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SEC to Employ Risk Modeling for its Accounting Investigations

The number of corporate accounting enforcement actions at the Securities and Exchange Commission (SEC) dropped to its lowest level in a decade, with only 79 financial fraud/issuer disclosure cases filed in 2012, the most recent fiscal year, but the S.E.C. prospectively intends to be more proactive by using risk modeling to analyze corporate filings to identify companies that might be outliers in reporting their results. 

In a speech in December, Craig M. Lewis, director of the SEC’s Division of Risk, Strategy, and Financial Innovation discussed a new “accounting quality model” that could help the S.E.C. “assess the degree to which registrants’ financial statements appear anomalous.” 

This analysis will even look at the wording in financial reports about the company’s results and future prospects, which usually appears under the heading “management discussion and analysis.”  Of course, no one ever admits to engaging in accounting shenanigans, but the kind of notoriously opaque statements used by Enron can give a clue about possible violations lurking inside a company’s books. 

The challenge for the S.E.C. is that accounting fraud cases have never been “sexy” by any stretch of the imagination. Financial misstatements do not simply happen overnight, unlike insider trading that usually takes place within a narrow time frame before the information hits the market. 

Developing evidence of violations means digging through years’ worth of complex financial records and trying to reconcile whether a company properly reported its results under the accounting rules.  The resources that must be committed to building a case are much greater than in other types of investigations, which often do not require the kind of expertise that accounting fraud does. 

Add to that the problem of proving there actually was a violation when the accounting rules – called generally accepted accounting principles, or GAAP – can be maddeningly vague.  That can give corporate management a basis to claim the company acted in good faith, even if it might have been overly aggressive. 

In an accounting fraud prosecution in California involving a high-tech company, the United States Court of Appeals for the Ninth Circuit overturned the conviction of the company’s chief financial officer because the government could not prove that aggressive accounting in recognizing revenue violated GAAP.  The appeals court said the government’s evidence about how he tried to meet sales targets showed he was just “doing his job diligently.” 

Outside auditors are usually loath to admit that anything improper happened because it could expose the firm to potentially significant liability.  Thus, in accounting investigations the S.E.C. has to overcome the “circling the wagons” approach of management and the accountants that can lead to a fight at every turn, stretching out a case. 

In 2002, the accounting scandals at Enron and WorldCom galvanized support for the Sarbanes-Oxley Act, which required companies to institute stronger internal controls and strengthened the hand of outside auditors to require compliance with accounting standards.  That has made it more difficult for companies to engage in the kind of brazen violations that came to light a decade ago. 

Thus, if the S.E.C. wants to return its focus to accounting fraud, it will need a long-term commitment to developing cases because the violations are unlikely to be quite as spectacular as those seen a decade ago.  Investigations may not produce results for a few years, and some inquiries will end without any enforcement action being taken. 
Putting resources into accounting cases may be a problem in the current environment, with Congress cutting budgets and questioning whether the S.E.C. is being too aggressive in how it regulates businesses.  Greater scrutiny of corporate financial disclosures is sure to ruffle more than a few feathers in executive suites, and those complaints have a way of showing up on Capitol Hill. 

Yet, this is the time to make the push to scrutinize financial statements for potential fraud and not just sit back and wait until a corporate accounting scandal comes to light. 

Accounting fraud usually starts small, as a company tries to meet earnings and revenue projections, so managers may fudge the numbers a little bit in the hope that the next quarter will let them make up for any questionable entries in the books.  What begins with cutting a few corners takes on a life of its own as the next quarter is never quite enough to correct the imbalance. 

Warren Buffet famously said, “You never know who’s swimming naked until the tide goes out.”  With widespread reports that the economy is improving, the financial tide is rising, which means some companies may be doffing bathing suits to make sure their results look good.  

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