The Securities and Exchange Commission has fined a Pennsylvania healthcare services firm $6 million for poor internal controls that allowed the company to keep looming lawsuit costs out of the financial statements, which in turn helped the company to meet Wall Street earnings expectations.
The firm in question is Healthcare Services Group ($HCSG), which provides housekeeping, laundry, dining, and other services to healthcare facilities around the United States. The SEC charged the company with failing to accrue for and disclose costs related to wage and hour litigation that employees had filed against HCSG in the early 2010s.
That’s a no-no under U.S. Generally Accepted Accounting Principles, which say that public companies must set aside funds to cover loss contingencies such as pending litigation, once the company has a good sense of how likely and how soon those costs might come due. The accruals also need to be disclosed in the quarterly financial statements.
In this case, according to the SEC, HCSG chief financial officer John Shea knew about the pending litigation settlements and their likely costs. He then failed to include those estimates in the contingencies line item, which allowed HCSG to report earnings per share that met analysts’ EPS estimates — including at least one instance of record-high EPS numbers.
HCSG and Shea neither admit nor deny the SEC’s findings, but did agree to cease-and-desist orders against future violations. The company agreed to pay a $6 million penalty (against $1.76 billion in revenue and $98.7 million in net income in 2020). Shea agreed to a $50,000 and a two-year suspension from appearing before the SEC. According to a company press release, he also has been re-assigned to chief administrative officer at HCGS.
We don’t see many accounting enforcement actions that hinge on loss contingencies, although weak internal controls for such disclosures are certainly one way that financial executives can manipulate earnings. So let’s look at the settlement order and see what controls were not working well.
Contingency Costs You Could See Coming
HCSG was facing a wave of wage-and-hour lawsuits from current and former employees in 2013. Five class-action lawsuits had been filed in the state of California, and by the end of that year the company had already settled two of them for $6 million.
At the start of 2014, HCSG wanted to settle the remaining three California lawsuits. The company had proposed a settlement to plaintiffs where HCSG would pay roughly $2.5 million to $3 million. Even more important for our story today, CFO Shea was involved in those settlement talks. He had participated in mediation talks along with HCSG lawyers, and “at all times, Shea was aware of the proposed settlement amount and the submission of the settlement agreement to the court for preliminary approval,” according to the SEC.
HCSG, however, did not accrue any monies for that looming settlement — even though the costs were “both probable and reasonably estimable,” which is the standard for disclosure under ASC 450, the accounting standard for reporting loss contingencies. Instead, in the company’s 10-Q filing for that period, HCSG only gave the usual vague boilerplate:
We are also subject to various claims and legal actions in the ordinary course of business. Some of these matters include payroll and employee-related matters and examinations by governmental agencies. As we become aware of such claims and legal actions, we provide accruals if the exposures are probable and estimable. If an adverse outcome of such claims and legal actions is reasonably possible, we assess materiality and provide such financial disclosure, as appropriate.
That disclosure wasn’t accurate. The company was aware of such claims, and the exposures were probable and estimable. Still, no accruals and disclosures were made. That happened in the first quarter of 2014.
Over the next two quarters, HCSG continued to play a shell game with its loss contingency. The company didn’t report the $2.5 million in Q2, when that would have led the company to miss consensus estimates on EPS, even though by that period the company had already won preliminary approval of its settlement.
Instead, HCSG disclosed the contingency in Q3, when it was already reporting terrible numbers — a net loss of $0.31 per share — due to various non-recurring charges. So basically, HCGS stalling on reporting its loss contingency until a bad quarter was coming along anyway, and then buried those costs in the larger pile of stink passing for a 10-Q.
HCSG and Shea ran a similar play the following year with another litigation settlement. This was a federal case under the Fair Labor Standards Act, and by June 2015 the company had agreed that it would settle for $8 million, with half that amount paid in company stock.
Once again, Shea was directly involved with the settlement talks. The company had accrued $4 million already, but that was for prior litigation costs — not the $4 million in cash that would come due from the June 2015 settlement. The company didn’t accrue any cash for that contingency.
Only at the end of 2015, when the settlement received final approval, did HCGS record a $6.6 million charge to cover its liability. Which had allowed HCGS to goose EPS all year long.
Control Issues Around Contingencies
The big weakness that I see here is documentation. There wasn’t any. Shea performed no analysis to justify why HCGS didn’t need to accrue for the lawsuit contingency (presumably because nobody could justify such a preposterous judgment) and nobody followed up to ask why. Not others on the accounting team, not the board’s audit committee, and not the external audit firm. (For the record, the audit firm was Grant Thornton.) We can’t even really say this is an example of management improperly overriding internal controls, because there weren’t sufficient internal controls in the first place.
HCSG did have a Disclosure Control Committee that met each quarter to assure that adequate disclosure controls and procedures existed, but the committee’s procedures were insufficient to identify and fix material inaccuracies in HCSG’s financial statements — especially relating to the accounting for and disclosure of litigation loss contingencies.
There were simply too many opportunities for manual adjustments to accounting items, with too much management discretion and too little documentation. Ain’t it funny how that issue keeps cropping up?