Making Accounting Enforcement a Priority: The Case for an SEC Financial Accounting Fraud Specialized Unit

Martin S. Wilczynski is a senior managing director in the FTI Consulting Forensic and Litigation segment and is the leader of FTI Consulting’s Forensic Accounting and Advisory Services practice. 

On January 13, 2010, Rob Khuzami, who was at that time the Director of the Securities and Exchange Commission’s Division of Enforcement, announced the names of the chiefs for the SEC’s newly established national specialized units. 

Martin S. Wilczynski, FTI Consulting

The announcement covered the leadership for the five priority areas established by the SEC: Asset Management, Market Abuse, Structured and New Products, Foreign Corrupt Practices, and Municipal Securities and Public Pensions.  Conspicuously absent was any specialty unit relating to financial accounting and disclosure fraud – an area that had been one of the largest and most prominent areas of focus for the SEC enforcement staff in the ten years leading up to the restructuring. 

Even more surprising, also during 2010, the SEC’s “Financial Fraud Task Force,” established in May, 2000 by the SEC in an effort to improve “the quality of our financial reporting system,” was disbanded.  Its termination flatly ended what had been by any measure an effective initiative.  During its operation, the Task Force coupled SEC Enforcement Division accounting staff with legal resources dedicated to improving financial accounting and disclosure and combating fraud.  The rationale offered for the disbandment was that accounting fraud was the specialty of the entire staff, and not just one group. In any event, whether as a result of the shifting Enforcement Division priorities, or the result of Sarbanes-Oxley or other reasons, accounting fraud cases brought by the SEC have continued to dwindle.  During the SEC’s fiscal 2012 year, a mere 94 financial fraud matters were brought by Enforcement, the fifth straight year of decline for this important category. 

Has accounting, reporting and disclosure fraud simply disappeared? The answer is almost certainly “no.”  So what are the reasons for the continuing decline in accounting enforcement matters being pursued by the SEC?  And what, if anything, should be done to make this area a priority once again? 

Monitoring, Enhancing and Enforcing Accounting Accuracy

The SEC has had longstanding statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. It is a critically important responsibility. Historically, the Commission has relied on the private sector for this standard-setting function. Promoting and enforcing the reliability and consistency of generally accepted accounting principles has always been a top priority and cornerstone of the SEC’s mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

Accordingly – principally through its Division of Corporation Finance – the SEC actively works to ensure that investors are provided with accurate accounting and disclosure information in order to make informed investment decisions. With a staff in excess of 500 employees, the Division of Corporation Finance remains a focal point in the SEC’s efforts to safeguard the propriety of financial and accounting information in the markets. The historically significant resources that are dedicated to this area reinforce what has always been true: that accurate accounting and disclosure information will always be a critical component of the mix of information that investors rely upon.

Corporation Finance monitors registrants’ compliance with reporting requirements, concentrating its review resources on disclosures that appear to be inconsistent with Commission rules or applicable accounting standards, or that appear to be materially deficient in their rationale or in clarity. When perceived accounting errors or potential non-compliance with the securities laws are suspected, the Division of Corporation Finance may, at its discretion, refer the matters to the Enforcement Division.

In addition to Corporation Finance referrals, however, the Enforcement Division also gathers leads on accounting improprieties from a wide number of other sources, including whistleblowers, exchange referrals, short sellers, self-disclosure by registrants and a variety of other places.  For example, one of the largest and most widespread Enforcement Division crackdowns in history – the stock option backdating scandal – arose in 2005 as a response to a Wall Street Journal article covering academic research performed by Erik Lie, a University of Iowa finance professor.[1]  Lie’s research study called attention to a significant number of cases where companies granted stock options to executives just before increases in the registrants’ stock prices.  While the practice of backdating, which involved accounting, disclosure and tax issues, was not necessarily illegal, the improper accounting for such grants was.  After the Lie research called out the anomalous patterns, the SEC began a series of investigations.  What followed was a spike in restatements and numerous accounting cases against companies and individuals.

While unusual because of the sheer number of companies that were affected by this ostensibly simple accounting application, the stock option backdating issue was just one more instance in a long line of accounting cases that the SEC has dealt with since its inception. The backdating issue was also significant for another reason – it fueled a period of activity that culminated with the crest of the SEC’s accounting enforcement caseload in 2007, when 219 accounting and financial fraud matters were brought.  Since then, this statistic has dropped in a steady and consistent fashion. But what are the reasons for the decline?

The Numbers Game

The perfect storm of problematic accounting and auditing conduct may have been foretold on September 28, 1998, at the 1998 NYU Center for Law and Business.  Arthur Levitt, then Chairman of the SEC, delivered what turned out to be a landmark speech entitled “The Numbers Game.”[2]  Prescient in its accuracy, Levitt’s concerns were validated in the years immediately following the speech when a series of high profile accounting matters – Enron, WorldCom, Cendant, Sunbeam, Adelphia, Waste Management and a host of others – erupted and exposed the risks hidden within registrants’ shady and misstated financial statements, and certain audit failures relating to the matters.  

