Federal regulators are investigating the case of the missing “4,” exploring the numeral’s conspicuous absence in quarterly reports that could mean companies have improperly rounded up their earnings per share to the next highest cent.
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The Securities and Exchange Commission is investigating whether companies have engaged in improper rounding up of quarterly earnings, people familiar with the matter said. SEC enforcement officials have sent queries to at least 10 companies, asking the firms to provide information about accounting adjustments that could push earnings per share results higher, one person familiar with the matter said.
The queries follow the release of an academic paper that found evidence of companies nudging up earnings results. The academic research found the number “4” appeared at an abnormally low rate in the tenths place of companies’ earnings per share. Reporting that figure as “5” or higher allows a firm to round up its earnings per share another cent.
For instance, a company with earnings of 55.4 cents a share would round to 55 cents a share, while a company with earnings of 55.5 cents per share would round to 56 cents.
Public companies have strong incentives to report higher earnings per share, particularly those followed by Wall Street analysts whose quarterly forecasts are used to benchmark corporate performance. Investors often snap up shares of companies that beat expectations, even by a cent, and, likewise, sell shares of firms that miss their forecast.
The names of the companies that received the SEC’s demand couldn’t be learned. The SEC didn’t immediately respond to a request for comment.
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The investigation is in its early stages, one of the people said. Accounting rules offer some discretion for when managers recognize revenue or expenses, so quarterly adjustments can be legal even when they boost reported earnings per share.
The researchers, Nadya Malenko and Joseph Grundfest, referred to the dynamic they detected as “quadrophobia.” The paper was widely read within the SEC, one of the people said.
The SEC has for several years sought to bring more cases over accounting fraud. Probes involving financial reporting previously had taken a back seat to investigations over complex financial instruments and insider trading after the 2008 financial crisis.
In 2012, the SEC announced it had developed an “accounting quality model” that could scan companies’ financial statements for anomalies that might indicate fraud.
SEC economists replicated aspects of Dr. Malenko’s and Mr. Grundfest’s study and found similar results — cases where the digit “4” rarely appeared over a large number of accounting quarters, one person said.
Dr. Malenko’s and Mr. Grundfest’s paper, which hasn’t appeared in an academic journal and was last updated in 2014, showed that companies with signs of strategic rounding over many quarters were more likely to be charged with accounting violations, restate earnings, or become targets of shareholder lawsuits.
“The rounding itself might not be fraud, but it signals a certain aggressive approach to accounting practices,” said Dr. Malenko, a finance professor at Boston College. “It can predict more serious accounting violations.”
