How is the Securities and Exchange Commission combating financial statement fraud?

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Financial statement fraud cases initiated by the SEC accounted for more than 25 percent of the total civil enforcement actions between 2003 and 2005. But in 2012, accounting fraud cases made up just 11 percent of SEC enforcement actions. Beginning in 2013, the SEC began to revamp its focus from the issues caused by the financial crisis of 2007/2008 to the issues of financial statement and accounting transaction frauds.

An outcome of the major accounting frauds perpetrated by Enron, Tyco and WorldCom was the Sarbanes-Oxley Act that passed in 2002. This legislation set standards for all U.S. publicly traded company’s boards, management and public accounting firms to follow regarding the accuracy of the financial statements they distribute to end users. All members of a company’s senior management must certify the accuracy of financial information released. The Securities and Exchange Commission (SEC) is charged with implementing the rules set by Sarbanes-Oxley. .

When looked at more closely you can see that the major reason for the decline in accounting fraud cases was that the SEC was concentrating on the rampant fraud happening in the financial markets regarding mortgages and mortgage backed derivatives. The SEC focused on cases involving insider trading, Ponzi schemes and other financial market based issues. The SEC was not able to focus as much on financial reporting fraud but now that the financial crisis of the mid -2000’s caused by the collapse of the sub-prime mortgage industry and the US government bailout of financial institutions has corrected itself somewhat, the SEC can once again turn to these issues.

In April, 2013, the SEC’s new Chairman was sworn into office. Mary Jo White is a former United States Attorney for the Southern District of New York and in several speeches she gave soon after starting at the SEC she emphasized the importance of a strong Enforcement Division. “The SEC is a law-enforcement agency. You have to be tough. You have to try to send as strong a message as you can, across as broad a swath of the market as you regulate.” (Hutchens and Noonan 1) In a speech to the American Law Institute in September, Andrew Ceresney, Co-Director of the SEC Division of Enforcement, admitted that the agency temporarily shifted its focus to reining in fraud in the financial markets, related to misleading information about investments such as subprime loans and mortgage bonds. (Huskins) Now that the financial crisis seems to be under control, the SEC is promising to renew its focus on accounting fraud and will monitor corporation to ensure that there are effective controls in place to find and decrease the instances of fraud.

The SEC’s Enforcement Division has recently updated its priorities include all violations, big and small and not just the security based violations they have been concentrating on in recent years. Chair White indicated in a speech made on October 9, 2013 to the Securities Enforcement Forum, the SEC will be using a strategy called “Broken Windows” that states if a window is broken and no one fixes it then it shows that violations will be accepted and breaking another will cost nothing. By fixing the window right away you show others that things like this will not be tolerated. Chair White further stated that even minor violations that are overlooked or ignored create a culture where laws and regulation will be disregarded. With this new guideline even the smallest infraction will be looked at.

The SEC has created a new group called the Financial Reporting and Audit Task Force. They will focus on detecting fraudulent or improper financial reporting. In 2013, the SEC only brought 68 enforcement actions having to do with financial statement or disclosure fraud which was the 6th year the number of actions brought declined. In 2007 there were 219 cases of this nature filed. Ceresney, Co-Director of the Enforcement Division has indicated that the incentives are still close at hand to allow for manipulation of financial statements. (Hutchens and Noonan 3) Also, he believes that the additional controls that have been instituted over the years to deter financial fraud are not always effective at finding fraud.

Another task force recently established is the Center for Risk and Quantitative Analytics. This task force will use quantitative data and analysis to profile high-risk behaviors and transactions and proactively identifying potential fraud. (Hutchens and Noonan 3) This team will develop methodologies to identify financial fraud, including new Accounting Quality Model. The Accounting Quality Model takes advantage of the SEC's ability to mine its own data. (Huskins) It is designed to "provide a set of quantitative analytics" which will allow the SEC to compare filings to a firms past filings and to the filings of its peers to determine if there are red flags. Red flags that the Accounting Quality Model may look for include: conflicts with or changes in auditors, filing delays, auditor independence violations, off-balance sheet transactions, and/or write-offs for goodwill impairment.

The SEC will be using its past experience and review what it feels are “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 and use the data from the Accounting Quality Model as well as other types of data mining to identify higher risk companies that might be candidates for close scrutiny. (Skadden 4)

Corporations can expect the new Financial Reporting and Audit Task Force to investigate areas that have been the focus if the Enforcement Division in the past such as, revenue recognition, valuation, capitalized versus non-capitalized expenses, reserves, acquisition accounting as well as revised financial statement information.

The SEC has also committed to better detection of accounting irregularities in the management’s discussion and analysis section of reports submitted to them. New software being developed will have the capability of analyzing vast amounts of text data (Skadden 2). There are certain word choices made by companies in the analysis sections of financial statements that may uncover warning signs of earnings manipulation. The SEC staff has suggested that companies engaged in misconduct may tend to overuse certain words and under-disclose risks prevalent among their peers. (Skadden 2)

Another area of focus will be on the conduct of individuals and charging more individuals as well as the corporation as a whole. Mary Jo White, Chair of the SEC has recently stated that the SEC would pursue charges against individuals “wherever possible,” rather than charging companies. The instructions to staff (as a “subtle shift”) are to look first at misconduct at the individual level, “working out to the entity, rather than starting with the entity as a whole and working in.” (Carangelo and Garcia 6)

Usually when investigations are begun, the focus on the individuals closest to the wrongdoing and then work out and up the chain to establish who else should be charged, as well as if the corporation should be charged. A company is the work of its employees if there is misconduct or fraud it is only reasonable that the responsible individuals be charged – as far up in management of the corporation as is needed. .

Andrew Ceresney (September 19, 2013) in a speech given at the American Law Institute Continuing Legal Education in Washington, D.C. stated “The importance of pursuing financial fraud cannot be overstated. Comprehensive, accurate and reliable financial reporting is the bedrock upon which our markets are based because false financial information saps investor confidence and erodes the integrity of the markets.” The time is right for the SEC to refocus on financial statement and accounting transaction frauds. They only have to look back at the crisis caused due the fraud perpetrated by Enron, Tyco and others. If the irregularities had been found and stopped early, things may have turned out differently. The priorities that SEC has re-focused their attention will expose even the smaller cases of fraud before they become so large that they affect the overall financial health of the country and we cannot afford another crisis on the scale of the past few years.