Mike: Did you know that the penny was the first coin to bear the face of an American president? That president, of course, is Abraham Lincoln. There are about 130 billion pennies in circulation and the U.S. Mint produces between 5 and 16 billion pennies every year. However, making a penny has cost more than one cent every year since 2006, with current cost estimates around 2 cents. In fact, between 2009-2019 the U.S. Mint produced pennies at a total loss of $586 million dollars. In the great penny debate, proponents of getting rid of the penny say the process of making pennies is costly, both financially and environmentally, as the process wastes zinc and copper, two important natural resources. However, penny lovers say that preserving the penny keeps consumer prices down, avoids harming low-income households and helps raise money for charities.
We’re talking about pennies on today’s episode of GAAP Chats, but whether or not they should be discontinued. Instead we’re talking about earnings management and how “smoothing” your earnings, even if it affects EPS by only a penny, can be considered material and get you into trouble with the SEC!
Mike: Welcome to GAAP Chats, the podcast dedicated to all things accounting, brought to you by GAAP Dynamics. I’m your host, Mike Walworth and with me today is Bob Laffler, as Chris away facilitating a course for one of our clients in Canada. We hope you’ll join us on our journey today as we share our passion for accounting and help change the way you train.
Mike: Bob, where do you stand on the great penny debate?
Bob: I must say, I feel conflicted by it because my wife is a bit of a penny collector. She's been collecting pennies ever since the days with her grandfather with these old copper coins. But I must say, I am an anti-change person. I no longer want change. I buy everything electronically with tapping my phone. I think it's time for us to move into the modern age and get rid of pennies and go from there.
Mike: But the interesting thing is there was a case recently where there was a change shortage. So, I think there's probably a lot of us around the U.S. that just collect this change. Maybe the US mint, especially if they're losing a penny for every penny they mint, they almost should say, hey, bring in your change. We'll do the rolling for you for free!
Bob: That's why some of these banks have the change machines that just sort it for you. You just dump it in there. It's sorted and off it goes. There's a local credit union that does it. They do it for free, though, up to a hundred bucks or whatever it is. There's a certain dollar amount that they'll let you do each time, and you can only do it like once or twice a month where you can kind of do it for free. Anyway, let’s move on to the topic at hand, which is what again, Mike?
Mike: Earnings management.
Bob: How does that relate to the penny debate?
Mike: Well, sometimes companies employ earnings management techniques to ensure that they meet earnings targets for the period and that even a penny move in EPS could draw the ire of the SEC and result in fines and penalties.
Bob: Tell us more.
Mike: I came across a story in the Wall Street Journal in March where the SEC, as part of its EPS Initiative, fined automotive-parts supplier Gentex Corp. $4 million for alleged earnings-management tactics that added a single penny to its reported EPS.
Bob: What is the SEC’s EPS Initiative?
Mike: The SEC’s EPS Initiative uses risk-based data analytics to detect potential accounting and disclosure violations caused by earnings management practices. Basically, the SEC uses issuer data to look for patterns where issuers meet or slightly exceed consensus EPS estimates for multiple consecutive quarters. This is usually followed by significant drops in EPS.
Bob: Ah, so the classic robbing Peter to pay Paul thing!
Mike: Exactly! Eventually, it all catches up with them. The first mention of the EPS Initiative came in September 2020 and, to date, it has resulted in cases against six companies and several individuals, including five current or former CFOs.
These cases often include hallmarks of improper earnings management, including unsupported manual adjustments or paper transactions that occur immediately prior to quarter- or year-end and that have an immediate impact on the company’s reported financial results.
Bob: So, what happened in this case with the auto-supplier?
Mike: Back in 2015…
Bob: 2015! Not exactly recent news. We're in 2023!
Mike: Well, the case wasn’t settled and made public until February 2023! Then, the Wall Street Journal picked it up in March 2023.
Bob: Guess there’s no statute of limitations with the SEC oversight and reach.
Mike: And you cannot hide from big data! The SEC is using this new technology to go back and see if company's were messing around with earnings. Anyway, at the time the company’s Chief Accounting Officer, who is now their CFO, reduced a reserve for paying executive bonuses from $300,000 to $100,000. This change meant that the company met its 27-cent-a-share earnings target. The SEC noted that the CAO said in an internal email “Had to reduce [the reserve] in order to keep 27 centers per share.” To which the current CFO responded, “Good call. That puts us in line with consensus, right?” To which the CAO replied, “Yes.”
Bob: Oh so he was caught redhanded! When will these people learn never to put this stuff in an email?
