In several recent public speeches, the Securities and Exchange Commission (SEC) has announced a renewed focus on financial reporting and accounting fraud, vowing to devote substantial resources to enforcement activities in these areas. This shift is significant for public companies, their officers, and auditors.
A decade ago, investigations targeting financial reporting and accounting fraud in publicly traded companies such as Enron and WorldCom represented nearly a third of the SEC’s enforcement activities. As a result of the global financial crisis, however, the SEC shifted its focus away from financial reporting and accounting fraud, instead dedicating its resources to cases arising from the financial crisis. Consequently, by 2012, the number of accounting fraud enforcement actions commenced was at its lowest in more than a decade, constituting only 11 percent of the enforcement actions filed by the agency.
As it has stated recently, the SEC is skeptical that incidences of accounting fraud have declined while its attention was diverted to financial crisis cases, noting, among other things, a significant decline in the number of public company restatements. The SEC accordingly established the Financial Reporting and Auditing Task Force, a unit comprising 12 attorneys and accountants that is expected to identify specific areas at high risk for improper financial reporting and then to “incubate” investigations that will be handled by other lawyers and accountants throughout the Division of Enforcement.
To fulfill its mission, the Task Force will rely upon a combination of recently developed technologies as well as traditional investigative techniques. In addition to closely monitoring high-risk public companies to identify misconduct, analyzing performance trends by industry, and monitoring class action complaints alleging fraudulent financial reporting, the Task Force will utilize the SEC’s Accounting Quality Model, which uses data analytics to identify accounting irregularities in a company’s financial report.
Recent statements by SEC officials provide some guidance regarding specific areas of interest, which are detailed below.
Revenue Recognition: Issues relating to revenue recognition traditionally have been, and will continue to be, a staple of the SEC’s accounting fraud enforcement activity. In particular, the SEC will be on the lookout for sham transactions, prematurely recognized revenue, and instances of billing for uncompleted products through “pre-booking” schemes.
Reserves: SEC officials have signaled an increase in inquiries into the manner in which management and auditors make decisions concerning reserves. The SEC will continue to pursue actions against issuers, executives, and auditors who intentionally or recklessly ignore the need to increase loss reserves.
Focus on Auditors: The SEC has emphasized that its investigation of improper accounting will not be limited to issuers and management. Rather, it intends to scrutinize the quality of the full audit to determine whether the auditors missed or ignored red flags, whether the audit is supported by proper documentation, and whether the auditors complied with professional standards. Further, SEC officials anticipate broader enforcement of the Auditor Independence Requirements, and signaled that the requirements will not only be applied to public company audits.
Audit Committees: The SEC similarly intends to examine the performance of audit committees and signified its willingness to penalize audit committees that fail to exercise proper oversight over the financial reporting process.
The SEC’s renewed focus on financial reporting and accounting fraud re-emphasizes the need for public companies to develop and maintain policies and procedures to ensure the accuracy and completeness of their financial reports. Further, the SEC’s anticipated enforcement efforts will refocus scrutiny on two of the groups it has identified as “gatekeepers”: audit committee members and auditors.
