SEC Is Focusing on Earnings Manipulation by Companies

Tough economic times have historically been fertile ground for earnings management. Executives use flexibility in the accounting treatment of items such as reserves for losses, or revenue recognition, to boost reported earnings per share.

In many instances, this is perfectly legal. It can, though, in some cases slide into securities-law violations or even fraud. Problematic tactics range from accounting changes that mask an underlying deterioration in the company’s finances to numbers-juggling that falls outside generally accepted accounting principles.

“There are more incentives for being clever with earnings because of the overall economic scenario,” said

Jack Ciesielski,

owner of investment research firm R.G. Associates Inc.

Regulators are on high alert. In recent months, the Securities and Exchange Commission has brought a string of cases accusing executives of cooking the books to meet numbers. Today’s tough climate for earnings will likely swell the pipeline of future actions.

“My money is on a few years from now, say 2026, we’ll see a lot more of these earnings management cases,” said Lenin Lopez, an attorney at insurance brokerage Woodruff Sawyer & Co.

The SEC’s enforcement armory includes its so-called EPS Initiative, which uses data-driven analytics to try to root out earnings manipulation. So far, that has resulted in cases against six companies and an unusually high number of individuals, including five current or former chief financial officers.

The SEC has put particular focus on pursuing individuals in the EPS cases in the hope of changing corporate behavior. The aim is to dissuade executives from the temptation to use accounting gimmicks to make the numbers. Even seemingly small accounting tweaks can result in a lawsuit.

In the latest case under the EPS Initiative, the SEC in February fined automotive-parts supplier

Gentex Corp.

$4 million for alleged earnings-management tactics that added a single penny to its reported EPS.

In 2015,

Kevin Nash,

who was then Gentex’s chief accounting officer and is now the company’s finance chief, reduced a reserve for paying executive bonuses from $300,000 to $100,000. The change meant the Michigan-based manufacturer met its 27-cent-a-share earnings target. “Had to reduce [the reserve] in order to keep .27 a share,” Mr. Nash wrote in an internal email, cited by the SEC.

“[G]ood call,” a senior Gentex executive responded. “That puts in line with consensus, right?” Mr. Nash replied yes.

Mr. Nash last month agreed to pay the SEC $75,000 to resolve its charges, without admitting liability. He didn’t respond to requests for comment.

Gentex “continues to have complete faith in Kevin Nash, who remains a critical member of our management team,” a spokesman said.

The SEC didn’t allege intentional wrongdoing by Gentex, and none of the accounting entries involved had a material impact on the company’s financial statements, the spokesman added. Gentex resolved the SEC case without admitting liability.

The SEC has a long history of trying to tamp down earnings manipulation. A quarter of a century ago, the agency’s then-chairman, Arthur Levitt, criticized what he called the widespread use of “accounting hocus-pocus” to smooth earnings.

His call to Wall Street to end this practice appears to have fallen on deaf ears.

Warren Buffett

last month warned that earnings can easily be manipulated by managers who wish to do so, calling it “one of the shames of capitalism.” In his annual letter to shareholders, the investor said tampering with earnings to beat expectations was often thought of as sophisticated.

“That activity is disgusting,” Mr. Buffett wrote.

Not all earnings management is bad, according to some analysts and academics. Provided it is done effectively, it can benefit shareholders by smoothing out the impact of one-off events, a 2020 study of more than 43,000 quarterly earnings reports found.

“Smoothing can help investors,” said David Farber, an accounting professor at Indiana University’s Kelley School of Business and a co-author of the paper. “Companies that manage earnings well can have more predictable earnings and cash flows, and that’s reflected in the price of their stock.”

A key determinant of whether smoothing helps or hinders the share price is the ability of the people running the company, measured by their ability to convert assets into cash, according to Mr. Farber. High-quality management teams use smoothing more often, and more effectively, than poor-quality ones, his research found.

At the other end of the spectrum, illegal earnings manipulation can carry a heavy price for companies and executives alike.

Peter Armbruster is currently serving a two-year prison sentence in Duluth, Minn., for an accounting fraud regulators said was designed to meet earnings targets. The former chief financial officer of

Roadrunner Transportation Systems Inc.

was convicted in 2021 on four criminal counts. His alleged conduct included hiding incurred expenses and failing to write-off millions of dollars in overvalued assets, the SEC said.

The scheme has cast a long shadow over his former employer, Roadrunner. The transport company in February resolved SEC allegations related to the alleged fraud, without admitting liability. Roadrunner had already paid $20 million in 2019 to settle a class-action lawsuit brought by shareholders, after it restated several years of financial statements.

Lawyers representing Mr. Ambruster didn’t respond to requests for comment. Roadrunner said in a statement the allegations related to “conduct that took place more than five years ago by individuals not involved with the company since 2018.”

