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The SEC Closes the Cookie Jar - Recent SEC Enforcement Activity Reaffirms Focus on Improper Earnings Management

The SEC Closes the Cookie Jar — Recent SEC Enforcement Activity Reaffirms Focus on Improper Earnings Management Background Image

On April 18, 2022, the Securities and Exchange Commission (“SEC”) announced the fourth enforcement action arising from its EPS Initiative, charging Rollins Inc. (“Rollins”) and its former chief financial officer (“CFO”) with violating Section 17(a) of the Securities Act of 1933 (“Securities Act”) and Sections 13(a), 13(b)(2)(A), and 13(b)(5) of the Securities Exchange Act of 1934 (“Exchange Act”) by engaging in improper accounting practices in order to boost the company’s publicly reported quarterly earnings per share (“EPS”) to meet research analysts’ consensus estimates.

Specifically, the SEC alleges that, in the first quarter of 2016 and the second quarter of 2017, Rollins’ then-CFO directed reductions to certain corporate-level accounting reserves without first conducting an analysis of the appropriate accounting criteria under generally accepted accounting principles (“GAAP”) in order to enable the company to publicly report EPS in line with research analysts’ consensus estimates.

For example, the SEC alleges that, on the second to last day of Rollins’ quarterly close process for Q1 2016, Rollins finance personnel received a flash report showing that Rollins would miss its consensus EPS estimates by $0.03. The next day, the CFO led a meeting with finance personnel where they discussed the fact that the company’s “termite reserve” was the “biggest driver” for the company missing its EPS estimates. Later that day, the CFO directed a $1.3 million reduction to the termite reserve account, as well as additional reductions to the company’s medical and outside services reserves. As a result of the reductions, Rollins publicly reported it had met its EPS estimates.

Similarly, during quarter-close for Q2 2017, the company’s preliminary numbers showed it would miss the consensus EPS estimates by $.05. The next day, the CFO directed an initial reduction to the company’s reserve accounts. When the adjustments did not drive the company’s projected EPS upward as he had expected, the CFO emailed another employee and asked: “I show a .237 [EPS] and thought that the [reserve account adjustments] would be a[n] [income] pickup of $2.7 [million]. What am I missing?” After telling the CFO he had overestimated how much the initial reduction would impact EPS, the other employee suggested Rollins could “scrap up $300K [from the medical reserve] and $600K [from the bad debt reserve]” to increase income. The employee also suggested that “if you are trying to get to [$].25 [consensus EPS] for the qtr it will take about [a] $1.2 million” reduction from the casualty reserve. The CFO then directed all of the suggested reductions to the medical, bad debt, and casualty reserves as the last accounting adjustments made during the quarterly close process without adequately documenting their basis. As a result of the reductions, Rollins publicly reported to the investing public that it has met its EPS estimates.

The SEC further alleges that the CFO knew at the time the reductions were made that the earnings were close to, but short of, Rollins’ consensus EPS estimates. Had these reserves not been reduced, the SEC found that Rollins would have missed consensus EPS estimates in the two quarters by one penny. Indeed, the SEC’s complaint quotes a Rollins executive as saying, “[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.” The same executive was quoted as advising the CFO that he “[n]eeded to keep something in the cookie jar for quarters like this.”

Finally, the SEC noted in its order that Rollins “often touted the consistency of [its earnings growth]” to the investing public and management “regularly tracked the company’s financial performance against various internal and external financial targets” including analyst EPS estimates. Thus, the SEC found that these actions took place in, and evidenced, an inadequate internal control environment that granted Rollins employees too much discretion to determine the company’s amount of reserves during the quarterly close process when they are aware of any potential shortfalls in the company’s reported financials. As part of the settlement, Rollins and the CFO have agreed to cease and desist from future violations and pay civil penalties of $8 million and $100,000, respectively.

Over the last few years, the SEC has become increasingly focused on identifying improper earnings management practices which result in inflated EPS figures. Indeed, in announcing the Rollins settlement, Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, warned issuers that the SEC “will continue to pursue public companies that lack adequate accounting controls and engage in improper earnings management practices.” Anita B. Bandy, a former Associate Director in the Division of Enforcement, previously explained that while earnings management can be difficult to detect, the SEC is focused on identifying these issues because “improper quarterly adjustments can have a material impact on reported EPS and how investors view a company’s reported financial results. Public companies must have accounting and disclosure controls sufficient to provide reasonable assurance that quarter-end adjustments comply with GAAP and do not hide weaker than expected performance.” SEC Press Release 2020-226, SEC Charges Companies, Former Executives as Part of Risk-Based Initiative (Sept. 30, 2020).

The SEC’s EPS Initiative uses analytics to try to pinpoint potential manipulators of EPS. Specifically, each of the enforcement actions that have come out of the EPS Initiative to date feature issuers that had patterns of meeting or slightly exceeding consensus EPS estimates for multiple consecutive quarters, often followed by significant drops in EPS. The issuers also publicly touted record-high or record-setting EPS during the manipulation period. In addition, these cases often include hallmarks of improper earnings management, including unsupported manual adjustments or paper transactions that occur immediately prior to quarter- or year-end and that have an immediate impact on the company’s reported financial results.

Accordingly, issuers should be mindful of any activity that could give the appearance that their earnings disclosures have been manipulated or lack sufficient support, as it could draw the scrutiny of the SEC. Manual journal entries and post-closing adjustments must be thoroughly documented, well supported, and approved by the appropriate persons. Issuers should also be wary of creating an internal environment that places too much pressure on meeting public performance targets. While it is expected that issuers will want to meet their targets, issuers that place too much emphasis on meeting targets can create incentives for executives and managers to do whatever it takes to meet those targets which can lead to earnings management issues.

Issuers should also emphasize maintaining strong internal control environments to limit the potential for improper earnings management to occur. One of the SEC’s key findings in the both Rollins order and its prior order regarding Healthcare Services Group, Inc. was that financial staff were making manual accounting adjustments without contemporaneous documentation, which automatically creates the impression that the adjustments were self-serving. Therefore, a strong control environment that limits the discretion allowed to managers to adjust reserves or other contingencies near quarter-end, and that requires any manual adjustments to be well documented, can help prevent the aggressive, reactionary accounting that can lead to an SEC inquiry and claims of earnings management. As shown by the Rollins action, issuer accounting and disclosure violations remain a focus of the SEC moving forward, and issuers should examine their discretionary accounting practices, financial reporting data, and shareholder communications to assess the risk of being targeted by the EPS Initiative.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.