The SEC Turns Up the Heat on EPS and Other Accounting Abuses
On August 24, the SEC brought the third case in its long-running program to detect and prosecute quarterly earnings per share (EPS) manipulations. See SEC Charges Healthcare Services Company and CFO for Failing to Accurately Report Loss Contingencies as part of Continuing EPS Initiative. In addition to serving as a reminder that the Commission continues to be vigilant with respect to efforts to manipulate EPS to meet analyst expectations, the case may also signal renewed SEC enforcement interest in accounting and financial reporting matters generally. To underscore that point, shortly after the Healthcare Services case, the Commission filed an action against Kraft Heinz Company (Kraft) alleging a scheme to overstate earnings by understating costs. See Company Will Pay $62 Million to Settle Charges Related to Inflated Cost Savings that Caused it to Restate Several Years of Financial Reporting.
The EPS Initiative and the Healthcare Service Group Case
In 2018, the SEC reportedly commenced an enforcement effort to detect quarterly EPS manipulations. This initiative was apparently triggered by academic research suggesting that the number four rarely appears in the first post-decimal digit of EPS. Since EPS amounts that end in .5 cents can be rounded to the next highest whole cent, there appears to be an incentive to make accounting adjustments that raise EPS calculations ending in .4 cents to .5. See Does Your Company Suffer From Quadrophobia? The SEC is Investigating the Fear of Four, June-July 2018 Update. Two years later, in 2020, the Commission filed two actions pursuant to the EPS initiative. See SEC Charges Companies, Former Executives as Part of Risk-Based Initiative.
The third EPS case was brought against Healthcare Services Group (HCSG), a provider of house-keeping, dining, and other services to healthcare facilities. The SEC’s order finds that, in 2014 and 2015, HCSG violated GAAP by failing to timely accrue and disclose material loss contingencies related to private litigation against the company. Not recording these loss contingencies in the proper quarters caused HCSG’s reported EPS to meet analyst consensus EPS estimates. The failure to book these loss accruals in the appropriate quarter also resulted in HCSG reporting multiple quarters of EPS growth, including record-high EPS. In addition to the company, the SEC’s order charges HCSG's former CFO and its controller with causing various securities law violations. Without admitting or denying the SEC's findings, HCSG, the CFO, and the controller agreed to cease and desist from future violations and to pay civil penalties of $6 million, $50,000, and $10,000, respectively. The CFO also agreed to a suspension from appearing and practicing before the SEC as an accountant.
In the SEC’s announcement of the HCSG action, Gurbir Grewal, the new Director of the SEC's Division of Enforcement said, "As today's actions demonstrate, we will continue to leverage our 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."
The Kraft Heinz Case
Less than two weeks after filing the HCSG case, the SEC announced an action against Kraft alleging a multi-year expense management scheme that resulted in Kraft’s reporting inflated earnings before interest, taxes, depreciation, and amortization – EBITDA – which the SEC described as “a key earnings performance metric for investors.” While the Kraft case is unrelated to the EPS initiative, it also illustrates the SEC’s enforcement emphasis on financial reporting.
According to the SEC's administrative order, between 2015 and 2018 Kraft engaged in various types of accounting misconduct, including recognizing unearned discounts from suppliers and maintaining false and misleading supplier contracts, that improperly reduced the company's cost of goods sold. These efforts were designed to create the appearance that the company had achieved cost reductions, as predicted in connection with the 2015 merger of Kraft and Heinz. The SEC's order finds that Kraft and its former Chief Operating Officer violated the anti-fraud, reporting, books and records, and internal accounting controls provisions of the federal securities laws and that the former COO provided inaccurate information to Kraft’s auditors. The Commission also filed a civil action against the company’s former Chief Procurement Officer, charging him with similar violations.
Without admitting or denying the SEC's findings or allegations, Kraft consented to cease and desist from future violations and to pay a civil penalty of $62 million. The former COO also consented to cease and desist from future violations, to pay disgorgement and prejudgment interest of $14,211.31, and to pay a civil penalty of $300,000. The former CPO consented to an injunction against future violations, a civil penalty of $100,000, and a bar against serving as an officer or director of a public company for five years.
Comment: While the investigations that resulted in the HCSG and Kraft cases were undoubtedly initiated many months, if not years, in the past, these matters may indicate that, under Chair Gensler, the SEC’s Enforcement staff will be active in pursuing accounting and financial reporting matters. Indeed, in an October 13 speech, Enforcement Director Grewal said:
“With respect to corporate responsibility, Congress has enacted many laws and the SEC has adopted many rules to ensure that corporations are being responsible and playing fair. But too often, they ignore these rules and fail to implement sufficient controls or procedures to ensure compliance. In some cases, firms are practically inviting fraud or waiting for misconduct to occur; in others, they are actively covering it up or minimizing it. All of this serves to undermine public trust and confidence. Enhancing it will require, among other things, robust enforcement of laws and rules concerning required disclosures, misuse of nonpublic information, violation of record-keeping obligations, and obfuscation of evidence from the SEC or other government agencies.”
For audit committees, the HCSG case could serve as a basis to revisit the controls around discretionary accounting adjustments and quarterly earnings reporting. Given the publicity surrounding the topic, it would be prudent to ask whether there are controls in place that would prevent or detect small adjustments intended to bring quarterly results in line with analyst estimates. More broadly, audit committees should be aware that the recent financial reporting cases and Commissioner and staff statements seem to suggest an aggressive SEC approach to financial reporting matters.