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SEC Digs Deeper Into Companies EPS Manipulation

The Securities and Exchange Commissions review of companies earnings per share has brought cases against three firms over the past year or so, and could come into greater focus under the regulators new leadership.

The initiative, launched a few years ago, reviews earnings per share for the majority of U.S. public companies at least once a year, looking to spot questionable reported figures. The team working on the effort, part of the SECs enforcement division, uses analytics and has built a database to try to pinpoint potential manipulators of EPS, the commonly used measure of a companys financial performance.

Three cases is not a huge amount, but it does show that theyre focused on it, said David Rosenfeld, associate law professor at Northern Illinois University and former co-head of enforcement for the SECs New York office. It takes a fair amount of time to unravel cases involving accounting issues.

The SECs ongoing effort to scrutinize these companies falls in line with Chairman Gary Genslers on requiring stronger corporate disclosures and overhauling some Wall Street firms business models to better protect investors.

Investors use a companys price-to-earnings ratio, which is calculated by dividing the share price by EPS, to help gauge a stocks value relative to earnings.

EPS of companies in the S&P 1500 have largely climbed over the past decade, and the quarterly average EPS, as of June 30, was $1.298, up from 38 cents a year earlier, when companies were dealing with the onset of the coronavirus pandemic, according to Inc., a data provider. Stock prices in recent years have risen faster than company profit, though corporate earnings remain of stocks over the long term.

Analysts come up with for companies ahead of quarterly earnings announcements based on their projected future growth. It is unclear to what extent companies rely on earnings-management practices to meet or beat analyst estimates.

Many investors suspect EPS manipulation 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 money managers.

EPS manipulations usually arent detected by auditors conducting high-level reviews of companies quarterly financials. Auditors generally test a companys internal controls and question executives about why they made large or unusual journal entries during a particular period, said Denis Usher, partner in charge of audit and consulting services for U.S.-listed companies at professional-services firm Mazars U.S.A. LLP. A challenge in detecting manipulations is that the accounting adjustments are usually small and dont exceed a certain materiality threshold that auditors use for determining the aspects of quarterly adjustments to examine, he said.

The SECs so-called EPS Initiative Inc., which provides housekeeping and other services to healthcare facilities. The agency said the Bensalem, Pa.-based company failed to accrue for and disclose material loss contingenciesor a potential future lossrelated to the settlement of private litigation in a timely fashion, as required by U.S. generally accepted accounting principles.

There are about 5,500 companies publicly listed on the New York Stock Exchange and Nasdaq combined, according to the exchanges. SEC officials use risk-based data analytics to find companies that may have engaged in manipulations, and sometimes rounding issues can lead to an investigation.

The initiatives database dating back to 2009 that examined the unusually high absence of the numeral 4 in companies quarterly financial numbers, posing questions whether firms were improperly rounding up their earnings.

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

he researchers assumed that every number should appear in the tenths place of unrounded EPS 10% of the time. Some companies could have an unusually low usage of 4 by statistical chance, but there is a strong correlation between this low usage and firms future restatements in their overall financials, Ms. Malenko said.

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

The SEC seeks to detect other earnings-management practices that are in violation of federal securities laws, including not recording loss contingencies in the appropriate quarters and making unsupported adjustments, such as those made to stock-based compensation accounts.

Before the Healthcare Services Group settlement, the SEC in September 2020 said it had brought similar charges of EPS inflation, modular carpet maker Corp.