Since we’re in the midst of earnings season, I thought Woodruff Sawyer’s recent two-part series on earnings management issues on its “D&O Notebook” blog was worth highlighting. The first installment reviews what “earnings management” means from the SEC’s perspective, and highlights some of the agency’s more high-profile earnings management enforcement proceedings, including its 2021 action against Under Armour. The second installment highlights several red flags for potential earnings management that boards and management should be on the lookout for, including the following:
Discussions regarding “meeting analysts’ expectations” and “making our numbers.” These are a hallmark of SEC cases related to earnings management and should be viewed as red flags since they can create an environment where improper earnings management practices can sprout—or at least give that impression when actions are reviewed after the fact by the SEC. For example, a CFO may emphasize to her direct reports that the company is feeling pressure to meet its numbers. Without intending it, that message may be misinterpreted by some direct reports to mean that they and their team need to find creative ways to help in the effort to meet the company’s numbers. The concern, of course, is that those efforts may cross the line into improper earnings management.
Consecutive periods of closely meeting or exceeding analysts’ expectations. This will undoubtedly garner congratulations during earnings call Q&As, as well as investor interest, but may also be a red flag in the eyes of the SEC. This is especially the case if these periods end with a sudden drop in earnings per share (EPS). I liken this to a track athlete who is breaking world records. As congratulations come in, so do questions as to whether that athlete is getting any extra help in the form of performance-enhancing drugs (PEDs). For companies that are meeting or exceeding analysts’ expectations, the analogous PEDs question is whether the company may be engaged in improper earnings management.
In addition to listing several other red flags, the blog offers some tips on how to avoid earnings management. The blog highlights the need for a fulsome review of the MD&A section of the company’s SEC filings as part of this effort, and suggests that boards require “pre-read” materials highlighting accounting policy changes or new business strategies implemented during the period, as well as the MD&A disclosures about those matters.
– John Jenkins