Companies Are Being Targeted By The SEC For Manipulating Earnings

Regulatory agencies are scrutinizing whether companies are able to manipulate financial results in order to meet Wall Street targets, as the profit squeeze increases pressure on executives to make the numbers succeed.

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There has been a trend this earnings season of falling profits as well as falling expectations for future returns, which has characterized the season. FactSet reports that S&P 500 earnings for the fourth quarter are down 4.65% compared to the same period last year, with more than 99% of the companies reporting. This is the first decline year-over-year since the fall of 2020, at the height of the pandemic, which marks the beginning of the decline.

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There has historically been a fertile ground for earnings management during times of tough economic times. It is not uncommon for executives to use flexibility in the accounting treatment of items such as reserves for losses and revenue recognition to boost the reported earnings per share in their companies.

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As a matter of fact, this is perfectly legal in many instances. In some cases, it can lead to violations of securities laws as well as fraud, which is a serious matter. There are a number of potentially problematic tactics that companies can employ, which range from accounting changes that hide a deterioration in the company's financial standing to numbers-juggling that is outside the scope of generally accepted accounting practices.

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“Due to the overall economic scenario, there are more incentives for being clever with earnings,” said Jack Ciesielski, owner of R.G. Associates Inc.

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There is a high level of alert among regulators. A string of cases has been brought by the Securities and Exchange Commission against executives in recent months, alleging they cooked the books in order to meet their targets. The challenging earnings climate we are experiencing today will likely lead to a flurry of future actions as a result of this climate.

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“My prediction is that in the next few years, say 2026, we'll see a lot more of these earnings management lawsuits,” said Lenin Lopez, an attorney at the insurance brokerage Woodruff-Sawyer & Co.

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Among the SEC's enforcement tools are the so-called Earnings Per Share Initiative, a program that uses data-driven analytics to try to bring an end to earnings manipulation. Consequently, as of now, six companies have been charged along with an unusually high number of individuals, including five current or former chief financial officers of those companies.

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It has been the SEC's priority to pursue individuals in the EPS cases in the hope that it will change the behavior of corporations in the future. To achieve this, the aim is to dissuade executives from making use of accounting gimmicks in order to boost their profits. The slightest accounting tweaks can lead to a lawsuit even if they seem like they are not very significant.

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Gentex Corp., an automotive parts supplier, was fined $4 million by the SEC in February for alleged earnings management tactics that added one penny to its reported earnings per share (EPS), the latest case to come under the SEC's EPS Initiative.

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Kevin Nash, who was then Gentex's chief accounting officer and is now the company's finance chief, reduced a reserve for paying executive bonuses from $300,000 to $100,000 in 2015 when he was Gentex's chief accounting officer. Due to the change, the Michigan-based manufacturer met its target of earning 27 cents per share for the year. “It was necessary to reduce the reserve in order to keep .27 a share,” Mr. Nash wrote in an internal email, which was cited by the SEC, in an attempt to keep the reserve.

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"Good call," responded a Gentex executive. “That aligns with consensus, right? ” Mr. Nash replied yes.

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In a settlement agreement last month, Mr. Nash agreed to pay $75,000 to the SEC without admitting any liability. Comments from him were not returned.

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The company's spokesman said the company "continues to place a great deal of trust in Kevin Nash, who is still an indispensable part of our management team.".

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Gentex was not accused of intentional wrongdoing by the SEC and none of the accounting entries involved had a material impact on Gentex's financial statements, according to a company spokesperson. The SEC case against Gentex was resolved without Gentex admitting any fault.

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The SEC has a long history of trying to curtail earnings manipulation in a variety of ways. A quarter of a century ago, the then-chairman of the agency, Arthur Levitt, criticized what he termed the widespread use of "accounting hocus-pocus" to smooth out earnings during a difficult economic period.

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It would appear that his call for Wall Street to end this practice has fallen on deaf ears. The investor Warren Buffett last month emphasized the fact that earnings can be easily manipulated by managers who wish to do so, calling this one of the shame of capitalism. The investor said in his annual shareholder letter that tampering with earnings in order to beat expectations was often considered sophisticated by investors.

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Mr. Buffett wrote that that activity was disgusting.

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Some analysts and academics believe that not all earnings management is bad, according to their observations. If implemented effectively, it can benefit shareholders by smoothing out the effects of one-off events, according to a study of more than 43,000 quarterly earnings reports conducted in 2020.

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'Smoothing can be a big help to investors,' said David Farber, a professor of accounting at Indiana University's Kelley School of Business and one of the co-authors of the research paper. "Companies that are able to manage their earnings well can have more predictable earnings and cash flows, and that will be reflected in the price of the stock of those companies."

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This can be measured by the ability of the people who run the company, measured by their ability to convert assets into cash, to determine whether smoothing is beneficial or detrimental to the share price, according to Mr. Farber. In his research, he found that high-quality management teams use smoothing more frequently, and they also use it more effectively, than poor-quality management teams.

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Additionally, companies and executives alike may pay a heavy price if they are found to have manipulated earnings in an illegal manner.

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The current sentence for Peter Armbruster in Duluth, Minn., is a two-year prison sentence for accounting fraud regulators said was designed in order to meet earnings targets through the use of accounting fraud. The former chief financial officer of Roadrunner Transportation Systems Inc. has been convicted of four criminal counts as a result of his conviction in 2021. The SEC accused him of concealing incurred expenses and failing to write off millions of dollars in overvalued assets due to his alleged conduct, as well as hiding incurred expenses.

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There is a long shadow cast over his former employer, Roadrunner, as a result of the scheme. In February, the transport company settled SEC allegations, related to the alleged fraud, without admitting any liability for the alleged fraud. A class-action lawsuit was filed against Roadrunner by shareholders in 2019 after its financial statements were restated and it had already paid $20 million to settle the lawsuit.

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The lawyers representing Mr. Ambruster did not respond to requests for comment. An official statement released by Roadrunner said that the allegations related to "conduct that took place more than five years ago by individuals who are no longer employed by the company."