For its part, the SEC’s Divisions of Corporation Finance and Enforcement — as well as its Enforcement accounting staff — were particularly effective during this historic period. Teams of Enforcement Division attorneys and accountants rigorously pursued the cases.  Many cases were also well-coordinated with Department of Justice criminal authorities.  Although the matters were, for the most part, highly complex and time consuming, the results were impressive. For the period from 1998 to 2007, the numbers of financial fraud and issuer disclosure accounting matters brought were as follows:[3]

The significance of matters relating to accounting fraud during this timeframe were also highlighted in the COSO study “Fraudulent Financial Reporting: 1998 – 2007; An Analysis of U.S. Public Companies.”[4]  The study references 347 alleged cases of public company fraudulent financial reporting from 1998 to 2007, with the dollar magnitude growing to a total cumulative misstatement or misappropriation of nearly $120 billion across the 300 fraud cases with available information. 

The fraudulent activity cited in the COSO report was covered by 1,335 individual Accounting and Auditing Enforcement Releases (“AAER”), with 1,013 of the AAER’s relating directly to fraud, while 322 others described non-fraud allegations relating to the fraud companies.[5]  In the world of accounting fraud, business was clearly booming. 

Restatements of Financial Reports

The sharp increase in accounting cases brought by the SEC corresponded with a similar pattern of increases in accounting restatements. Restatement activity spiked during the period, driven by a variety of reporting issues ranging from fraud to stock option backdating issues.  According to research performed by Audit Analytics in a 2011 analysis of Financial Restatements, the restatement activity between 2001 and 2007 peaked in 2006, when nearly 1,800 restatements were filed.[6]

Sarbanes-Oxley Implementation and Effects on Restatement Activity

As a response to the historically significant accounting and auditing failures – and the resultant public outrage that followed — legislation was pursued and the Sarbanes Oxley bill was passed in 2002. While significant in scope and costly to implement, the legislation required significant corporate attention to internal control structure and monitoring, “tone at the top” expectations and management responsibility for the integrity of the accounting information contained in publicly disseminated information.

In the years following Sarbanes Oxley, improvements in financial reporting were apparent.  The most frequently cited measurement – restatements – continued to increase in the years immediately following passage, but then reflected a decline after the 2006 stock option backdating era peak.[7] 

The trends in restatement activity are not without certain caveats, however.  In 2004, in the wake of Sarbanes-Oxley reforms, the SEC expanded the Form 8-K disclosures to include, as a reportable event, any instance in which a conclusion is reached that a past financial statement should no longer be relied upon.  These rules required a report to be filed on Form 8-K within four business days of the time that the conclusion was reached. In nearly all instances, this Form 8-K report is a precursor to the filing of restated financial statement information.

In practice, however, registrants sometimes determine that identified errors did not materially misstate prior year financial statements, but that those periods require restatement, or “revision” when presented for comparative purposes in subsequent periodic filings, to reflect the appropriate accounting treatment.  These instances differ from regular restatements in that the registrant will not file a Form 8-K to advise that existing financial statements should not be relied upon.  These situations are commonly referred to as “stealth” or “revision” restatements. 

In the 2011 Audit Analytics report on restatements, it was noted that “revision restatements” accounted for over 57% of the restatements, representing the highest percentage since 2005 of this measurement.[8] Critics of this practice have questioned whether the judgmental nature of these revisions is justified, or whether they are simply a less conspicuous way for registrants and auditors to correct errors in financial reporting.

Whatever the reason, the declines in restatement activity since 2006 have been impressive, as shown in the following chart:[9] 

The Numbers Game, Revisited

One indicator of the relative priorities of the SEC’s Enforcement Division is the annual summary presented by the SEC staff of activity for a given fiscal year.  These summaries are viewed – rightly or wrongly – as one measure of how busy and effective the Enforcement Division has been in any year.  It also provides some interesting perspective on Commission priorities. 

In recent years, references have been made to “record levels” of Enforcement Division activity that have been reported by the SEC staff.  Like all collections of statistics and data, however, the summaries have been dissected and debated by interested parties to evaluate the substance of the activity and to delve into whether the results were, in fact, “record levels.”[10]

The area of accounting enforcement appears to be one area in which there is little disagreement.  The numbers for the past several years have been declining in a consistent and remarkable fashion.  In fact, the most recent summary confirms that during fiscal year 2012, the SEC brought 94 financial fraud and disclosure matters, the same number as in fiscal 1999, the year following Levitt’s “Numbers Game” speech.[11] 

Although a convenient cause and effect may be assumed in which the trend of declines in restatements is used as an explanation for the corresponding decline in SEC accounting enforcement activity, a core question remains:  Has accounting fraud actually declined in a dramatic way, or has it simply become a less important priority of the regulators?  And importantly, if there was an accounting or financial fraud specialization unit, would the results be different? 

