The New SEC Financial Fraud Task Force
Last week the SEC announced the formation of a Financial Reporting and Audit Task Force. Its purpose is to detect “fraudulent or improper financial reporting” and “enhance the [Enforcement] Division’s ongoing enforcement efforts related to accounting and disclosure fraud.” At the same time the Commission announced the formation of a similar group focused on microcap fraud and the creation of the Center for Risk and Quantitative Analysis. The new Center for Risk and Quantitative Analysis will work in close coordination with the Division of Economic and Risk Analysis and “serve as both an analytical hub and a source of information about characteristics and patterns indicative of possible fraud or other illegality.”
While this is clearly a positive step for the Enforcement Division, there is little that is new about the financial fraud task force — except perhaps its apparently “high tech” adjunct, the Center for Risk and Quantitative Analysis. In 1998 then SEC Chairman Arthur Levitt originated a similar effort. In his well known address titled “The Numbers Game,” Chairman Levitt announced an eight part plan to combat abuses in financial reporting because he had “become concerned that the motivation to meet Wall Street earnings expectations my be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; Integrity may be losing out to illusion.”
Chairman Levitt identified five key practices being used to manipulate financial results through what he labeled as “accounting hocus-pocus:”
Big Bath charges; The use of restructuring charges to clean up the balance sheet;
Acquisitions/R&D: The classification of portions of the acquisition price as “in-process” research and development so it can be written-off in a one-time charge to avoid a drag on future earnings;
Cookie jar reserves: The use of unrealistic assumptions to create pools of cash to smooth earnings;
Materiality: Building in flexibility by creating small errors that are just below the so-called materiality threshold which can then later be utilized; and
Revenue recognition: Boosting earnings through inappropriate manipulation of the recognition of revenue.
In the wake of Chairman Levitt’s speech the Commission brought a series of financial statement fraud actions. Two years later, for example, Richard Walker, then the Director of the Enforcement Division stated that for fiscal 1999 the Commission brought about 90 financial statement and reporting actions, a 15% increase over 1998. Those cases “cover a broad spectrum of conduct – from multi-faceted pervasive frauds to more subtle instances of earnings management to situation involving violations of auditor independence rules,” he noted. Richard H. Walker, Director, Division of Enforcement, addressing 27th Annual national AICPA Conference on Current SEC Developments (Dec. 7, 1999). In the years that followed the SEC brought a series of financial fraud actions involving an array of issuers such as Waste Management, WorldCom, Tyco International, Enron, Xerox Corporation and others.
In recent years, however, the number of these cases has declined. One reason may be the reforms initiated by the Sarbanes-Oxley Act of 2002. Another may be that the focus of SEC enforcement has been on market crisis cases, offering frauds and Ponzi schemes rather than difficult to develop, and time and resource consuming, financial statement fraud cases. Whatever the reason, while the world of financial reporting has become more sophisticated and complex, the root of Chairman Levitt’s concerns has not changed. The “pressure to make the numbers” is still present. This suggests that the Commission’s new task force will have much to do.