Public companies have generally been operating under the assumption that certain deliberate actions affecting financial metrics—known as “earnings management”—are acceptable and don’t require disclosure.
Earnings management occurs when a company employs operational or accounting measures to accelerate or delay the recognition of income or expense items in order to achieve certain financial results—typically to meet investors’ expectations for revenue, net income, earnings per share (EPS), or another GAAP or non-GAAP financial metric.
However, recent Securities and Exchange Commission enforcement efforts, including the Marvell Technology Group (Marvell) case filed in September 2019, and certain ongoing investigations evaluating potential improper rounding of EPS, indicate that the SEC is focusing on quarter-end transactions or accounting adjustments done primarily or solely to meet desired financial metrics.
Therefore, financial reporting and compliance personnel should reassess quarter-end techniques used to “close-the-gap” to determine whether accounting and disclosure practices comply with GAAP and Regulation S-K, Management Discussion and Analysis (MD&A).
The SEC brought a settled enforcement action against Marvell alleging the company failed to disclose that it engaged in earnings management by accelerating revenue from future quarters. Specifically, the SEC alleged that when Marvell was behind revenue guidance at quarter-end, management pressured salespersons to offer inducements to customers to purchase products in an earlier quarter than scheduled.
When employees objected that these “pull-in” sales were obfuscating the company’s deteriorating financial results, management falsely assured them they were not being used “primarily or solely” to meet revenue guidance.
The SEC, however, concluded that Marvell failed to disclose that a significant portion of its revenue had resulted from the use of “pull-ins” intended to meet revenue guidance. The SEC concluded that Marvell’s failure to disclose its pull-in tactics was misleading because it gave investors the impression that guidance had been met organically. Investors were also unaware that revenue was being shifted to earlier quarters, thus adversely impacting future quarters, and that pull-ins masked a decline in sales and market share.
The SEC reasoned that without access to the same information as management, investors could not evaluate financial results in context and compare across periods. Consequently, it concluded that Marvell failed to comply with MD&A provisions requiring disclosure of known trends, events or uncertainties likely to have a material impact on financial condition or results of operations.
The SEC has also initiated a number of investigations looking into whether companies made improper quarter-end adjustments that caused EPS to round up. While no enforcement actions alleging improper rounding have yet been filed, these investigations were spurred by a paper published in July 2014, by Nadya Malenko and Joseph Grundfest (Boston College and Stanford University) entitled Quadraphopia: Strategic Rounding of EPS Data, which observed the absence of the .4 decimal in certain companies’ EPS calculations.
For example, a company having a preliminary EPS calculation of $1.444 per share, might potentially record an accounting entry causing the calculation to become $1.445, thus rounding up to $1.45. While a $.01 difference might not seem significant, stock prices could be punished if analysts expected $1.45, but the company only reported $1.44.
To Disclose or Not-Disclose
Virtually all public companies are impacted by the SEC’s focus on earnings management because most engage in forecasting, many provide guidance to analysts and, in my experience it is not uncommon for companies to evaluate strategies to “close-the-gap” between actual and expected performance. This could include a spectrum of tactics as basic as encouraging salespersons to sell more products, delaying travel or hiring to intentionally recording transactions in contravention of GAAP.
So, how should companies that have taken more aggressive measures to manage earnings assess their disclosure obligations?
First, whether disclosure is required depends on the facts and circumstances. Historically, companies generally have not been prosecuted for delaying sales or delaying the incurrence of expenditures because no transaction has occurred, even if the effect is to meet issued guidance.
However, the SEC has routinely prosecuted companies for engaging in improper revenue and expense recognition schemes including those involving ‘cookie-jar” reserves. Additionally, even in situations where transactions complied with GAAP, the SEC has brought disclosure-based prosecutions for failing to comply with MD&A provisions.
How Should Companies Evaluate Earnings Management
Companies would be wise to update their financial reporting fraud risk assessments to ensure they are addressing earnings management. Risk factors include:
- Touting—a practice of touting GAAP or non-GAAP financial metrics on earnings calls and in press releases;
- Patterns—a pattern of always meeting, or just exceeding analysts’ expectations for relevant financial metrics, which may suggest smoothing of earnings;
- Pressure—a history of management pressuring employees to meet targets, especially when the trend has been contrary to market conditions;
- Accounting Practices—a history of minimally supported closing entries, changing or considering changes to accounting policies or practices involving accounting estimates primarily or solely as a means to meet targets;
- Operational Practices—a history of aggressively offering customers incentives to purchase in down markets and/or pushing them to purchase quantities of product beyond their needs.
Companies should also ensure they have adequate documentation for accounting estimates, especially when changes in practices or methodologies occur.
And, while the SEC did not allege Marvell committed control violations, it did state that its disclosure process failed to ensure that Marvell adequately considered disclosure obligations—thus highlighting the need to assess internal and disclosure controls relating to earnings management.
In light of the SEC’s enforcement efforts, companies should not assume that particular earnings management techniques are permitted or non-disclosable as even mildly aggressive measures done primarily to meet targets could come under scrutiny.
In light of Marvell and the rounding investigations, it is important to have a process to evaluate whether quarter-end practices could impact the qualitative factors discussed in SAB 99, or trends, events or uncertainties reasonably likely to have a material impact—as Marvell appears to have expanded the range of MD&A prosecutions beyond channel stuffing allegations.
Specifically, companies should think about how they should monitor for revenue acceleration and deceleration tactics intended to shift income between quarters, and for changes to accounting estimates done to meet financial targets, so that disclosure obligations can be assessed in an appropriate and timely manner.
Whatever the approach adopted to address earning management, companies will be better positioned to respond to a whistleblower complaint or an SEC inquiry if financial reporting and compliance personnel, potentially along with experienced SEC counsel and forensic accountants, take proactive steps to evaluate past practices and current controls.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Howard A. Scheck is a partner in the Washington, D.C., office of global advisory firm StoneTurn, and previously served as the chief accountant in the SEC’s Division of Enforcement.