SEC EPS Enforcement Initiative Bags Another Company
The SEC has brought another case as part of its initiative to uncover and prosecute accounting practices designed to manipulate earnings per share. See SEC Notches Another EPS Enforcement Case, April-May 2022 Update. In the most recent action, filed on February 7, the SEC charged that Gentex Corporation, a Michigan-based manufacturing company, violated financial reporting, books and records, and internal control requirements as a result of unsupported quarterly adjustments to an accrual for performance-based bonuses. In at least one case, the change in the accrual was apparently intended to cause Gentex’s EPS to meet the analyst community’s earnings expectations for the quarter. Kevin Nash, Gentex’s CFO, who served as Chief Accounting Officer during the events in question, was also charged.
According to the SEC’s order, Gentex maintained a discretionary profit-sharing bonus plan. Bonuses were paid annually, but accrued monthly based pre-tax, pre-bonus income. During the quarterly closing process, Nash, as CAO, determined whether the monthly accruals reflected the company’s expected bonus payout for the quarter or whether adjustments were necessary. In 2015, the company decided to adopt a second bonus plan (the PB plan), which would take effect in 2016, and Gentex’s then-CFO instructed Nash to reserve for the PB plan. Accordingly, on October 7, 2015, as part of the 2015 third quarter close, Nash directed that $300,000 be reserved for the PB plan. No documentation or analysis supported the amount of this accrual.
On October 8, Nash realized that the $300,000 accrual would cause Gentex to miss the consensus analyst EPS estimate of $0.27 for the third quarter of 2015. He directed a journal entry to reduce the $300,000 accrual to $100,000. This journal entry, like the original accrual, was made without any supporting documentation or analysis. However, in an October 9 email exchange, the then-CFO asked Nash if he had reserved for the PB plan. According to the order, “Nash responded, ‘100K. had [sic] 300K, but had to reduce in order to keep .27 per share.’ The CFO replied, ‘[g]ood call. That puts in line with consensus, right?’ to which Nash replied, ‘[y]es.’” The order further states: “Had Nash not directed the partial reduction of the $300,000 accrual for the PB Bonus Plan expense, Gentex would have missed the third quarter 2015 EPS consensus estimate by a penny.”
During several subsequent quarters in 2016, 2017, and 2018, Nash made accruals to the bonus reserve account without adequate supporting documentation. In 2017, Nash recommended to the then-CFO that the company make bonus payments in an amount that would leave $568,000 in the reserve account, stating in an email that such a cushion “would not be bad to have for the third quarter and fourth quarter of 2017.”
Gentex was charged with violations of the reporting requirements, the books-and-records requirements, and the internal control requirements of the Securities Exchange Act, including Exchange Act Section 13(b)(5) which prohibits any person from “knowingly circumventing or knowingly failing to implement a system of internal accounting controls or knowingly falsifying any book, record, or account.” Nash was charged with violating Section 13(b)(5) and with causing Gentex’s violations. Gentex and Nash agreed to settle without admitting or denying the Commission’s allegations. Gentex was ordered to pay a civil money penalty of $4 million and Nash to pay a penalty of $75,000; both were ordered to cease and desist from future violations.
Comment: As noted in prior Updates, audit committees should be vigilant in circumstances where management seems focused on analysts’ quarterly EPS expectations, particularly when the company has a long history of meeting expectations. The audit committee might also want to be sure that there are controls that require, and confirm the existence of, documentation to support discretionary accounting adjustments. Adjustments to estimated accruals, such as those in the Gentex case, are a classic vehicle for EPS manipulation.