SEC probes whether companies rounded up earnings per share

Regulators investigating the case of the missing '4'

Federal regulators are investigating the case of the missing “4,” exploring the numeral’s conspicuous absence in quarterly reports that could mean companies have improperly rounded up their earnings per share to the next highest cent, according to people familiar with the matter.

Enforcement officials at the Securities and Exchange Commission have sent queries to at least 10 companies, asking the firms to provide information about accounting adjustments that could push their reported earnings per share higher, one person familiar with the matter said.

The queries follow the release of an academic paper that found evidence of companies nudging up earnings results. The academic research found the number “4” appeared at an abnormally low rate in the tenths place of companies’ earnings per share. Reporting that figure as “5” or higher allows a firm to round up its earnings per share another cent.

For instance, a company with earnings of 55.4 cents a share would round to 55 cents a share, while a company with earnings of 55.5 cents a share would round to 56 cents.
 

Public companies have strong incentives to report higher earnings per share, particularly those followed by Wall Street analysts whose quarterly forecasts are used to benchmark corporate performance. Investors often snap up shares of companies that beat expectations, even by a cent, and, likewise, sell shares of companies that miss their forecasts.

The names of the companies that received the SEC’s queries couldn’t be learned. The SEC didn’t immediately respond to a request for comment.

Queries to 10 companies

* Enforcement officials at SEC have sent queries to at least 10 companies, asking the firms to provide information about accounting adjustments that could push their reported earnings per share higher

* The queries follow the release of an academic paper that found evidence of companies nudging up earnings results

* The academic research found the number “4” appeared at an abnormally low rate in the tenths place of companies’ earnings per share

* Reporting that figure as “5” or higher allows a firm to round up its earnings per share another cent

The investigation is in its early stages, one of the people said. Accounting rules offer some discretion for when managers recognize revenue or expenses, so quarterly adjustments can be legal even when they boost reported earnings per share.

The researchers, Nadya Malenko and Joseph Grundfest, referred to the dynamic they detected as “quadrophobia.” The paper was widely read within the SEC, one of the people said.
 

The SEC has for several years sought to bring more cases over accounting fraud. Probes involving financial reporting previously had taken a back seat to investigations over complex financial instruments and insider trading after the 2008 financial crisis.

In 2012, the SEC announced it had developed an “accounting quality model” that could scan companies’ financial statements for anomalies that might indicate fraud.

SEC economists replicated aspects of Dr Malenko’s and Mr Grundfest’s study and found similar results-cases where the digit “4” rarely appeared over a large number of accounting quarters, one person said.

Dr Malenko’s and Mr Grundfest’s paper, which hasn’t appeared in an academic journal and was last updated in 2014, showed that companies with signs of strategic rounding over many quarters were more likely to be charged with accounting violations, restate earnings, or become targets of shareholder lawsuits.

“The rounding itself might not be fraud, but it signals a certain aggressive approach to accounting practices,” said Dr Malenko, a finance professor at Boston College. “It can predict more serious accounting violations.”

The research rests on an assumption that every number should appear in the tenths place 10% of the time. After reviewing nearly 951,612 quarterly results for over 25,000 companies from 1980 to 2013, however, the authors found that “4” appeared in the tenths place only 8.6% of the time. Both “2” and “3” were also underrepresented in the tenths place; all other digits appeared more frequently than would be expected by chance.

The researchers checked their assumption by examining other metrics that tend to be less correlated with stock price moves than EPS. For those ratios, including sales per share and operating income per share, the digit “4” appeared in the tenths place about 10% of the time in all years of the researchers’ sample data.

Companies closely followed by analysts were more likely to report fewer “4s,” as were both the largest and the smallest firms. Firms with high stock market valuations, as well as those with lower earnings per share, were also more likely to show signs of rounding up their earnings, the authors found.

As The Wall Street Journal reported in 2010, computer maker Dell didn’t report earnings per share with a “4” in the tenths place between its 1988 initial public offering and 2006. The likelihood of that happening by random chance was 1 in 2,500.

In July 2010, Dell paid $100 million to settle SEC charges that it misled investors about the source of earnings and used “cookie jar” reserves to manipulate quarterly results. Reversing excess reserves turned them into income, which allowed Dell to meet quarterly EPS targets in some cases, the SEC said.

At the time, a Dell spokesman said the company’s financial-reporting practices are “rigorous” and the company is “committed to ongoing transparent and accurate reporting.”
 

Pushing up EPS by a 10th of a cent doesn’t require a significant accounting adjustment, making it easier for companies to nudge the ratio higher without attracting much scrutiny. In 2013, the mean additional amount of earnings required to do so was $222,000, the researchers found. 

Source: The Wall Street Journal