SEC Considers Returning to Its Roots

June 17, 2013

The SEC has recently taken a well-deserved beating for its lack of attention to financial fraud at publicly traded companies.  The numbers speak for themselves.  In 2012, the SEC brought 79 financial fraud cases, when in years past the annual number has pushed or exceeded 200.  Granted, the Commission has a lot of things on its plate, but if the country’s primary securities regulator isn’t going to bring actions enforcing financial disclosure rules against issuers and their executives, it’s hard to figure who will.

At least two people want to restore the SEC’s place in the accounting fraud universe.  Fortunately, they’re in a position to matter.  One is Mary Jo White, who according to the Wall Street Journal wants to turn the agency’s attention back to what she sees as its core mission of policing corporate disclosures.

The other is Craig Lewis, whose Division of Economic and Risk Analysis has developed an “accounting quality model” that could help the SEC “assess the degree to which registrants’ financial statements appear anomalous.”  As Lewis said in a speech last December, when companies use “earnings management” to adjust those financial statements, the trick is to distinguish between merely aggressive accounting practices that fall within GAAP, and fraudulent accounting practices that violate GAAP.  Mistaking one for the other can be very costly, not only for the company wrongly tagged as cooking the books, but also for enforcement staff who waste resources investigating lawful behavior.

Lewis’s hope is that the accounting quality model will limit those false positives.  As he also said last December, “[A]t the highest level of generality it is a model that allows us to discern whether a registrant’s financial statements stick out from the pack, while taking into account the contemporaneous attributes of that pack.”  But Lewis also noted several examples that could indicate specific types of earnings management:

  • An accounting policy that results in relatively high reported book earnings, even though firms simultaneously select alternative tax treatments that minimize taxable income;
  • A high proportion of transactions structured as “off-balance sheet.”  (Though the vast majority of firms use off-balance sheet financing for legitimate business purposes, many of the largest accounting scandals, Lewis said, used off-balance sheet activities to hide poor financial performance.);
  • The frequency and types of conflicts with independent auditors, as measured by changes in auditors or delays in the release of financial statements or earnings.

In these instances, Lewis said, the metrics associated with the accounting policies can be consistently estimated from filings data and compared to peers.  The hope is that the SEC will be able to see what companies are saying about their finances, and also what massive amounts of data say they probably ought to be saying about their finances.  This tool could be a remarkably effective boon for the SEC’s enforcement staff.  Accounting matters are very hard to untangle, and a data-mined head start could put the Commission on the trail of good cases before they blow up into disasters.

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