Mike: Yeah, right? The SEC’s order noted:
"During the quarter closing process in the third quarter of 2015, Gentex's then-Chief Accounting Officer, directed the reduction of an accrual for a performance-based bonus program, resulting in Gentex reporting EPS that met consensus research analyst estimates. The CAO directed the reduction without performing an analysis of relevant criteria under U.S. GAAP and without documenting the basis for his decision. The order further finds that in multiple additional quarters between 2015 and 2018, the CAO and other Gentex employees made adjustments to bonus compensation accruals without the required accounting analysis or without adequate supporting documentation. These entries were made possible by Gentex's failure to devise and maintain a sufficient system of internal accounting controls related to its closing process, including its accounting for bonus compensation, and failure to maintain internal control over financial reporting."
Bob: Didn’t you say that the amount of the bonus accrual reduction was only $200,000? That doesn’t seem like a lot of money. What problem did the SEC have exactly and what was the size of the company?
Mike: On October 7, 2015, the CAO made an accrual for an executive bonus plan of $300,000. According to the SEC, this journal entry was made prior to approval by the Board of Directors and without any supporting documentation. Additionally, the CAO did not maintain documentation of any purported analysis that was required to be performed pursuant to ASC Topic 450, Contingencies, concerning the loss contingency associated with this bonus plan.
Mike: Then, on October 8, 2015, realizing his initial accrual would cause Gentex to miss the consensus EPS estimate of $0.27 for the third quarter of 2015, he directed a journal entry to reduce the $300,000 accrual to $100,000. Again, according to the SEC, this revised accrual was made without any supporting documentation and the CAO did not conduct any analysis that should have been performed under U.S. GAAP. But to answer your question about the size of the company. Back in 2015, when the event transpired, Gentex had total assets of $2.1 billion and net income of $318.5 million.
Bob: That’s not a small company. $200,000 doesn’t seem like it would be material.
Mike: Interestingly, according to the Wall Street Journal, a company spokesman noted that none of the accounting entries involved had a material impact on the company’s financial statements.
Bob: I think the Gentex spokesman doesn’t know the definition of materiality! If they didn’t reduce the reserve and, consequently, didn’t meet consensus EPS estimates, then they must have thought the market would have reacted negatively, which is why they did it in the first place.
Mike: BINGO! Let's talk about materiality a bit. According to FASB Concept Statement No. 8:
"Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation."
Mike: U.S. GAAS has recently amended its definition of materiality as follows:
Misstatements, including omissions, are considered to be material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements.
Bob: What does the SEC say about materiality?
Mike: Well, according to the SEC’s Chief Accountant in a statement given in March 2022, our old friend Paul Munter, references the Supreme Court which noted that a fact is material if there is “a substantial likelihood that the…fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” He went on to say that:
"…those who assess the materiality of errors, including registrants, auditors, audit committees, and others, should do so through the lens of the reasonable investor. To be consistent with the concept of materiality, this assessment must be objective. A materiality analysis is not a mechanical exercise, nor should it be based solely on a quantitative analysis. Rather, registrants, auditors, and audit committees need to thoroughly and objectively evaluate the total mix of information. Such an evaluation should take into consideration all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, to determine whether an error is material to investors."
Bob: Sounds like solid advice. Let’s go ahead and put a link to Paul’s statement in the notes to the podcast.
Mike: So, Gentex messed around with reserves, which is a classic earnings management technique. Bob, what are some other ways that companies engagement in earnings management?
Bob: Well, first, I think we need to be clear that some earnings management techniques are perfectly legal. These include things like reducing or eliminating non mandatory expenses in the short-term if revenues are below expectations. If revenue is good, companies might increase their spending on expenses like capex or marketing, or even bonuses and raises. These are business decisions and all perfectly legal.
Bob: Then you get into things that may or may not be on the “up and up,” depending on the reasoning behind them and the related disclosures. This might include things like lowering or raising capitalization limits on fixed asset purchases, changing inventory (or other) valuation methods, such as going from LIFO to FIFO, and messing around with the assumptions and/or inputs on management estimates, including reserves.
Mike: Well, in Gentex case it was like it was 2015 to 2018. They were kind of messing around with this bonus accrual up and down. It's the old “cookie jar” reserves. Gotta love them. Increase them when times are good and release them when times are bad. By the way, that is not allowed. That reminds me of a story which I think fits well with our discussion. The SEC had a problem with the the support and the documentation and analysis surrounding these reserves required by ASC Topic 450.
Bob: I remember back in my old days of being an auditor, the early days when I first went over to Europe. I was auditing a client and it was shocking to me when I was in charge of the consolidation, so I was looking at topside adjustments and kind of making sure what they were. There was one line item, and this was not under U.S. GAAP, so who knows, maybe it was legal for all we know. But, basically the line item was called "CFO Reserve". I remember asking the controller like, "hey, I see this topside adjustment that you book every quarter. It's called CFO Reserve. What's that?" And they're like, "Oh, well, that's our reserve that we put on there, depending on whether we need money or don't need money. That's kind of the CFOs kind of extra cushion that he puts into the the accounts." I'm like, "pretty sure that's not allowed."
