Friday, May 13, 2022

How Some Companies Cheat... All So They Don't Miss Estimates

By Herb Greenberg (View Archive)

Here's something that somehow fell through the holes of grabbing headlines, but shows just how desperate some companies are to 'make' their numbers...

It all has to do with something at quarter-end that was called "the art of the close" at Rollins (ROL), which owns the Orkin exterminating company.

And it's everything you hear about some companies that have a history of not missing earnings-per-share ("EPS") estimates – but nobody cares about – because it amounts to a mere penny or two.

This time, Rollins got caught, courtesy of a data analytics program the U.S. Securities and Exchange Commission ("SEC") says it uses to dig up "hard to detect" accounting and disclosure issues.

The SEC laid out the scheme in this lawsuit filed a few weeks ago against Rollins and its former chief financial officer, Paul Northen. Both the company and Northen settled, with Rollins paying $8 million and Northen paying $100,000.

The crazy part is – what Northen did is one of the most basic and least creative ways companies cheat on earnings. It's something that should be high on any analyst's checklist for earnings quality: reversing accounting reserves established against estimates of possible claims, such as bad debts... or in the case of Rollins, future termite damage after a house has been treated.

It's more commonly known as "cookie jar" accounting.

The suit says Northen did it twice...

And each time, he did it just enough to fill the gap by a few pennies – enough so the quarters wouldn't miss expectations.

Rather than me trying to regurgitate what happened and why, this is directly from the lawsuit...

  • On the morning of July 10, 2017, the fifth day of Rollins' six-day close process following the end of the quarter, Northen and other finance personnel received a flash report showing a preliminary EPS of $0.20, short of the consensus EPS estimates of $0.25.
  • The following day, July 11, 2017, was the sixth day when Northen would typically meet with Rollins finance personnel to finalize adjustments to corporate-level reserves. But Northen was out of the country on business, so instead of meeting with the other finance personnel in person, Northen corresponded with them by email to finalize the reserve account adjustments.
  • After making initial adjustments to corporate-level reserves, Northen emailed another Rollins finance employee: "I show a .237 [EPS] and thought that the [reserve account adjustments] would be a[n] [income] pickup of $2.7 [million]. What am I missing?" The Rollins finance employee responded that the adjustments resulted in "a[n] [income] pickup of $1 million," not $2.7 million as Northen had anticipated.
  • A few minutes later, Northen asked the finance employee "how the other [reserve account] accruals look." The finance employee advised Northen that "if [Northen] needed it," Rollins could "scrap up $300K [from] medical and $600K [from] bad debt" to increase Rollins' income. Northen directed that the medical and bad debt reserves be reduced by these amounts and further directed the finance employee to "update [the] spreadsheet with these two items."

Northen directed the reduction in the medical and bad debt reserves without adequately documenting the basis for their reductions and without consideration of any accounting criteria or guidance. The finance employee further provided an updated analysis which showed an increase in EPS to $0.2427 (or $.24 rounded), which although an increase from the earlier $0.237, was still short of the consensus estimate of $0.25.

  • Northen also inquired whether the casualty reserve account was "ok" and whether there was "[a]nything else to take a look at" in the reserve accounts. The finance employee responded: "No, if you are trying to get to [$].25 [consensus EPS] for the qtr it will take about $1.2 million," and asked Northen to "[p]lease advise if you want to" reduce the casualty reserve account by $1.2 million.
  • Shortly thereafter on the same day, July 11, Northen directed a $1 million reduction in the casualty reserve account, which increased Rollins' income. The adjustment was contrary to an initial recommendation that Northen received from Rollins risk personnel, who advised that no adjustment to the casualty reserve account should be made in the second quarter of 2017 and that the need for any adjustments would be "more apparent" in the third quarter or fourth quarter of 2017.

Later on the same day, and prior to the entry of the adjustment, Rollins risk personnel agreed with the reduction. After the casualty reserve adjustment, Rollins further made a termite reserve adjustment based on an amount provided by Northen.

  • The reductions to the bad debt, medical, casualty, and termite reserves were among the very last accounting adjustments made during the quarterly close process. Following these adjustments, Rollins finance personnel sent Northen an updated calculation that showed that Rollins EPS was now at $0.2462 EPS, which rounded to $0.25.
  • As a result of these inadequately supported reserve adjustments, Rollins publicly reported in its Form 10-Q for the second quarter of 2017 and in its earnings release an EPS of $0.25. Without the reductions to the bad debt, medical, casualty, and termite reserves, Rollins would have reported EPS of $0.24, thereby missing consensus EPS estimates by one penny.

A penny here, a penny there...

Pretty soon, that adds up to real money – or with companies whose executives dip into the cookie jar, enough money to fool investors into thinking the company is doing better during any given quarter than it really is.

Pretty pathetic, if you ask me.

Have a great weekend, everybody. I'm taking a few weeks off from writing Empire Financial Daily essays... See you when I return!

As always, feel free to reach out via e-mail by clicking here. And if you're on Twitter, feel free to follow me there at @herbgreenberg. My DMs are open. I look forward to hearing from you.

Regards,

Herb Greenberg
May 13, 2022

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Herb Greenberg

Herb Greenberg is a senior editor at Empire Financial Research. Previously, he was the co-founder of Pacific Square Research and Greenberg Meritz Research & Analytics – both independent, short-biased investment research firms. Greenberg spent more than 40 years as a financial journalist at some of the country's leading newspapers, websites, and broadcast media, where he covered almost every industry. He served as senior stocks commentator at CNBC and was financial correspondent at the Chicago Tribune. He also spent 10 years as the daily business columnist for the San Francisco Chronicle, during which time he started his five-year run as Fortune's monthly Against the Grain columnist and was the morning business reporter for San Francisco's KRON-TV. When the Internet and online media were still emerging, Greenberg was one of the first mainstream journalists to make the shift online, when he became senior columnist at TheStreet. He later shifted to the same role at MarketWatch. When Dow Jones bought out MarketWatch, he added a weekend investor column for the Wall Street Journal to the mix. Earlier in his career, Greenberg was a reporter at Crain's Chicago Business and a business reporter for the St. Paul Pioneer Press. He also spent a year as an analyst at a risk arbitrage firm. Greenberg holds a bachelor's degree in journalism from the University of Miami and completed the Herbert J. Davenport Fellowship at the University of Missouri.

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