The Securities and Exchange Commission continues to review and investigate public companies for “earnings management practices.” As part of its data-driven earnings per share (EPS) Initiative, the SEC has filed lawsuits against three companies and four individuals since September 2020, imposing a total of more than $ 12 million in civil penalties. Three senior executives have agreed to be suspended from appearing and practicing before the SEC as accountants because of the charges.
Businesses should be aware that the SEC will not simply wait for issuers to announce restatements or self-report conduct before initiating investigations. In addition to the advice provided by whistleblowers, the SEC monitors and analyzes data through its EPS initiative to initiate investigations into potential accounting and disclosure violations arising from profit management practices, violations that are otherwise often difficult to detect.
Three EPS actions to date
In September 2020, the SEC uttered for the first time its EPS initiative at the same time as it announced the settlement of separate actions against two public companies. Both regulations alleged violations that resulted in incorrect reporting of quarterly EPS that met or exceeded consensus analysts’ EPS estimates.
In one case, the SEC issued an order finding that Interface, a Georgia-based modular carpet designer and manufacturer, made a series of unsupported manual accounting adjustments over several quarters. From the second quarter of 2015 to the second quarter of 2016, the SEC found that Interface’s corporate controller and chief accounting officer
and its then CFO ordered others to account for unsupported manual accounting adjustments to Interface management bonuses, independent consultant expenses, and stock-based compensation expenses .
These adjustments were often made when Interface’s internal forecast indicated that the company would likely be below consensus EPS estimates. These quarterly adjustments, however, inflated the company’s revenue and allowed it to meet or exceed consensus estimates for those five consecutive quarters.
Finding that these actions violated federal securities laws, the SEC fined Interface, its chief accountant of $ 70,000 and its chief financial officer $ 45,000 of $ 5 million. The former executives also agreed to be suspended from appearing and practicing before the SEC as accountants.
The SEC also issued an order finding that Fulton, a Pennsylvania-based financial services company, has inaccurately described in its public documents the process it used to assess its mortgage management rights (MSR). The SEC found that for two quarters, Fulton said he was on track to meet or exceed consensus EPS estimates.
During those quarters, however, Fulton deviated from its publicly stated valuation method for its MSR: instead of following its valuation method, which would have led to a reversal of the $ 3 million provision, Fulton elected to selectively write off $ 1.7 million but maintain the MSR valuation allowance of $ 1.3 million. . With that valuation allowance still on the books, Fulton was able to narrowly beat consensus EPS estimates for the quarter.
Fulton then belatedly canceled the $ 1.3 million allocation in the following quarter, allowing Fulton to meet consensus expectations that it otherwise would not have been able to. The SEC alleged that Fulton’s disclosures gave the misleading impression that the reversal of the valuation allowance was timely when it was two quarters late. Finding that the actions violated federal securities laws, the SEC fined Fulton $ 1.5 million.
More recently, in August 2021, the SEC issued an order imposing Health Services Group (HCSG)– a Pennsylvania-based provider of housekeeping, catering and other healthcare facility services – which failed to properly record the contingencies of losses for several quarters over two years. As of the end of 2013, HCSG was facing eight pending labor and employment class or class actions from current and former employees.
Beginning in 2014, HCSG negotiated and ultimately sought approval for the settlement of the eight actions, triggering an obligation for HCSG to report the dispute in a manner consistent with the statute of the negotiated settlements. The SEC order concluded that the company and its CFO failed to timely recognize and disclose the potential for significant losses from pending settlements in accordance with GAAP.
The SEC fined HCSG, its former CFO $ 50,000 and its former controller $ 10,000, $ 6 million. The former CFO also agreed to be suspended from appearing and practicing before the SEC as an accountant.
Common elements and takeaways
While the SEC has not specified what in an issuer’s data can trigger red flags in the EPS Initiative, there are some common elements among the three actions:
Companies have met or exceeded analysts’ consensus EPS estimates for several consecutive quarters, often for as little as a dime. Although it has met or exceeded estimates for several consecutive quarters, every company has experienced significant declines in its EPS.
The SEC alleged that every company would not have been able to meet quarterly EPS estimates if they had not adopted practices the SEC appeared to find manipulative or misleading, including making manual adjustments without documentary support and not following the established and disclosed valuation methodology. The SEC accused each company of not maintaining sufficient internal accounting controls or failing to ensure compliance with its internal accounting controls.
In view of these actions under the EPS initiative, SOEs should pay attention to the data, metrics and communications they disclose; document accounting judgments at the same time; maintain strong internal accounting controls; and ensure and supervise compliance with these accounting controls.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owner.
Jina choi is a partner of Morrison & Foerster and previously served as the director of the SEC’s San Francisco regional office.
Andre Fontana is an associate in the Litigation department of the Morrison & Foerster office in San Francisco.