SEC Refocuses on Accounting Fraud

The Securities and Exchange Commission is reportedly preparing to turn its attention to accounting fraud cases after being diverted in recent years to Ponzi schemes and subprime mortgage fraud in the wake of the financial crisis.

The Wall Street Journal reported Monday that the SEC is planning to target accounting fraud and financial disclosure cases once again, which used to make up a larger proportion of civil enforcement cases. From 2003 to 2005, they comprised approximately 25 percent of the SEC’s enforcement actions, but that proportion dropped to around 11 percent in the fiscal year ending Sept. 30, 2012.

Now the SEC will be armed with more sophisticated software that will analyze terms in the management discussion and analysis portion of financial reports, looking for telltale signs of earnings skullduggery. For example, when a company spends much of the MD&A describing a relatively harmless accounting treatment, that could be a signal that they are avoiding discussion of riskier issues that have emerged in the business.

The SEC has a tough new chairman at the helm, with the appointment of former federal prosecutor Mary Jo White, whose team in New York put mob boss John Gotti behind bars in the 1990s, along with the terrorists behind the 1993 bombing of the World Trade Center. She also has a pair of new co-directors of the SEC’s Division of Enforcement who are also former federal prosecutors, George Canellos and Andrew Ceresney.

The SEC’s Division of Corporate Finance will no doubt also be playing a key role in the effort. Leaders of the Corp Fin division regularly exhort accountants at conferences to be more specific in their financial reports, and they issue a regularly updated Finance Reporting Manual, with instructions for improving the MD&A portion of the reports such as, “One of the most common deficiencies is when registrants simply repeat items reported in statement of cash flows. Registrants should focus on the primary drivers of and other material factors necessary to an understanding of the registrant’s cash flows and the indicative value of historical cash flows.”

When corporate executives fail to provide the necessary information in a financial report, they can be on the receiving end of a so-called “Dear CFO” letter from the SEC, such as a sample letter provided on the SEC’s Web site for companies whose MD&A disclosures on provisions and allowances for loan losses were found to be wanting.

The SEC may also be able to leverage technology such as XBRL, or Extensible Business Reporting Language, to find signs of suspicious activity. The promise of XBRL is that it can help investors analyze and compare companies across different industries. The SEC has been requiring public companies to file their financial reports in XBRL in recent years. The data-tagging technology in XBRL is also used in the U.S. GAAP Financial Reporting Taxonomy that the Financial Accounting Standards Board now maintains and the SEC requires public companies to use.

While there have been a lot of questions about the data quality in many of the XBRL submissions and a steep learning curve for plenty of corporate filers, the SEC by now should have accumulated a critical mass of XBRL filings so it can sift through the data and look for similar patterns. If the patterns are suggestive of suspicious transactions, a sophisticated data analysis program should be able to flag such reports for further review. It’s not clear if the SEC is using XBRL for such purposes yet, but the potential is certainly there for at least streamlining the kind of analysis that the SEC is contemplating.

As the SEC’s focus on fraud moves from Wall Street to Main Street, business executives will need to be extra careful about the language they use in their reports to the SEC and make sure they honestly disclose the risks and accounting choices potentially affecting their investors. Otherwise, they may find a “Dear CFO” letter in their mailbox or, worse yet, a subpoena.