SEC Dings Two Firms on Internal Controls

For years regulators have talked about the importance of data analytics in enforcement actions. Now the SEC has demonstrated that point with two enforcement actions for poor internal control and earnings manipulation, driven by the agency’s in-house analytics team. So we can’t say nobody warned us. 

The enforcement actions were announced Monday, against a carpet manufacturing business in Georgia and a financial services firm in Pennsylvania. The SEC accused both companies of violating various internal accounting controls to goose their earnings per share numbers. Both companies towed the usual “neither admitting nor denying the SEC’s findings” language, while then agreeing to pay monetary penalties and promising not to violate SEC rules again.

So what happened? Let’s start with Interface Inc., the Georgia carpet company and the larger of the two enforcement actions. 

According to the SEC complaint, Interface’s corporate controller Gregory Bauer and CFO Patrick Lynch engaged in numerous accounting maneuvers in 2015 and 2016, all intended to lower legitimate expenses and therefore inflate earnings per share (EPS) to artificial heights. The practical effect was to push EPS to materially misleading levels — like, reporting EPS of $0.31 in third-quarter 2015, when the actual number should have been a $0.04 loss. 

Most of the SEC allegations center around write-downs or adjustments that Lynch and Bauer made without necessary supporting evidence. For example, in October 2015 as Interface was preparing its Q3 financials, Bauer told his staff to book adjustments to achieve “a pick up of about 740k.” Later that day, he and the staff reduced the expense of a stock grant to $628,000. That move alone pushed Interface’s EPS upward by $0.01, when the company had been only $0.02 from meeting market earnings expectations. 

Bonus accruals were another go-to move for Bauer and Lynch. In one quarter, Interface’s performance metrics and cash flow projections suggested that the company should have accrued $1.67 million for management bonuses. (Clearly the carpet business was good that year.) Instead, Bauer accrued only $100,000 — which allowed the $1.57 million difference to drop into the net income number. In another quarter, he and Lynch improperly reduced the bonus accrual by $500,00. 

So what were the specific internal control failures? No requirement for supporting evidence to justify a management adjustment.

As the SEC said in its order: 

Interface did not require, for example, corporate level accounting entries to have supporting documentation, and corporate finance staff regularly recorded manual adjustments with nothing more than an email or oral directive. In addition, Bauer’s direct reports did not analyze or consider the propriety of the entries he directed, and Interface’s Internal Audit function did not perform procedures sufficient to ensure adjustments directed by Lynch and Bauer had support and complied with GAAP.

We’ve talked about the perils of management estimates before; they are a recurring theme in SEC enforcement actions involving poor internal control. Internal control systems should require supporting documentation for any estimate, including those pushed by senior management. Moreover, your internal control system should include a single repository of data to make it harder for others to doctor or fabricate evidence — which was another allegation against Interface, but we have only so many hours in the day to dwell on this case. 

Final result: Interface pays a $5 million penalty; Lynch pays a $70,000 penalty and is barred from appearing before the SEC for one year; Bauer pays a $45,000 penalty and is barred for three years.

More Internal Control Violations

In the other enforcement action, the SEC said Fulton Financial Corp. tinkered with the valuation of financial assets known as “mortgage servicing rights” (MSRs) in 2016 and 2017. Those MSR assets were worth roughly $38.2 million at the time. As part of Fulton’s financial reporting, every quarter the firm tested the assets for impairment, and booked a valuation allowance equal to whatever that impairment might be. For example, in Q2 2016, that valuation allowance was $1.7 million; in the third quarter, Fulton increased that allowance to $3 million. 

Key detail: that valuation allowance is established as a charge against earnings. So if Fulton wanted to manipulate earnings, manipulating the valuation allowance would be one way to do it.

What’s interesting here is that those MSR assets actually were never in any danger of impairment. Interest rates were rising at the time, so Fulton didn’t need that valuation allowance at all. 

So what went wrong? Fulton had been using an outside specialist to provide estimates for MSR assets and the valuation assets for several years. At the end of 2016 and into early 2017, Fulton changed how it worked with that outside specialist

The details are too obscure to matter here, but suffice to say: the specialist firm provided an interim report in November 2016 that would have allowed Fulton to reverse the entire valuation allowance right away. Instead, Fulton staff chit-chatted with the specialist firm over a period of time — long enough that while Fulton should have reversed the whole allowance amount in Q4 2016, Fulton didn’t recognize $1.3 million of that reversal until Q2 2017. Which pushed up EPS for that quarter, when those earnings should have been recognized earlier.

Fulton had no clear, consistent policy for how to deal with its valuation specialist; that was the internal control failure. Moreover, Fulton didn’t disclose to investors that it deviated from its typical practices with the specialist. And once more for emphasis: typical practices are not internal controls. They’re just habits you have, subject to change. 

Final result: Fulton receives a $1.5 million penalty.

About the SEC’s EPS Initiative

The SEC was also quick to say that these enforcement actions were the first from the Division of Enforcement’s EPS Initiative, “which uses risk-based data analytics to uncover potential accounting and disclosure violations caused by, among other things, earnings management practices.” 

The SEC has a few data analytics programs running at the agency, with nifty acronyms such as NEAT, HAL, and ATLAS. Chairman Jay Clayton gave a speech last year outlining what some of these programs do

The EPS Initiative is new to me, but I suspect we’ll hear more from it in the future. It’s yet another reminder to financial compliance and internal audit functions that you need to improve your internal control testing and monitoring, as well as your data analytics capabilities — because if an agency as dysfunctional as the SEC can do this, there’s no excuse for you not doing it too. 

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