SEC Cracks Down on Earnings Management

Neil Whoriskey is partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Whoriskey.

The SEC is taking renewed aim at earnings management, and this time it’s not just improper revenue recognition.

Both in its recent enforcement order against Marvell Technology Group—imposing s $5.5 million fine and a cease-and-desist order—and in its on-going action against Under Armour, [1] the SEC has focused on what, anecdotally, is not a terribly uncommon practice—accelerating (or “pulling in”) sales from a future quarter to the present in order to “close the gap between actual and forecasted revenue.” [2] In both cases, the schemes consisted of offering various incentives, such as “price rebates, discounted prices, free products, and extended payment terms” [3] to entice customers to accept products in the current quarter that they would not need until the next. In an environment of declining sales, these inorganic efforts to meet earnings numbers allegedly misled the market about the direction of the business.

Lest anyone think the SEC’s focus on “pulling in” revenues is an issue of limited relevance, note that approximately 27% of US public companies provide quarterly guidance, and evidence of widespread earnings management is not merely anecdotal. A broad survey by McKinsey reveals that, when facing a quarterly earnings miss, 61% of companies without a self-identified long-term culture [4] would take some action to close the gap between guided and actual earnings, with 47% opting to “pull-in” sales. 71% of those companies would decrease discretionary spending (e.g., spending on R&D or advertising), 55% would delay starting a new project, even if some value would be sacrificed, and 34% would delay taking an accounting charge. [5] The use of any of these techniques, if resulting in the obfuscation of a “known trend or uncertainty . . . that may have an unfavorable impact on net sales or revenues or income from continuing operations,” [6] would presumably be equally objectionable to the SEC.

And the SEC’s current focus on “pulling in” sales revenues (as opposed to other earnings management techniques) is understandable. In the two cases noted above, “pulling in” revenues succeeded only in delaying the bad news and in creating a more spectacular market disappointment when, a few quarters into the scheme, there were no more future sales to cannibalize. Decreasing discretionary spending might seem a more sustainable tactic—cutting advertising or, even better, R&D, is presumably much less likely to bite heavily into actual sales in the next quarter’s earnings (and this may account for its relative popularity (71%!) among earnings management practitioners). But the benefit is only that the securities law violation is less obvious in the near term, and the technique less likely to snowball as quickly to disaster if sales really are in decline. Regardless of the immediacy of the effect, however, all of these techniques inherently mislead investors about earnings stability and growth when unaccompanied by forthright disclosure about how the earnings numbers were achieved.

Accordingly, for those companies that are still providing earnings guidance, it would be prudent to make sure that your disclosure committee is having frank and frequent discussions with management about exactly what, if any, earnings management tools are being used, whether these tools fit squarely within the company’s revenue recognition policies, whether the company’s auditors are aware of the scope and persistence of these practices, and, most importantly, whether the use of the tools is, intentionally or not, masking a trend of declining sales, a declining market share, declining margins, or other significant uncertainties.

Of course, these companies could also reconsider earnings guidance altogether. The justification for guidance is that keeping the trading markets informed of earnings on a more current basis provides more immediately actionable data to the market, leading to better intra-quarter price discovery and less volatility. But if a company—worried about a market overreaction to a quarterly earnings miss—finds itself “pulling in” sales or cutting discretionary spending to hit earnings guidance, it has ceased to provide good information to the market. The prevalence of these practices may point to the inherent difficulty of communicating anything more nuanced than an earnings number to the trading market, but this difficulty only underlines the importance of reducing the market’s singular reliance on that simple quarterly number to drive valuations.

Endnotes

1Wall Street Journal, November 14, 2019, “Inside Under Armour’s Sales Scramble: ‘Pulling Forward Every Quarter’”(go back)

2SEC Press Release, SEC Charges Silicon Valley-Based Issuer with Misleading Disclosure Violations (September 16, 2019) at https://www.sec.gov/news/press-release/2019-175 (“According to the SEC’s order, Marvell orchestrated a scheme to accelerate, or “pull-in,” sales to the current quarter that had been scheduled for future quarters. As stated in the order, the purpose of the pull-in sales, which took place during the fourth quarter of 2015 and first quarter of 2016, was to close the gap between actual and forecasted revenue and to meet publicly-issued revenue guidance.”).(go back)

3SEC Cease and Desist Order in the Matter of Marvell Technology Group, Ltd. (September 16, 2019), p. 4.(go back)

4Only 37% of the survey’s respondents self-identified as working at a long-term oriented company.(go back)

5Barton, Bailey and Zoffer, Rising to the Challenge of Short-Termism, p.8.(go back)

6Regulation S-K, Item 303.(go back)

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