On August 24, the U.S. Securities and Exchange Commission (SEC announced) its third enforcement action under its Earnings Per Share (EPS) Initiative. The SEC’s data-focused initiative targets potential violations linked to earnings management practices.

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The SEC’s latest enforcement action was a result of Healthcare Services Group failing to record certain loss contingencies in accordance with GAAP (ASC 450 or FAS 5) in order to meet research analysts’ estimates. However, what may have initially caught the SEC’s attention was that the company rounded up in 12 of the 19 quarters most recently reported.  It is likely the SEC used these results to inquire into HSC’s accounting practices, which led to them uncovering the GAAP violations. In particular, Anita Bandy, associate director of SEC Enforcement, said: “It is critical for public companies to ensure that accounting judgments, including those involving loss contingencies, are not being used to manage earnings and distort financial statements.”

Key takeaways from the SEC’s announcement and recent case experience are as follows:

  1. The SEC’s enhanced resources in data analytics helps them identify potential issues that “open the door” into investigating a company’s financial reporting.
  2. Companies need to continue to enhance their internal controls around performing appropriate analyses that support recording, or in some cases, not recording certain quarter end entries.
  3. Specifically, when companies calculate and report EPS, if the result is rounded up (i.e., 0.5 cents or more) and therefore potentially very sensitive to downward, even quantitatively “immaterial” adjustments, they should ensure underlying estimates are sufficiently documented and supported if challenged.
  4. Even if accounting transactions are in accordance with GAAP, companies may have disclosure obligations regarding certain accounting practices, e.g., channel stuffing, pull aheads. For companies with external reporting obligations, it is important to have disclosure controls and procedures in place to ensure compliance with the SEC as they will differ from internal control over finance reporting (ICFR).