The Cost of a Penny: SEC Using Analytics to Levy Fines Against Earnings Manipulation

A public company’s earnings per share (“EPS”) is one of the most used metrics for determining its profitability. (Jason Fernando, Investopedia). EPS is a formula that calculates a company’s profit by dividing its net income by its outstanding shares of stock. Id. A company’s goal is to meet or exceed its consensus EPS estimate, as this demonstrates a successful quarter and shows investors a reliable stock. Id. Unfortunately, companies can easily manipulate the EPS to look better, both legally and illegally. (Jean Eaglesham, Wall Street Journal).

In recent years, the Securities and Exchange Commission (“SEC”) has rolled out the EPS Initiative, which utilizes risk-based analytics to identify potential illegal manipulation. The goal of the EPS Initiative is to change corporate behavior around EPS manipulation and discourage companies from using illegal accounting tricks to meet EPS estimates and mislead investors. Id. The SEC requires publicly traded companies to follow generally accepted accounting principles (“GAAP”), which are issued by the Financial Accounting Standards Board. (Jason Fernando, Investopedia). Companies are allowed to publish certain metrics that do not align with GAAP guidelines but must identify the metrics as non-GAAP and provide an explanation of why GAAP was not used. Id. The SEC’s focus on earnings manipulation that violates federal securities laws demonstrates its mission to require stronger corporate disclosures to better protect investors. (Mark Maurer, Wall Street Journal).

In September of 2020, the SEC settled its first action arising from this new analytical approach to spotting EPS manipulation. (SEC). The SEC charged Interface Inc., a carpet manufacturer, for allegedly using non-GAAP compliant accounting tactics to illegally manipulate its earnings. (Dave Sebastian, Wall Street Journal). The company allegedly made manual accounting adjustments when internal forecasts showed it would fall short of EPS estimates, so that it could publicly report consistently meeting or exceeding consensus estimates. (SEC). Without admitting or denying the accusations, the company agreed to pay $5 million in penalties and cease and desist from future violations. Id.

The SEC is doing its due diligence to understand and identify aggressive accounting tactics companies are using to manipulate earnings. (Mark Maurer, Wall Street Journal). Over the past three years, the SEC has continually increased the number of companies it is questioning regarding compliance with GAAP standards. Id. At the end of last year, the SEC expanded guidance on what constitutes a possible violation. Id. Recently, the SEC released letters the Division of Corporation Finance sent to Lyft Inc., the ride hailing company, asking the company to explain its use of non-GAAP calculations. Unsatisfied with Lyft’s justifications, the SEC instructed Lyft to remove the non-GAAP calculations in its reported earnings before interest, taxes, depreciation, and amortization (“EBITDA”), another commonly used method for determining profitability. (Id.; Adam Hayes, Investopedia). The pushback showed how manipulative non-GAAP measures can be as Lyft’s EBITDA moved from negative $47.6 million in the prior year to negative $248.3 million for only the final quarter of the prior year. (Maurer, Wall Street Journal).

The current economic struggles have led to the most earnings manipulation in over 40 years. (Josh Zumbrun, Wall Street Journal). To combat this, the SEC has ramped up its focus on EPS manipulation to protect investors, resulting in a string of cases that accuse companies of violations to meet numbers. (Eaglesham, Wall Street Journal). Over the past three years, the release of settlement figures to the public detailing the hefty fines associated with illegal manipulation now provides a company the ability put a dollar figure on how big of a risk it is taking if it manipulates its EPS to meet estimates. (Cydney Posner, JDSupra). A recent case against Gentex Corp., an automotive parts supplier, showed an internal email correspondence between its then CFO and Chief Accounting Officer that alleged the company manipulated its executive bonus program to boost earnings and meet the $0.27 EPS estimate just before it closed its books. (Carolyn Muyskens, Law360). Gentex Corp. and its Chief Accounting Officer agreed to pay fines of $4 million and $75,000, respectively, to resolve the charges Id. the SEC press release following the settlement noted that had Gentex Corp. not manipulated earnings, the company would have been evaluated at a $0.26 EPS and missed the estimate by one penny. Id.

The SEC’s reliance on analytics illustrates how it has adapted to combat the long-standing problem of earnings manipulation and has found an effective way to identify violations. As the SEC sends out inquiries into non-GAAP measures, companies will hopefully begin to realize that consistent accounting is better for the market than inflated numbers. However, changing corporate behavior is a challenging undertaking. Especially as some manipulation is legal, this creates a delicate balance for accounting teams. With fines being levied against individuals as well as their companies, it may be enough for some to rethink practices and adhere to GAAP measures more closely or risk large fines. (Mark Maurer, Wall Street Journal). As SEC press releases continue to show new fines for non-compliance, companies will be forced to evaluate whether the cost of a penny in EPS estimates is really worth $4 million in fines.