Diversity & Inclusion
The U.S. Securities and Exchange Commission (SEC or Commission) has announced plans to reinvigorate its enforcement efforts with respect to accounting issues. These plans include adding dedicated personnel and using data mining capabilities to identify suspicious activity and build cases against suspected wrongdoers.
Following a wave of tips to the SEC’s whistleblower office alleging financial reporting misconduct in the past year, this renewed effort by the SEC likely will lead to an increase in the number of accounting investigations and subsequent enforcement actions against issuers and corporate officers, directors and employees. This shift in enforcement attention is of significant moment for all public companies and their management. Set forth below is an overview of the background and nature of the new initiative, and guidance regarding steps that companies can take now to attempt to minimize the risk of enhanced scrutiny of their financial results and to be prepared to address any questions raised by the SEC.
A decade ago, blockbuster accounting and disclosure fraud cases, including actions involving public companies such as Enron, WorldCom, Adelphia, and HealthSouth, commanded public attention and defined the public face of the SEC. These cases constituted between 24 percent and 33 percent of all enforcement actions filed by the agency in fiscal years 2003 to 2007. However, in the wake of the global financial crisis, accounting cases receded as an enforcement priority, and resources and attention shifted to other areas. In the reorganization of the Division of Enforcement in 2010, the division’s task force dedicated to investigating accounting matters was quietly disbanded. A sharp decline in the proportion of accounting-related enforcement actions by the SEC followed, with such cases representing only 11 percent of SEC enforcement actions in fiscal year 2012.1
New SEC Chair Mary Jo White appears eager to renew the pursuit of accounting cases.2 On July 2, 2013, the SEC announced the formation of a Financial Reporting and Audit Task Force (the Task Force) dedicated to detecting fraudulent or improper financial reporting.3 The Task Force will reportedly concentrate on expanding and strengthening the Division of Enforcement’s efforts to identify securities law violations relating to the preparation of financial statements, issuer reporting and disclosure, and audit failures. In an apparent departure from the “specialty group” model created as part of the 2010 reorganization of the division, the co-director of the Enforcement Division, Andrew Ceresney, described the Task Force of about eight attorneys and accountants as an “incubator” to develop potential accounting cases, which would be handed over to larger units for full investigations.4
According to the SEC announcement, the Task Force will focus on identifying and exploring areas susceptible to improper financial reporting. The Task Force is expected to identify issues by reviewing financial statement restatements and revisions, analyzing performance trends by industry and using technology-based tools, such as a newly developed accounting quality model. It will include enforcement attorneys and accountants from across the country, working in close consultation with the division’s Office of the Chief Accountant, the SEC’s Office of the Chief Accountant, the Division of Corporation Finance, and the Division of Economic and Risk Analysis.
More than a year ago, the director of the Commission’s Division of Risk, Strategy and Financial Innovation commented on efforts to develop an analytic accounting quality model to assist in identifying companies that may be engaged in earnings management by scouring companies’ SEC filings for a variety of risk factors.5 Although such analytic efforts are not new in the world of academic finance, the SEC staff acknowledged that such models generally had not been perceived to be reliable identifiers of earnings management. Nevertheless, the SEC staff believed that by drawing on the experience of personnel throughout the Commission, and considering criteria that it considered “risk indicators” (e.g., significant off balance sheet transactions, disputes with independent auditors, particular accounting policy choices) and “risk inducers” (e.g., declining market share or margins inferior to peer firms), it could develop a program to automate the identification of higher risk companies that might be candidates for closer scrutiny.
Although the precise parameters employed by the accounting quality model are not public, and the reliability of its output untested, it appears to have captured the interest of the SEC’s Enforcement Division. David Woodcock, the newly appointed chairman of the Task Force, noted the reduced cost and increased power of electronic data analysis in describing it as a tool the Task Force will use, and pledged to work with the Commission’s analytic staff on data mining efforts.
