Earnings Management Red Flags: Part Two

In part one of this two-part series, I reviewed what earnings management is (and isn’t) and went through a few examples of earnings-management-related actions brought by the Securities and Exchange Commission (SEC). In this article, I will address the “red flags” that boards and management teams should watch for and the steps they can take to avoid improper earnings management.

Boards and Management Teams: Watch for These Red Flags

The following are a few common red flags related to earnings management that boards and management teams should watch for.

1. Discussions regarding “meeting analysts’ expectations” and “making our numbers.” These are a hallmark of SEC cases related to earnings management and should be viewed as red flags since they can create an environment where improper earnings management practices can sprout—or at least give that impression when actions are reviewed after the fact by the SEC. For example, a CFO may emphasize to her direct reports that the company is feeling pressure to meet its numbers. Without intending it, that message may be misinterpreted by some direct reports to mean that they and their team need to find creative ways to help in the effort to meet the company’s numbers. The concern, of course, is that those efforts may cross the line into improper earnings management.
2. Consecutive periods of closely meeting or exceeding analysts’ expectations. This will undoubtedly garner congratulations during earnings call Q&As, as well as investor interest, but may also be a red flag in the eyes of the SEC. This is especially the case if these periods end with a sudden drop in earnings per share (EPS). I liken this to a track athlete who is breaking world records. As congratulations come in, so do questions as to whether that athlete is getting any extra help in the form of performance-enhancing drugs (PEDs). For companies that are meeting or exceeding analysts’ expectations, the analogous PEDs question is whether the company may be engaged in improper earnings management.
3. Transactions not in accordance with company accounting policies or changing policies so that they are. Whether it is an internal accounting policy, authorization matrix, or something similar, companies aren’t generally lacking when it comes to policies. Ignoring, bending, or changing those policies should be considered red flags, especially when those actions result in improved financial outcomes.
4. Creative or unusual transactions/accounting. As boards and management teams review drafts of a company’s periodic reports and earnings materials, here are some examples of key questions they can ask to discern whether the company may be using improper earnings management techniques: Are revenues changing in a way the narrative disclosure fails to fully and clearly explain? Are cash flows remaining steady while revenues rise dramatically? Did the company’s EPS benefit significantly from “nonrecurring” transactions (e.g., writing down assets or establishing a restructuring reserve)? If any of these occurred during the last quarter of the company’s fiscal year, it is an especially prudent time to ask questions.
5. “Immaterial” errors. A company may be compelled to correct financial statements or update disclosure to cleanse previous misstatements of performance. Of course, any company would prefer to avoid a re-issuance restatement or a “Big R” restatement. Unfortunately, this could cause a company to attempt to find a way to shoehorn what would otherwise be a material error into the immaterial error category. The law firm Wilmer Cutler provided a great discussion of the types of red flags to watch for when assessing errors in financial statements, including circumstances where a quantitively small error could be material when considering qualitative factors.

Tips for Avoiding Improper Earnings Management 

Here are more tips to help avoid improper earnings management, as well as being put under the microscope by the SEC for inadequate disclosure of accounting practices:

1. Tone at the top. Earnings management may start off with a few small accounting tactics that can be rationalized as working within the bounds of generally accepted accounting principles (GAAP), only temporarily, or to avoid the volatility that would be detrimental to shareholders’ best interests. To avoid having a gray area turn into an enormous black eye, the board and upper-level management should emphasize integrity in financial reporting as part of the company’s ethical culture. Management can also train functional areas within the business that touch the company’s financial statements and related disclosures on improper earnings management. Pairing this training with a culture where employees feel comfortable reporting potential issues ensures that management and the board will be primed to address potentially problematic issues early.
2. Maintaining strong internal controls and robust documentation practices. A common denominator in cases related to earnings management is subpar internal controls. In the Rollins case detailed in part one, accounting adjustments were made without adequate documentation. If your company gets a knock on the door from the SEC regarding one of your accounting decisions, lack of documentation is a bad look. Instead, companies should conduct an analysis of the appropriate accounting criteria under GAAP and memorialize this exercise with contemporaneous documentation. There should also be controls in place to ensure that individuals, whether that is the CFO or a manager in finance, be limited in the amount of discretion they can exercise in making accounting decisions.

3. Fulsome review of MD&A. It’s important that the board and management conduct a fulsome review of the MD&A. As a reminder, the Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A) is a section of a company’s annual report or quarterly filing. It's where the company provides a narrative explanation of the financial statements and other statistical data that it believes will enhance a reader’s understanding of its financial condition, changes in financial condition, and results of operation.

   Thinking back to the Under Armour example detailed in part one, the SEC’s inquiry started with an accounting issue, but the SEC ultimately brought charges based on the company’s failure to disclose the pulling forward of customer orders. It’s possible that thoughtful inquiry by the board into management’s decision to pull forward sales could have led to a few additional lines in the MD&A, likely avoiding SEC charges altogether.

   One practice that can help ensure an effective review of the company’s MD&A by the board is the preparation of pre-read materials that highlight, among other things, changes in accounting policies or new business strategies implemented during the period covered by the report, as well as how those changes are reflected and/or disclosed in the report.

4. Ensure all accounting treatments conform to existing policies. Before a company diverges from its normal policy, the reason for the divergence should be vetted, and as appropriate, the policy should be revised. In addition, consideration should be given to the company’s disclosure. The general theme here is that companies should ensure that disclosure provides a reasonably complete and materially accurate representation of the company’s financial condition, results of operations, and outlook. For instance, if a change in an accounting practice makes the difference between meeting or exceeding analysts’ expectations, that practice should be disclosed in the company’s periodic report and earnings materials.

Parting Thoughts

As noted in the first article of this series, improper earnings management often starts with a decline or anticipated decline in the business, coupled by pressure to meet internal or external expectations. Even if the SEC doesn’t find improper earnings management, the SEC may bring charges based on inadequate disclosure of accounting practices. Be mindful of the earnings management red flags and implement the recommended steps described above—it will go a long way to keeping your company out of harm’s way.