Earnings Management Red Flags: Part One

Public companies are under tremendous pressure to meet or beat stock analyst earnings estimates. This pressure caused Warren Buffet to observe: “Managers that always promise to 'make the numbers' will at some point be tempted to make up the numbers.”

Engaging in tactics designed to meet earnings estimates is commonly referred to as earnings management. Some earnings management techniques may be perfectly legal; others, not so much.

This article, the first in a two-part series, provides:

1. An overview of what earnings management is (and isn’t)
2. A few examples of Securities and Exchange Commission (SEC) actions related to earnings management.

Part two addresses the “red flags” that boards and management teams should watch for and steps they can take to avoid improper earnings management.

What Is Earnings Management?

In 1998, in a speech before the NYU Center for Law and Business, SEC Chairman Arthur Levitt famously used the phrase “accounting hocus-pocus” when describing earnings management. He said:

“Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to obscure actual financial volatility. This, in turn, masks the true consequences of management's decisions.”

Chairman Levitt went on to describe “[f]ive of the more popular” techniques used by companies to inappropriately manage earnings.

1. “Big Bath” Charges: Deliberately overstating restructuring charges above what is likely. By accelerating expenses and losses into a single year with already poor results, this approach gets all the bad news out at once, and the theory is that Wall Street will then focus on future earnings.
2. Creative Acquisition Accounting: Allocating the purchase price to “in-process” research and development, then expensing the costs immediately as a one-time charge to overstate earnings.
3. “Cookie-Jar” Reserves: Over-accruing charges for items such as sales returns, loan losses, or warranty costs when the company is doing well and using those reserves to smooth future earnings when the company isn’t as profitable.
4. “Materiality”: Misusing the concept of materiality to intentionally record errors in a company’s financial statements such that they improperly get labeled as immaterial. In some cases, this can allow a company to meet earnings projections.
5. Revenue Recognition: Prematurely recognizing revenue (e.g., before a sale is complete, before the product is delivered, or at a time when the customer has options to terminate), rather than waiting until the promised product or service has been fully delivered.

The techniques used above generally boil down to misrepresenting financial statements. However, earnings management shouldn’t always be equated to “cooking the books.”

There are legitimate reasons to manage earnings. For example, a company may decide to postpone an acquisition or a disposal of assets until a later period, postpone expenses to a future period when earnings are low, or accelerate expenses when earnings are high.

So where is the line between legitimate and fraudulent earnings management, the latter being the type of earnings management that Chairman Levitt was focused on in his speech and that the SEC views as a basis to bring a related enforcement action? A few SEC enforcement actions will help ground our discussion.

SEC Enforcement Actions Related to Earnings Management

General Electric Company: $50 million penalty (2009)

Meeting or exceeding analyst expectations for close to a decade would be music to any investor’s ears. General Electric Company (GE) did that from 1995 through 2004. According to the SEC, it was too good to be true.

The SEC conducted a risk-based investigation of GE’s accounting practices with a focus on the potential misuse of hedge accounting. As a reminder, in a risk-based investigation, the SEC identifies a potential risk within a particular industry or at a specific company. The SEC goes on to develop an investigative plan to test whether the problem exists. With the potential misuse of hedge accounting as the basis for the SEC’s investigation, the investigation ultimately uncovered four separate accounting violations. This led the SEC to file civil fraud and other charges against GE in 2009.

For instance, the SEC found GE reported end-of-year sales of locomotives that had not yet occurred in order to accelerate more than $370 million in revenue into the quarter. In another example, the SEC alleged that GE made an improper change to its accounting for sales of commercial aircraft engines’ spare parts that increased GE’s 2002 net earnings by $585 million.

The SEC alleged that GE’s motivation was “to increase earnings or revenues or to avoid reporting negative financial results.” In one case, GE’s accounting tactics allowed the company to avoid missing analysts’ earnings per share (EPS) expectations. The complaint also describes shortfalls in internal controls as well as internal flag-raising. One email the SEC uncovered from a senior accountant in GE’s corporate accounting group described how this individual believed a particular accounting approach GE intended to use was problematic:

How do we intend to deal with the SEC “one strike and you’re out” position? Doesn’t this mean that potentially we can no longer qualify for cash flow hedging??? Urgent that you find disclosures of others who have had cash flow failures. Isn’t this an extraordinarily big deal?

GE settled the charges for $50 million without admitting or denying guilt. By the time of the settlement, GE had already restated some of its financial statements and taken remedial actions, including improvement to its internal audit and controllership operations. GE noted that it incurred approximately $200 million over four years in associated legal and accounting fees to cooperate with the SEC and conduct its own review.

General Electric Company: $200 million penalty (2020)

In 2020, GE found itself the subject of another SEC action. This time, as noted by Reuters, the SEC’s investigation was sparked by GE’s accounting practices following a 2017 surprise $6.2 billion accounting charge. Once the SEC started looking, their scope of inquiry expanded.

For example, the SEC stated that in public disclosures, “GE misled investors by describing its Power segment profits without explaining that more than $1.4 billion in 2016 and $1.1 billion in the first three quarters of 2017 stemmed from reductions in cost estimates.” This was all apparently done to conceal the challenges those businesses were facing. Cooley LLP provides a detailed discussion of the action.