Write to Jean Eaglesham at [email protected]

Tough economic times have historically been fertile ground for earnings management. Executives use flexibility in the accounting treatment of items such as reserves for losses, or revenue recognition, to boost reported earnings per share.

In many instances, this is perfectly legal. It can, though, in some cases slide into securities-law violations or even fraud. Problematic tactics range from accounting changes that mask an underlying deterioration in the company’s finances to numbers-juggling that falls outside generally accepted accounting principles.

“There are more incentives for being clever with earnings because of the overall economic scenario,” said

Jack Ciesielski,

owner of investment research firm R.G. Associates Inc.

Regulators are on high alert. In recent months, the Securities and Exchange Commission has brought a string of cases accusing executives of cooking the books to meet numbers. Today’s tough climate for earnings will likely swell the pipeline of future actions.

“My money is on a few years from now, say 2026, we’ll see a lot more of these earnings management cases,” said Lenin Lopez, an attorney at insurance brokerage Woodruff Sawyer & Co.

The SEC’s enforcement armory includes its so-called EPS Initiative, which uses data-driven analytics to try to root out earnings manipulation. So far, that has resulted in cases against six companies and an unusually high number of individuals, including five current or former chief financial officers.

The SEC has put particular focus on pursuing individuals in the EPS cases in the hope of changing corporate behavior. The aim is to dissuade executives from the temptation to use accounting gimmicks to make the numbers. Even seemingly small accounting tweaks can result in a lawsuit.

In the latest case under the EPS Initiative, the SEC in February fined automotive-parts supplier

Gentex Corp.

$4 million for alleged earnings-management tactics that added a single penny to its reported EPS.

In 2015,

Kevin Nash,

who was then Gentex’s chief accounting officer and is now the company’s finance chief, reduced a reserve for paying executive bonuses from $300,000 to $100,000. The change meant the Michigan-based manufacturer met its 27-cent-a-share earnings target. “Had to reduce [the reserve] in order to keep .27 a share,” Mr. Nash wrote in an internal email, cited by the SEC.

“[G]ood call,” a senior Gentex executive responded. “That puts in line with consensus, right?” Mr. Nash replied yes.

Mr. Nash last month agreed to pay the SEC $75,000 to resolve its charges, without admitting liability. He didn’t respond to requests for comment.

Gentex “continues to have complete faith in Kevin Nash, who remains a critical member of our management team,” a spokesman said.

The SEC didn’t allege intentional wrongdoing by Gentex, and none of the accounting entries involved had a material impact on the company’s financial statements, the spokesman added. Gentex resolved the SEC case without admitting liability.

The SEC has a long history of trying to tamp down earnings manipulation. A quarter of a century ago, the agency’s then-chairman, Arthur Levitt, criticized what he called the widespread use of “accounting hocus-pocus” to smooth earnings.

His call to Wall Street to end this practice appears to have fallen on deaf ears.

Warren Buffett

last month warned that earnings can easily be manipulated by managers who wish to do so, calling it “one of the shames of capitalism.” In his annual letter to shareholders, the investor said tampering with earnings to beat expectations was often thought of as sophisticated.

“That activity is disgusting,” Mr. Buffett wrote.

Not all earnings management is bad, according to some analysts and academics. Provided it is done effectively, it can benefit shareholders by smoothing out the impact of one-off events, a 2020 study of more than 43,000 quarterly earnings reports found.

“Smoothing can help investors,” said David Farber, an accounting professor at Indiana University’s Kelley School of Business and a co-author of the paper. “Companies that manage earnings well can have more predictable earnings and cash flows, and that’s reflected in the price of their stock.”

A key determinant of whether smoothing helps or hinders the share price is the ability of the people running the company, measured by their ability to convert assets into cash, according to Mr. Farber. High-quality management teams use smoothing more often, and more effectively, than poor-quality ones, his research found.

At the other end of the spectrum, illegal earnings manipulation can carry a heavy price for companies and executives alike.

Peter Armbruster is currently serving a two-year prison sentence in Duluth, Minn., for an accounting fraud regulators said was designed to meet earnings targets. The former chief financial officer of

Roadrunner Transportation Systems Inc.

was convicted in 2021 on four criminal counts. His alleged conduct included hiding incurred expenses and failing to write-off millions of dollars in overvalued assets, the SEC said.

The scheme has cast a long shadow over his former employer, Roadrunner. The transport company in February resolved SEC allegations related to the alleged fraud, without admitting liability. Roadrunner had already paid $20 million in 2019 to settle a class-action lawsuit brought by shareholders, after it restated several years of financial statements.

Lawyers representing Mr. Ambruster didn’t respond to requests for comment. Roadrunner said in a statement the allegations related to “conduct that took place more than five years ago by individuals not involved with the company since 2018.”

Write to Jean Eaglesham at [email protected]