On April 18, the SEC brought an administrative action against Rollins Inc. alleging that the pest control company reduced certain accounting reserves, including the “termite reserve,” in order to raise quarterly earnings per share and meet analysts’ earnings expectations. This is the fourth Commission case resulting from the Division of Enforcement’s initiative, announced in 2018, to identify and prosecute EPS manipulations. See The SEC Turns Up the Heat on EPS and Other Accounting Abuses, September-October 2021 Update. The Rollins case, like the earlier EPS cases, signals an aggressive SEC approach to financial reporting matters.
The SEC’s order finds that, in the first quarter of 2016 and the second quarter of 2017, Rollins, made unsupported reductions to accounting reserves in amounts sufficient to allow the company to round up reported EPS to the next penny. The company’s then-CFO, who was also charged in the SEC action, allegedly directed the accounting adjustments without conducting an analysis of the appropriate GAAP accounting criteria and without adequately memorializing the basis for the adjustments. If these reserves not been reduced, Rollins would have missed consensus EPS estimates in the two quarters by one penny. The order also finds that Rollins made other accounting entries that were not supported by adequate documentation in additional quarters from 2016 through 2018.
Rollins’ quarterly close process allegedly included explicit consideration of the impact of reserves on EPS. In quarters where the company’s preliminary EPS calculation fell short of analysts’ consensus estimates, the CFO and other finance personnel discussed whether any corporate-level reserves could be reduced in order to increase reported EPS. Indeed, another Rollins executive had advised the CFO that, with respect to the reserve accounts, “[s]ome quarters you need flexibility, and it is good to know a place where you might have it. It's part of the art of the close” and that Rollins “need[ed] to keep something in that cookie jar for quarters like this.” The reserves that served this purpose included the termite reserve (an estimate of repairs, settlements, and other costs relative to termite control services), the casualty and medical reserve (amounts accrued to pay for workers compensation and employee medical claims), the customer bad debt reserve, and the outside services reserve (accrued amounts payable to third-party service providers).
In connection with the improper reserve reductions, the Commission also alleged that Rollins failed to maintain accurate books and records and sufficient internal accounting controls:
“Although Rollins had policies and procedures requiring accounting entries to have adequate supporting documentation, its finance staff recorded manual journal entries with no or inadequate supporting documentation. Rollins also lacked procedures to ensure that the accounting personnel received necessary information to properly record and document quarter-end reserve adjustments. Finally, Rollins did not maintain a sufficient complement of personnel with the requisite level of accounting knowledge, experience, and training.
“As a result, Rollins’ internal accounting controls were not designed or maintained to provide reasonable assurance that Rollins’ financial statements would be presented in conformity with GAAP, and it further failed to maintain internal control over financial reporting. Rollins’s books, records, and accounts also did not accurately and fairly reflect, in reasonable detail, Rollins’ transactions and disposition of assets.”
Without admitting or denying the SEC’s findings, Rollins and its former CFO agreed to cease and desist from future violations and to pay civil penalties of $8 million and $100,000, respectively.
Comment: Rollins could serve as a trigger for the audit committee to revisit its understanding of the controls around discretionary accounting adjustments and quarterly earnings reporting. Audit committees should be especially vigilant in circumstances where management seems particularly focused on analysts’ quarterly EPS expectations and the company has a long history of meeting expectations. Quarters in which market expectations are met as a result of rounding up EPS to the next penny should draw special scrutiny. See Does Your Company Suffer From Quadrophobia? The SEC is Investigating the Fear of Four, June-July 2018 Update. It would be prudent to ask what controls in place to prevent or detect small adjustments intended to bring quarterly results in line with analyst estimates. 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.