SEC deepens manipulation of corporate EPS

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The Securities and Exchange Commission’s review of corporate earnings per share has filed complaints against three companies in the past year or so, and may become larger under the regulator’s new leadership.

The initiative, launched a few years ago, examines the earnings per share of the majority of U.S. public companies at least once a year, looking to spot questionable published figures. The team working on the effort, which is part of the SEC’s enforcement division, uses analytics and has built a database to try to identify potential manipulators of EPS, the commonly used measure of financial performance of a business.

“Three cases isn’t huge, but it shows they are focused on it,” said David Rosenfeld, associate professor of law at Northern Illinois University and former SEC office co-head of enforcement. At New York. “It takes a long time to sort out cases involving accounting issues. “

The SEC’s continued effort to scrutinize these companies is part of President Gary Gensler’s far-reaching political agenda to demand more stringent corporate reporting and to revise the business models of certain Wall Street companies to better protect investors.

Investors use a company’s price-to-earnings ratio, which is calculated by dividing the stock price by EPS, to help gauge a stock’s value in relation to earnings.

S&P 1500 companies’ EPS has grown significantly over the past decade, and average quarterly EPS, as of June 30, was $ 1.298, down from 38 cents a year earlier, when companies faced the onset of the pandemic. coronavirus, according to FactSet research systems Inc.,

a data provider. In recent years, stock prices have grown faster than corporate earnings, although corporate earnings remain the main driver for stocks over the long term.

Analysts are offering EPS estimates for companies ahead of quarterly earnings announcements based on their expected future growth. It is not known to what extent companies rely on profit management practices to meet or exceed analyst estimates.

“Many investors suspect that manipulation of BPA is more common than the cases suggest,” said Amy Borrus, executive director of the Council of Institutional Investors, which represents pension funds and other large fund managers.

Learn more about the SEC’s EPS survey

BPA manipulations generally go undetected by auditors performing high-level reviews of companies’ quarterly financial statements. Auditors typically test a company’s internal controls and ask executives about why they made significant or unusual journal entries during a given time period, said Denis Usher, partner in charge of corporate services. auditing and consulting for companies listed in the United States within the professional services firm Mazars USA LLP. A challenge in detecting manipulation is that accounting adjustments are generally small and do not exceed a certain materiality threshold that auditors use to determine which aspects of quarterly adjustments to review, he said.

The SEC’s so-called EPS initiative in August tasked Healthcare Services Group Inc.,

which provides housekeeping and other services to health facilities. The agency said the Bensalem, Pa.-Based company failed to recognize and disclose the eventuality of material loss – or potential future loss – related to a timely resolution of a private litigation, as required. generally accepted accounting principles in the United States.

According to the stock exchanges, there are approximately 5,500 companies listed on the New York Stock Exchange and the Nasdaq. SEC officials use risk-based data analyzes to find companies that may have engaged in manipulation, and sometimes rounding issues can lead to an investigation.

The initiative’s database was built on the basis of academic research dating back to 2009 that examined the unusually large absence of the number “4” in quarterly financial figures for companies, asking whether companies are rounding up. incorrectly their profits.

Companies continue to use the number “4” in their unrounded quarterly EPS in less than 10% of cases, highlighting the potential for profit manipulation through strategic rounding, said Nadya Malenko, associate professor of finance at the ‘University of Michigan. She conducted the research with former SEC Commissioner Joseph Grundfest and Yao Shen, assistant professor of finance at Baruch College.

The researchers assumed that each number should appear in tenth place in the unrounded EPS 10% of the time. Some companies might have an unusually low usage of “4” by statistical coincidence, but there is a strong correlation between this low usage and the companies’ future restatements in their overall financial statements, Ms. Malenko said.

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

The SEC seeks to detect other profit management practices that violate federal securities laws, including failing to record contingencies of losses in the appropriate quarters and making unwarranted 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 made similar accusations of BPA inflation for two other companies, modular mat maker Interface Inc.

and financial services firm Fulton Financial Corp.

Fulton Financial agreed to pay $ 1.5 million to settle the charges, while Interface settled $ 5 million and Healthcare Services for $ 6 million. The median fine that state-owned companies paid in cases involving financial reporting for the fiscal year ended September 2020 was $ 1.5 million, according to consulting firm Cornerstone Research.

Interface and Fulton Financial declined to comment. Health services did not respond to a request for comment. The companies and individuals did not admit or deny the accusations in entering into a deal with the SEC.

The U.S. securities regulator is currently investigating several companies about potential earnings per share manipulation as part of the ongoing initiative, which could lead to charges, a person familiar with the matter said.

Unlike initiatives such as those focused on disclosure of share class selection – in which investment advisers provide conflicts of interest related to their practices – and short selling, the EPS initiative is all about investigating on financial fraud, which is particularly complex. The probes require witnesses and auditors to testify and that the SEC conduct a detailed GAAP analysis. Investigations into financial fraud typically take between 18 and 24 months.

Recent SEC regulations may cause auditors to review more quarterly journal entries than they normally would, Mr. Usher de Mazars said. “It can increase our sense of risk with these little journal entries that we may not have paid so much attention to in the past,” he said.

Write to Mark Maurer at [email protected]

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