The SEC found that GE violated the antifraud, reporting, disclosure controls, and accounting controls provisions of the federal securities laws. GE settled the charges for $200 million without admitting or denying guilt. The penalty would likely have been higher if GE hadn’t already taken remedial measures that the SEC viewed as positive. For example, GE replaced certain members of management in its power and insurance businesses, revised certain investor-related disclosures, added internal controls and testing processes, and added disclosure controls and procedures. Notably, the penalty doesn’t include legal and accounting costs GE incurred to cooperate with the SEC and conduct its own review. If the case from 2009 is any indication, it’s likely the costs were significantly greater than the penalty.

Under Armour, Inc.: $9 million penalty (2021)

In 2021, the SEC charged Under Armour, Inc., with misleading investors as to the bases of its revenue growth and certain disclosure failures concerning its future revenue prospects in 2015 and 2016. The SEC’s order noted that “[b]y the second half of 2015, Under Armour’s internal revenue and revenue growth forecasts for the third and fourth quarters of 2015 began to indicate shortfalls from analysts’ revenue estimates.” Note that the company had consistently met or exceeded revenue estimates since going public in 2005.

The anticipated miss in sales was partially a function of a warmer winter in North America, which negatively impacted sales of the company’s higher-priced cold weather apparel. The SEC found that in response, Under Armour accelerated, or “pulled forward,” existing customer orders that were requested to be shipped in future quarters. Under Armour accomplished this by asking its customers to accept shipment of certain products in the current quarter that they had already ordered for delivery in the next quarter. This allowed the company to meet analysts’ revenue estimates.

The SEC’s order found that Under Armour publicly attributed the increased revenue growth to factors like “growth in training, running, golf and basketball,” as well as increased sales in footwear and apparel. Under Armour failed to mention the pulling forward of customer orders. Referring to discussions within Under Armour’s senior management and finance function, including some that noted the need to implement pull forwards to make up for “significant and increasing revenue shortfall,” the SEC’s order argues that Under Armour knew or should have known that pulling forward customer orders concealed its failure to meet analysts’ revenue estimates without such pull forwards. Further, the SEC found that “the company’s senior management implicitly admitted the unsustainability of this practice by describing pull forward revenue as “bad,” “unnatural,” and “unhealthy.”

The SEC found that Under Armour violated the antifraud provisions and certain reporting provisions of the federal securities laws. Under Armour agreed to pay a $9 million penalty without admitting or denying the charges.

Rollins Inc.: $8 million penalty (2022)

The SEC doesn’t just focus on household names like GE and Under Armour. Rollins Inc., a pest control company, made its way onto the SEC’s radar in connection with the SEC’s Division of Enforcement’s EPS Initiative. The SEC’s EPS Initiative uses risk-based data analytics to help the SEC uncover potential accounting and disclosure violations caused by, among other things, earnings management practices. The case brought against Rollins is the highest penalty to date against a company in connection with the SEC’s EPS Initiative.

Details from the SEC’s release announcing the charges:

“The SEC’s order finds that, in the first quarter of 2016 and the second quarter of 2017, Rollins, a nationwide provider of pest control services, made unsupported reductions to their accounting reserves in amounts sufficient to allow the company to round up reported EPS to the next penny. According to the order, the company’s then CFO, Paul Edward Northen, directed the improper accounting adjustments without conducting an analysis of the appropriate accounting criteria under generally accepted accounting principles (GAAP) and without adequately memorializing the basis for those accounting entries. The order also finds that Rollins made other accounting entries that were not supported by adequate documentation in multiple additional quarters from 2016 through 2018.”

Unlike in the other actions brought in connection with the EPS Initiative and other cases discussed in this article, the SEC specifically noted in its release and in its order that the Rollins case involved “improper earnings management practices.”

A unique aspect of the Rollins case was that the record showed that Rollins’ CFO was very involved in directing the company’s finance team to make accounting adjustments that appeared to be focused solely on increasing net income. In one instance, the CFO directed the team to make adjustments just after the CFO had met with members of the finance team to discuss “how to manage the unexpectedly low income that was causing a lower-than-expected EPS.”

The SEC found that Rollins and the CFO violated antifraud provisions of the federal securities laws and that Rollins violated the financial reporting, books and records, and internal controls provisions of the same. The order also found that the CFO caused Rollins’ violations of the financial reporting, books and records, and internal controls provisions of the federal securities laws. Without admitting or denying the SEC’s findings, Rollins and its CFO agreed to pay penalties of $8 million and $100,000, respectively.

Parting Thoughts

Improper earnings management often starts with a decline or anticipated decline in the business, coupled with pressure to meet internal or external expectations. It is tempting to believe that a few small improper accounting tactics will fly under the proverbial radar. However, these things have a way of catching up with companies. Even if the SEC doesn’t find improper earnings management, the SEC may bring charges based on inadequate disclosure of accounting practices.

Be certain to read part two, where I address the “red flags” that boards and management teams should watch for and steps they can take to avoid improper earnings management.