Mike: Well, yeah, if it's a client I'm thinking about basically that was probably one of the first GAAP adjustments we made to switch them over to U.S. GAAP, the CFO Reserve. But it happens all the time. So, here this wasn't like erroneously labeled, it looked fine enough, right? It's the bonus reserve. I think as auditors, you've got to be careful of those types of things. You know, increases and decreases - making sure that they can be substantiated because otherwise clients can use those to to manage earnings. Last was it last week we talked about Trump and Clarence Thomas. We talked about uncertain tax positions. Well, that would be another one where companies could monkey around with it to to potentially, you know, meet earnings.
Bob: In our experience, let's let's not fool ourselves. Every company does it to some extent. The question is how blatant is it and and how well hidden is it? You need to have some kind of justification for it. There's lots of different ways to justify stuff and so forth. But, there's always the potential of earnings management and guess it's the age old game of auditor versus company. Trying to identify where those areas are and making sure you get proper documentation and support for for any of those estimates that are being taken.
Mike: Yeah, you can have the estimates like the reserves, that's just sort of straight up what the accrual should be. But, you can monkey around with just management estimates in general. You and I are both banking guys and financial services, you know, sort of investment companies, etc. You can kind of mess around with with earnings management there, too, in regards to estimates and fair valuations. It reminds me of a story about a person we knew left public accounting and went to become a CFO for a mortgage company. He was the CFO of a publicly traded mortgage company. And one of the things that they had to do each quarter was value their mortgage servicing rights. Now, Bob, in two minutes or less: mortgage servicing rights, what are they?
Bob: Mortgage servicing rights are basically an asset or liability, but usually it's an asset account that a lot of times is a mortgage banker that will have it because basically you get a mortgage servicing rights. When you sell a loan, you no longer have the rights to hold the cash and interest from a loan. But you still are servicing that loan, meaning you're still the one that collects on defaults and late payments and so forth. Basically you get paid a fee for that type of work, right? You get a percentage of the collections as a mortgage servicing revenue. Basically, these are assets that are trying to predict the amount of future cash flows that you're going to earn from these these mortgage servicing arrangements.
Mike: Okay, and under GAAP, and I believe this is still the case after the securitization, a piece of that purchase price of the loan is sort of allocated to the mortgage servicing. You can either sort of take that amount and sort of amortize it down over the life of the of the servicing. Keeping in mind impairment because that's important, right? If it ever gets impaired or under the fair value option you could probably fair value these things as well, right?
Mike: So you could do either. I forget what this company was doing, but they were valuing mortgage servicing rights. Now, one of the main inputs in this mortgage servicing right, or the valuation was really the prepayment speed of the underlying mortgage. If the mortgage is prepaid quicker, then that mortgage asset would would come down quicker and it might be impaired or whatever. If they would prepay less, then the asset would stay on the books because it's expected you're going to service it for longer. What this guy and this company was doing was they were messing around with the prepayment speed of the MSRs to meet earnings or not. Here's where the auditors fell down. And, this is why whenever I teach this, whenever I teach mortgage servicing rights and also when I teach the auditing, I sort of say you need to know the assumptions and the inputs that go into any valuation model and understand the sensitivity. Where this Big Four firm kind of fell down was they came in and they said, Hey, a prepayment speed, here's the high end and here's the low end for this quarter of what it should be. Of course, this guy and this company always was within the reasonable range. But, what they ended up doing was this: the CEO would come in and say, "hey, you, how are we doing? How are we doing for earnings this month?" And he'd be like, "Oh, boss, I think we're going to be a penny short." Then he would say to slow down the prepayment speed. "Oh, boss, I think we're going to be we've exceeded it by two pennies." "Increase the prepayment speed." So they were basically driving the prepayment speeds, the prepayment prepayment input on that MSR. They were driving it like a stick shift and using it to manage earnings. So, this auditor didn't really notice it because it was always within that that range, which is why when we teach it, Bob, whenever we teach fair value, we're sort of saying, Hey, not only does it need to be in the reasonable range, but you need to see whether it's in the middle one quarter, it's at the lower end one quarter, or it's at the higher end. It's very, very important. Now, another thing I like to say and use this when I teach this is when you sort of understand the entity, t's important to understand the tone at the top and understand management's incentives or whatever.
Bob: Yeah, that probably is getting close to the third category of earnings management techniques which is outright fraud. Failing to write down overvalued assets, hiding incurred expenses and erroneously pumping up revenues.
Mike: That is why, in accordance with auditing standards, you should always consider fraud with respect to revenue accounts.
Mike: Well, can you take us out Bob?
Bob: That’s all for this episode of GAAP Chats, your source for all things accounting. Notes and resources from today’s episode are linked in the description and as always you can find us online at GAAPDynamics.com, and @gaapdynamics across social media. It’s never too late to become a GAAPologist! Head over to our website and subscribe to our blog so that you’re the first to know what’s new with GAAP Dynamics.
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