SEC starts EPS rounding probe

What you need to know to understand and manage this emerging risk

Gray, purple, and teal interlocking diamondsThe 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 were:

  • 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.

Quadrophobia 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:

  • 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.

Grant Thornton’s perspective 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.

Contacts Erik LioyErik Lioy
National Managing Partner
Forensic Advisory Services
T: +1 704 632 6915

Mark SullivanMark Sullivan
Forensic Advisory Services
T: +1 312 602 8110

Brian WolohanBrian Wolohan
National Partner
Audit Innovation and Strategy
T: +1 703 637 4160

Trent Gazzaway
National Managing Partner
Audit Quality and Innovation
T: +1 704 632 6834

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein.
Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.