In that regard, another new resource in the SEC’s new effort to detect accounting irregularities is the deployment of software that analyzes the management’s discussion and analysis (MD&A) section of periodic reports. According to SEC officials, certain word choices made by companies in their analysis of the companies’ performance may reveal warning signs of earnings manipulation.6 The SEC staff has suggested that companies engaged in misconduct may tend to overuse certain words and phrases that are associated with benign activities and under-disclose risks prevalent among their peers. Preliminary tests of the new software’s ability to detect potential accounting irregularities by flagging suspect word or phrase choices reportedly have been positive. SEC officials have stated that, if the word-analysis software proves effective in tests, it will be added to the accounting quality model.
In addition to the SEC’s new internal resources, the Enforcement Division is receiving a significant number of accounting-related tips through its whistleblower reporting program. In fiscal year 2012, the SEC received 547 claims alleging financial reporting misconduct.7 This was the biggest single category of tips under the SEC’s whistleblower program, representing 18 percent of all complaints received. This flow of tips likely will continue in the coming year, given the significant financial incentives for whistleblowers to report issues, and the most actionable tips will then be investigated by the new Task Force.
It is expected that the new Task Force’s investigations will focus on common problem areas that have been the subject of enforcement action in the accounting arena over the years: revenue recognition, valuation, capitalized versus non-capitalized expenses, reserves, acquisition accounting and the use of non-GAAP performance benchmarks. Recent statements by SEC officials provide some guidance regarding how they view these issues and specific areas of likely enforcement activity.
Although it is difficult to prepare fully for the intense scrutiny of an SEC enforcement investigation, there are some steps that companies can take in advance to minimize the risk of enhanced SEC scrutiny of their financials, or at least be prepared to address any questions the SEC may raise.
2 Jean Eaglesham, Accounting Fraud Targeted, WALL ST. J., May 27, 2013, http://online.wsj.com/article/SB10001424127887324125504578509241215284044.html; Joshua Gallu, SEC to Move Past Financial Crisis Cases Under Chairman White, Bloomberg.com, Apr. 18, 2013, http://www.bloomberg.com/news/2013-04-18/sec-to-move-past-financial-crisis-cases-under-new-chairman-white.html.
3 Press Release, U.S. Sec. & Exch. Comm’n, SEC Announces Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis, Rel. No. 2013-121 (July 2, 2013).
4 Emily Chasan, New Fraud Crackdown Looms, Wall St. J., July 9, 2013, http://blogs.wsj.com/cfo/2013/07/09/new-fraud-crackdown-looms/.
5 Craig M. Lewis, Chief Economist and Dir., Div. of Risk, Strategy, and Fin. Innovation, SEC, Speech to Financial Executives International Committee on Finance and Information Technology: Risk Modeling at the SEC: The Accounting Quality Model (Dec. 13, 2012).
6 Eaglesham, supra note 2.
7 U.S. Sec. & Exch. Comm’n, Annual Report on the Dodd-Frank Whistleblower Program – Fiscal Year 2012, published November 2012.
8 Sarah Frier, IBM Defends Cloud-Computing Accounting Amid SEC Probe, Bloomberg.com, (July 31, 2013), http://www.bloomberg.com/news/2013-07-31/ibm-says-sec-investigating-its-cloud-computing-revenue-figures.html.
9 Emily Chasan, SEC Seeks More Goodwill Disclosure, Wall St. J., Dec. 4, 2012, http://blogs.wsj.com/cfo/2012/12/04/sec-seeks-more-goodwill-disclosure/.
10 Lewis, supra note 5.
11 Francine McKenna, Where Should SEC Start a Fraud Crackdown? Maybe Look at Fake Restatements, Forbes, June 18, 2013, http://www.forbes.com/sites/francinemckenna/2013/06/18/where-should-sec-start-a-fraud-crack-down-maybe-look-at-fake-restatements/.
12 Kathleen Hoffelder, Restatements by Accelerated Filers Shoot Up, CFO.com, March 13, 2013, http://www3.cfo.com/article/2013/3/auditing_pcaob-audit-analytics-accelerated-filers-.
14 Press Release, U.S. Sec. & Exch. Comm’n, SEC Charges Former Vice President of Investor Relations With Violating Fair Disclosure Rules, Rel. No. 2013-174 (Sept. 6, 2013).
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