Betting on Technology: SEC's Reliance on Risk-Based Data Analytics to Detect Earnings Management
As the SECond Opinions Blog continues our review of fiscal year (FY) 2021 SEC enforcement activity, we take a deeper dive into the agency's use of technology to generate enforcement leads. The SEC's Division of Enforcement has never been shy about using technology to investigate and prosecute what it sometimes calls "harder-to-detect" violations. Indeed, the SEC frequently relies on data analytics to further its mission to protect retail investors and maintain fair, orderly and efficient markets, as in its approach to investigating possible insider trading.1 The Enforcement's EPS Initiative is a useful example of the staff leveraging data analytics to gather and assess large volumes of often complex information provided by thousands of publicly traded companies to more quickly and accurately identify earnings mismanagement. And although there have only been three reported enforcement actions since the EPS Initiative was first announced in September 2020, we anticipate that alleged earnings management and public companies' accounting controls will remain a priority for the Division of Enforcement in 2022.
What Is Earnings Management?
Earnings management is a term used to describe accounting practices undertaken by companies to produce a more optimistic (or less pessimistic) picture of a company's operations and financial results. Efforts to "smooth" earnings per share (EPS) can occur where accounting rules require or allow management to make their own judgment calls.
When it investigates the possibility of earnings management, Enforcement will often look for patterns in a company's financial results. For instance, a public company consistently meeting or exceeding (or even just narrowly missing) analysts' earnings estimates, only to be followed by a drop in EPS could suggest unnatural accounting contortions and mismanagement. Ultimately, when it alleges unlawful earnings management, Enforcement contends that management broke accounting rules in order to achieve better quarter- or year-end share price outcomes — thereby misleading investors.2
What Is the EPS Initiative?
At the end of FY 2020, the SEC unveiled its EPS Initiative, premised on Enforcement's risk-based use of data analytics, by announcing the filing of two settled public company actions totaling $4.5 million in civil penalties.3 In the first action, the SEC charged a carpet manufacturer for manually adjusting the company's earnings to meet analysts' EPS estimates, while in the second, the SEC alleged that a financial services company inaccurately presented its financial performance by manipulating its valuation allowance.4
A year later, in August 2021, the SEC's EPS Initiative generated another settled action with a publicly traded healthcare company that it claimed failed to follow generally accepted accounting principles (GAAP), resulting in inflated quarterly EPS.5 Relying on its internal data tools, the SEC alleged that if proper accounting principles were followed, the company would have reported lower EPS and missed analysts' consensus in several quarters — some by as little as a penny.6 Commenting on the action, Enforcement Director Gurbir Grewal emphasized that the SEC "will continue to leverage [its] in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations."7
Grewal's statement provides insight into what lies ahead for future enforcement actions in the EPS Initiative (and beyond): continued investment in, and reliance on, data analytics and a willingness to pursue questionable or improper accounting practices, lax internal controls and efforts to manipulate financial results – even where the outcomes differ by pennies.
What Should Companies Think About?
The SEC's Division of Enforcement is continuing to investigate potential earnings management, and will likely bring additional enforcement actions in 2022 against companies it believes are engaged in impermissible accounting practices to offer a rosier financial picture to investors. SECond Opinions Blog thinks management's time is well spent when assessing things such as:
- the key risks the company faces in terms of accurately accounting and disclosing financial results
- key accounting policies and areas where judgment is allowed or required
- whether accounting and disclosure policies and procedures are documented, and what mechanisms exist to track policy adherence and prevent, detect and mitigate the risk of deviation8
- whether the right people are involved in the process of making accounting and disclosure decisions for the company
- whether the company has a pattern of consistently meeting, beating or narrowly missing a particular earnings metric and, if so, take the time to understand why (is the company "rounding up" – i.e., changing EPS by .5 cent or more?9)and be ready to explain it
- when problems are identified, or complaints reported, promptly determine whether an investigation is warranted and, if so, invest sufficient resources and knowledge to understand and address the salient facts and deal with them appropriately
What Should Companies Expect?
During a panel at last week's 49th Annual Securities Regulation Institute, Director Grewal addressed how the agency – and more specicificaly the Enforcement Division – uses data analytics. Grewal claimed that Enforcement won't second guess honest efforts by companies to reach correct outcomes, particularly where companies have proper procedures in place and are accounting for all the relevant information. But, in referencing the cases from the EPS Initiative, he noted that the cases the agency has filed to date haven't been of that ilk.
This will be an interesting area to monitor going forward, particularly in light of Grewal's comments about not second-guessing good faith efforts. Based on limited history, it appears that the agency is at least willing to charge companies for purported earnings management where alleged misstatements may otherwise appear quantitatively immaterial. Companies should expect that the SEC will continue to use risk-based data analytics to crunch and compare earnings information and accounting disclosures made by thousands of public companies in an effort to weed out and pursue those the staff believes have manipulated information – even to a small degree. And although there have only been three reported cases filed as part of the EPS Initiative, they signal that the SEC continues to invest time and resources to unravel and understand complex accounting issues. Although the breadth and scope of the EPS Initiative is tough to project, companies should expect to see EPS enforcement investigations – and likely actions – in FY 2022 and beyond.
1 SECond Opinions Blog recently reported on the SEC's directed verdict loss in an insider trading action premised on statistical and data-based evidence.
2 This is significant because investors use a company's price-to-earnings ratio to gauge a stock's value, and a company's price-to-earnings ratio is calculated by dividing the share price by EPS.
3 Press Release, U.S. Sec. & Exch. Comm'n, SEC Charges Companies, Former Executives as Part of a Risk-Based Initiative (Sept. 28, 2020).
5 Press Release, U.S. Sec. & Exch. Comm'n, SEC Charges Healthcare Services Company and CFO for Failing to Accurately Report Loss Contingencies as part of Continuing EPS Initiative(Aug. 14, 2021).
6 Healthcare Services Group, Inc., Securities Act Release No. 10967, Exchange Act Release No. 92735, Accounting and Auditing Enforcement Release No. 4244 (Aug. 24, 2021).
7 Press Release, U.S. Sec. & Exch. Comm'n, SEC Charges Healthcare Services Company and CFO for Failing to Accurately Report Loss Contingencies as part of Continuing EPS Initiative, supra note 3.
8Companies likely also want to think about whether they are complying with their own disclosure controls and procedures (DCP), as non-compliance may provide the SEC a basis to support a claim under Exchange Act Rule 13a-15(a). Likewise, deficient accounting policies can result in exposure to books and records or internal accounting controls claims under Section 13(b) of the Exchange Act
9 See Malenko, Nadya and Grundfest, Joseph A. and Shen, Yao, Quadrophobia: Strategic Rounding of EPS Data (Aug. 9, 2020). Rock Center for Corporate Governance at Stanford University Working Paper No. 65, Stanford Law and Economics Olin Working Paper No. 388,