An Uptick in Activity 

The question regarding the priority of the accounting enforcement program appears to be increasingly relevant due to recent research and reports that have begun to suggest that it may be time to pay closer attention to financial reporting and fraud again. 

A March 2013 Cornerstone Research article – “Accounting Class Action Filings and Settlements” presents a wealth of interesting accounting-related litigation information.[12]  The report covers court-approved class action settlements reported during 2012, and concludes that accounting allegations played an important role in many of the settled actions.  In fact, the Cornerstone Research article pointed out that “[i]n 2012, the proportion of securities class action settlements involving accounting allegations increased to almost 70 percent from less than 50 percent in 2011.”  

The article goes on to state that “accounting cases continue to represent a substantial portion of the dollar value of all settlements.  While accounting cases represented less than 70 percent of the number of 2012 case settlements, they represented over 90 percent of the total value of settlements.”  

Finally, the Cornerstone article goes on to point out the correlation between SEC actions and settlements.  Specifically, it states that “accounting matters accompanied by derivative actions, SEC actions, and/or involving auditors as named defendants have settled for higher amounts than accounting cases not involving these factors.” 

A second Cornerstone report “Securities Class Action Settlements – 2012 Review and Analysis” also presents data covering declines in “the percentage of settled cases that involved a corresponding SEC action (evidenced by the filing of a litigation release or administrative proceeding) prior to the settlement of the class action.”[13]  A review of the statistics reflects that for years including 2003 through 2007, corresponding SEC actions were identified in over 25.5% of the settled actions.  From 2008 through 2012, the percentage declined nearly 5 percentage points, to 20.8% of settled actions. 

Recent technological innovations have also given the SEC additional ammunition to cull out and monitor potential accounting problems on a proactive basis.  Craig Lewis, who is the SEC’s Chief Economist and Director of the Division of Risk, Strategy and Financial Innovation (“RiskFin), has created the SEC’s Office of Quantitative Research, which is developing custom analytics to monitor various registrant metrics.  One of the more innovative applications being pursued is the “Accounting Quality Model,” designed to use analytics to identify registrants that may exhibit financial or reporting metrics that deviate from industry or competitor norms, or that may suggest accounting impropriety.  Used on a contemporaneous basis, these types of quantitative tools would make available a wealth of accounting information and could help to spot negative trends or potential accounting issues to evaluate, follow up and eradicate before significant reporting problems develop. 

Perhaps the most significant recent development, however, is the SEC’s own 2012 whistleblower program statistics from the Office of Market Intelligence.  According to the report, the most common tips received by the SEC during its most recent fiscal year are for corporate disclosures and financial fraud, at a startling 18.2% of whistleblower tips received.  Given the Dodd-Frank bounty rules that now incentivize the reporting of accounting fraud and securities rule violations – and based on the varied and widespread comments made by SEC Enforcement Division staff members regarding the “quality” of tips that have been received – it would seem to follow that investigation of financial accounting and corporate disclosures should be an area in need of focused and increasing attention.  

The Need for a Specialized Unit

From an accounting resources perspective, ramping up activity and investigations of potential financial fraud should not be a problem, given the ample supply of dedicated accountants who are presently assigned to the SEC’s Enforcement Division.  In 1999, the last time that 94 financial fraud and disclosure matters were brought, the SEC’s Office of the Chief Enforcement Accountant counted among its ranks less than 20 accounting staff at the SEC’s headquarters in Washington DC.   In contrast, during fiscal 2012, when an equal number of financial fraud and disclosure matters were brought, the same office contained approximately 35 accountants, nearly double the number.  While recent efforts required to bring accounting cases related to the financial institution crisis understandably required significant resources, it is unlikely the effort would have been measurably in excess of that expended on accounting cases pursued in fiscal 1999, such as Cendant, Livent and W.R. Grace & Co., or in the years that followed in which many of the historic accounting frauds were uncovered.  In any event, the growth of the SEC’s Enforcement Division accounting staff to its current levels should provide adequate resources to pursue additional initiatives in this area. 

Notwithstanding the availability of accounting staff, however, in order for activity in the financial fraud area to increase, a reliable supply of SEC Enforcement attorneys will be required.  A perception within the SEC Enforcement bar and legal community is that in the past few years, recruiting SEC attorneys to work on accounting matters has been more challenging due to the competing requirements of the specialization units and the additional focus that has been placed on other priorities, such as insider trading and investment advisor matters.  The SEC’s recent focus on bringing matters quickly and increasing enforcement statistics in the process may actually discourage attorneys from committing to accounting cases, which sometimes take a year or more to investigate and charge or settle.  

