The Wall Street Journal
recently reported that the SEC launched a probe of at least 10 companies for potentially rounding up their reported Earnings per Share (EPS).
Board members, CFOs, Chief Audit Executives and other concerned parties need to be sure they don’t have an issue buried in their books. Not only is the SEC interested, the plaintiffs’ bar will surely be following this closely. Investigation notices from plaintiffs’ attorneys may follow as they learn more of the details from the SEC’s initial wave of requests for information.
Where are all the 4s?
According to the Wall Street Journal,
many within the SEC have read an academic paper, Quadrophobia: The Strategic Rounding of EPS Data,
which identified a statistical underrepresentation of the number four as the first post-decimal number in reported EPS. The paper named this trend “quadrophobia.” The authors focused on the number four because the amount of accounting discretion needed to increase the first post-decimal digit from four to five, thus rounding up EPS, is minimal. This paper built on a number of earlier studies that found similar statistical aberrations in the frequency of EPS first post-decimal numbers. Of particular note, Quadrophobia
developed a scoring system to assess the likelihood that specific companies would engage in EPS rounding, though the paper did not name those companies.
Related findings in Quadrophobia
- The pattern of quadrophobia is pervasive and persistent. Companies with a history of this behavior are more likely to repeat it.
- In 1997, when FAS 128 required companies to report diluted EPS, analysts switched their focus to that metric. At the same time, the pattern of quadrophobia switched from being evident in reported basic EPS to diluted EPS.
- The prevalence of quadrophobia is higher among companies where small changes in EPS are more influential. Such companies include those with:
- Analyst coverage – companies without coverage are under less continuous scrutiny while companies that begin to receive analyst coverage are more likely to engage in earnings rounding.
- Small EPS – with a small absolute value EPS, a small rounding change in EPS is relatively large.
- High market-to-book ratio – such companies are more likely growth-oriented and have an interest in raising capital.
- Mid-sized market capitalization – there are different reasons why companies at the opposite end of the size spectrum are less likely to engage in earnings rounding. This leaves mid-sized companies relatively exposed to the pressures and flexibility to engage in earnings rounding.
also found that companies with a pattern of quadrophobia were also more likely to have a history of restatements, SEC enforcement actions, shareholder class action litigation or other adverse accounting developments. While the accounting discretion required to push EPS by one tenth of a cent is minor, persistent quadrophobia should also raise concerns over the quality of financial statements. The authors recommended that analysis of quadrophobia be used in conjunction with other forensic tools to assess accounting abnormalities and fraud risk.
Companies should start to consider this risk now by:
Grant Thornton’s perspective
- Consulting with outside legal counsel to take advantage of any applicable legal privileges over their internal analysis.
- Becoming familiar with Benford’s law (including more powerful derivations of this law) and other relevant statistical tools, and reading the academic study that may be the genesis of the probe.
- Starting a data analytics driven approach to identifying potential issues through testing of transactional data and closing entries.
Whether this is the start of the next wave of SEC enforcement actions remains to be seen. However, as the Wall Street Journal
noted, the SEC has long sought to bring more cases over accounting fraud. Quadrophobia
did not address the related issue of earnings smoothing. What is clear is that boards of directors and management should ensure that their corporate culture, ethics and compliance programs and fraud risk assessments are addressing the risk that employees may try to manipulate earnings. As Quadrophobia
suggests, if rounding of EPS is occurring, it is a decision that calls into question all decisions. If a company is willing to cheat a little bit, what else are they willing to do?
Grant Thornton takes a unique approach to profiling companies for accounting abnormalities and fraud risks, and to investigating the issues surrounding potential earnings management. We have harnessed the tools and perspectives of experts from our audit, data analytics and forensic practices to bring a point of view and advanced analytic approach that drives results and answers. Additionally, the Firm’s ethics and compliance, fraud risk assessment and human capital culture assessment teams have helped many of the world’s largest companies build high performing and ethical cultures. How can we help you?
To discuss how our proprietary tools and services can help your company, please call your local Grant Thornton contact or one of the leaders listed below.
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