nadya Malenko, an associate finance professor at the University of Michigan, highlighting the potential for earnings manipulation through strategic rounds. . He conducted the research with former SEC commissioner Joseph Grundfest and Yao Shen, assistant finance professor at Baruch College.

The researchers assumed that every number should appear on the tenth of the EPS without fail 10% of the time. Some companies may have an unusually low use of “4” by statistical coincidence, but there is a strong correlation between this low use and the future realignment of firms in their overall financials, Malenko said.

“We have a…metric that appears to be a remarkably powerful predictor of problematic accounting behavior,” said Mr. Grundfest, who is now a professor of law and business at Stanford University.

The SEC attempts to detect other income-management practices that violate federal securities laws, including not recording loss contingencies in appropriate quarters and making unsupported adjustments, such as those made to stock-based compensation accounts. .

Prior to the Healthcare Services Group settlement, the SEC said in September 2020 that it had brought charges similar to EPS inflation for two other companies, Modular Carpet Maker Interface. Inc.

and financial-services firm Fulton Financial Corporation

Fulton Financial agreed to pay $1.5 million to settle the charges, while Interface for $5 million and Healthcare Services settled for $6 million. According to consulting firm Cornerstone Research, the average fines that public companies paid for financial reporting related matters was $1.5 million for the year ended September 2020.

Interface and Fulton Financial declined to comment. Healthcare Services did not respond to a request for comment. The companies and individuals did not admit or deny the allegations in settlement with the SEC.

The US securities regulator is currently investigating several companies over possible manipulation of earnings per share as part of an ongoing initiative that could result in charges, a person familiar with the matter said.

Unlike initiatives focused on share-category selection disclosure—in which investment advisors provide conflicts of interest related to their practices—and short selling, the EPS initiative involves the investigation of financial fraud, which is particularly complex. The investigation requires witnesses and auditors to testify and the SEC is required to conduct a detailed analysis of GAAP. Financial fraud investigations typically take 18 to 24 months.

The SEC’s recent settlement could prompt auditors to review journal entries more quarterly than they normally would, Mr. Usher of Mazar said. “It can heighten our sense of risk associated with those small journal entries that we may not have paid as much attention to in the past,” he said.

Mark Maurer at [email protected]

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