Discrepancies in Corporate Disclosure

Several weeks ago we had an update here about the SEC’s idea to relax quarterly reporting rules, perhaps in favor of letting companies disclose more via their earnings release. Today let’s explore two practical challenges with that notion: companies can omit unwelcome numbers in their earnings releases, and change what those numbers are by the time the actual quarterly report gets filed.

That might seem like an odd risk to mention, since just last week Kraft Heinz reported a disastrous $15 billion goodwill impairment to Wall Street and disclosed an SEC probe — all via an earnings release. That shouldn’t fool anyone. Firms have considerable discretion over what they put in the earnings release, and plenty of them take full advantage of that.

So if the SEC is going to grant companies more power to report important numbers via the earnings release only, it’s worth considering what discrepancies and burying of unwelcome news already happens now.

Calcbench, a financial data firm (and, in full disclosure, a business partner of Radical Compliance) has been doing some great work lately finding filers who say one thing in their earnings release and then report something else several weeks later in the 10-K or the 10-Q. Let’s take a look.

First is Virtu Financial, a financial services firm in New York with $1 billion in annual revenue. On 8 Feb. 2018, Virtu published an earnings release reporting 2017 full-year results. Net income attributable to stockholders was $17.3 million.

That sounds fine, but when Virtu filed its Form 10-K five weeks later, net income attributable to shareholders was only $2.9 million. That’s $14.4 million of net income vaporized, a decline of 83 percent.

What happened? Much of the answer lies in the line-item just above net income: provision for income taxes. In the earnings release, Virtu reported a provision for income taxes at $78.1 million. By the time Virtu filed its 10-K, that number was $94.2 million — an increase of $16.1 million.

Virtu also fiddled with a few other numbers here and there on the income statement. For example, interest and dividends income dropped by $3 million, while commissions on technology services rose by $5 million. The ever popular “other, net” also rose by $1.7 million. Add up all those fluctuations, and Virtu’s net income for the year practically disappeared.

The important detail for investors and the SEC is this. On Feb. 3, when Virtu’s earnings release reported $17.3 million in net income, Virtu’s stock went from $21.65 to $26.50 — a jump of 22 percent. On March 13, when Virtu filed the whole 10-K and actual net income of only $2.9 million, the stock opened at $32.80 and closed at $32.95.

In other words, nobody noticed the real news. Investors had already responded favorably to numbers in the earnings statement that, in the fullness of time, were proven not to exist.

Other examples aren’t hard to find. When Amerisource filed an earnings release on Nov. 2, 2017, it reported net income at $414.5 million. But in its 10-K filed 19 days later, net income had dropped to $364.5 million — a decrease of $50 million, or 12 percent.

The culprit was an increase in the company’s litigation settlements line item, from $864.4 million to $914.4 million. Granted, that’s not a huge amount of money for Amerisource, which had $153 billion in revenue that year. But investors would not know the truth unless they took the time to read both the earnings release and the 10-K.

Implications for Disclosure Reform

Right now there’s nothing inherently wrong with reporting different numbers in the earnings statement and the quarterly report, because everything eventually does get disclosed in the quarterly report. Numbers change between earnings release and quarterly report for perfectly legitimate reasons. If an investor is dumb enough to place total trust in the earnings release, and ignore the more reliable details subsequently in the 10-Q — well, that’s your mistake.

For example, earnings releases are furnished to the SEC rather than filed as they are with the quarterly report, which means the company faces less liability for misstatement in an earnings release. And while audit firms review disclosures in the 10-Q (and audit them for the 10-K), audit firms don’t need to examine disclosures in the earnings release at all.

So if the SEC scales back disclosures made via quarterly reports, in favor of letting companies rely more on distributing information via the earnings release — then we also need to ask how to provide more assurance around the numbers in the earnings release, since investors will rely more on those without the fallback resource of the 10-Q.

In other words, it’s OK that investors can’t quite trust the numbers in an earnings release right now, because more trustworthy, detailed numbers eventually come out in the 10-Q. But if such numbers don’t come out in the 10-Q, because the SEC rolls back disclosure requirements, then we need to make numbers in the earnings release more trustworthy.

So, do we require audit firms to review numbers in the earnings release? Do we require firms to file earnings release rather than furnish them? Steps like that would give investors more assurance. They also really just move disclosure requirements from one place (the 10-Q) to another (the earnings release), which should make everyone wonder why we’d bother with that idea at all.

Questions like that should be part of the SEC’s debate later this year as it ponders disclosure reform. Let’s see if they actually get the consideration they deserve.