The establishment of a Financial Accounting Fraud Specialty Unit would not, however, necessitate large investments in manpower.  The SEC could choose to leverage this area by drawing upon the ample supply of Enforcement accounting staff and by coupling that resource with a proportionately smaller number of strategically dedicated legal staff to oversee open inquiries. 

For example, whistleblower tips or referrals of interest could be set up as a Matter Under Inquiry, be assigned to accounting staff and then monitored by SEC Enforcement Division attorneys.  The Commission could leverage its ability to oversee this area by informing entities under inquiry of the parameters of the accounting issues, and by allowing them, in certain circumstances, to self-inspect by conducting an independent audit or special committee review of the issues of interest.  Through its independent counsel, the registrant could then self-report back to the SEC counsel and accounting staff on findings from the investigation, and be challenged in a manner consistent with current SEC staff practice.  For those matters in which the independent investigation discloses problematic or illicit conduct, the SEC could then assign a dedicated legal resource to collaborate with the Enforcement Division accountant to pursue an action that would almost assuredly be merited.  Conversely, if the thorough independent investigation disclosed no reasonable likelihood of wrongdoing, the SEC would have a basis to close the inquiry without being required to expend significant amounts of staff time, and without burdening the registrant with a costly and distracting, open ended regulatory investigation.  

A specialized unit relating to accounting and financial fraud and disclosure would also allow attorneys who specialize in these types of cases to collaborate on a strategic and proactive basis with SEC Enforcement Division leadership and accounting staff to craft a program that would coordinate efforts between the Enforcement Division, Corporation Finance, RiskFin, and the Office of Market Intelligence to set priorities, monitor tips, perform well-founded risk based initiatives and staff cases that warrant full investigation.  The lessons learned and special skills currently employed by the other specialized units would be a perfect template for the Commission to apply to the financial fraud area.

Until a dedicated group of attorneys are assigned on a full time basis to work on accounting cases, it will be difficult for the SEC to refocus its attention on the critical mission of financial accounting and reporting enforcement.  Instances of accounting fraud and abuse continue to permeate the financial markets.  Creating a financial accounting fraud specialty unit would be a major step and statement by the SEC to the markets that this important area will once again be the true priority that it should be. 

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[1] Erik Lie, On the Timing of CEO Stock Option Awards, Management Science, Vol. 51, No. 5, May 2005, pp. 802-812.

[2] Chairman Arthur Levitt, Securities and Exchange Commission, Remarks at the NYU Center for Law and Business – The “Numbers Game,” September 28, 1998.

[3] Securities and Exchange Commission website, http://www.sec.gov/about/annrep.shtml, Annual Reports, 1998-2007.

[4] Mark S. Beasley, Joseph V. Carcello, Dana R. Hermanson & Terry L. Neal, COSO, Fraudulent Financial Reporting: 1998-2007 – An Analysis of U.S. Public Companies, May 2010.

[5] Beasley, Carcello, Hermanson, Neal; COSO report, at 1.

[6] Don Whalen, Esq., Mark Cheffers, Olga Usvyatsky, 2011 Financial Restatements – An Eleven Year Comparison, Audit Analytics, April 2012. 

[7] While much of the credit would intuitively be attributed to the increased regulation, it is also worth noting that according to Wilshire Associates, the number of listed companies on U.S. stock exchanges has dropped by 47% since 1997.  In 1997 there were 7,459 companies listed on the NASDAQ and NYSE. In contrast, the number of companies listed in 2011 had dropped to 3,927.  See Rick Ferri, “The Incredible Shrinking Market,”  http://www.forbes.com/sites/rickferri/2011/03/10/the-incredible-shrinking-market/.

[8] Whalen, Cheffers, Usvyatsky; Audit Analytics, at 19.

[9] Whalen, Cheffers, Usvyatsky; Audit Analytics, at 10.

[10] Two categories, in particular, have drawn the attention of critics. The “delinquent filings” actions brought by the SEC involve sanctioning or delisting of companies that have ceased filing public statements.  Critics have argued that these matters require little investigation compared to securities fraud cases.  In fiscal 2012, 127 such matters were brought, an all-time high.  Combined with 228 “follow-on” administrative proceedings brought in fiscal 2012 to institute penalties in cases already brought, over 48% of the 734 enforcement matters reported fell into one of those two categories.

[11] Securities and Exchange Commission website, http://www.sec.gov/about/annrep.shtml, Annual Reports, 1998-2012

[12] Cornerstone Research, Accounting Class Action Filings and Settlements – 2012 Review and Analysis; www.cornerstone.com/accounting-class-action-filings-and-settlements

[13] Ellen M. Ryan, Laura E. Simmons, Cornerstone Research, Securities Class Action Settlements – 2012 Review and Analysis, March 20, 2013.

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