Speech by SEC Staff:
Remarks before the 2010 AICPA National Conference on Current SEC and PCAOB Developments
Chief Accountant, Division of Enforcement
U.S. Securities and Exchange Commission
December 6, 2010
Thank you for that very kind introduction; Good Afternoon everyone, I’m honored to have been asked to speak to you today.
As Rob indicated, I’ll give the standard disclaimer that my remarks today are my views and my views only and they do not necessarily reflect the views of the Commission or its staff.
In preparing for today’s speech, I thought about what a distinguished group of accounting professionals would want to hear from the Chief Accountant of the Enforcement Division.
I started from the presumption that the most likely response you would want from me is that I’m not investigating you, your company or any of your clients. I trust that you can tolerate hearing from me at professional events like this or at a social gathering like a wedding — especially if you can get some CPE credits out of it, but you would tend to avoid much else as that would likely mean you were caught up in an Enforcement investigation. No doubt getting a request from me or one my Enforcement colleagues asking for accounting information or testimony on a GAAP issue could ruin your day.
- With that in mind, I settled on a few topics that I believe are important for you to hear from me.
- First, I’ll address common themes associated with the accounting fraud cases that Rob mentioned and most others
- Next, I’ll describe conduct that particularly troubles me and that I believe should bother you too as it impacts fair presentation to investors
- Finally, I’ll offer some ideas on how you can prevent, deter and detect fraud and thoughts on how to stay out of the SEC’s crosshairs
I’ll try not to lecture too much, but may not be able to resist the opportunity to use the bully pulpit for just a short while.
To set the stage a bit, I thought I would give you some context regarding where I fit within the Enforcement Division.
- I lead the Enforcement accountants who are the subject matter experts and act as the specialized unit for financial reporting investigations. There are 35 accountants in my group in DC and there are about 65 more across the country conducting accounting investigations.
- The enforcement accountants work in tandem with enforcement attorneys in connection investigating whether a company cooked the books.
- We interact frequently with other Divisions on our accounting cases and I often meet with the Chief Accountants in other SEC Divisions to discuss pending recommendations and emerging issues.
- As you know, most of the accounting cases that the SEC files involve allegations of fraud in which the Commission alleges that the wrongdoers intentionally or recklessly participated in an accounting or disclosure fraud.
- We also charge non-fraud violations in our enforcement actions relating to the reporting, books and records and internal controls provisions of the securities laws. Often these charges are in addition to fraud charges. In appropriate cases, the SEC levies stand alone non-fraud charges the evidences suggests a lack of good faith or something other than an honest accounting error or judgment.
- The subjects of our investigations not only include Issuers, but also individuals such as officers, directors and employees, transaction counterparties and independent auditors.
- We have various legal remedies to combat misconduct, including injunctions, cease and desist orders, disgorgement, clawbacks, penalties and O&D bars.
- As you know, Rule 102(e) of the SEC’s Rules of Practice enables the Commission to suspend accountants from practicing before the Commission for improper professional conduct. This can be from one instance of highly unreasonable conduct where heightened scrutiny is warranted or multiple instances of unreasonable conduct. A 102(e) suspension would restrict your ability to serve as an auditor or work in most financial reporting positions at a public company.
Before I begin talking about accounting shenanigans, I want to start by saying that my assumption is that most SEC practitioners are honest hard working professionals who simply want to do the right thing.
They understand that providing investors with transparent, comparable, high quality financial information on a consistent basis is essential to public company financial reporting and the integrity of the financial markets
However, there is Dark Side to financial reporting — as Darth Vader might say because there is a minority of bad apples willing to mislead investors in favor of keeping their jobs, getting their bonuses and selling their stock at high prices.
For these persons, providing high quality and credible disclosure documents to investors and the SEC is optional and they break the law by knowingly or recklessly preparing and filing false financial statements with the SEC.
Fortunately, only a small fraction of the many thousands of public companies have had an enforcement actions filed against them;
- Similarly most individuals and CPA’s have never received a Wells Notice, let alone have been subjects of an SEC Enforcement investigation or Rule 102(e) proceeding.
Now I’ll focus on some common themes that are present in most accounting enforcement actions. I’ll do so for two reasons.
- One — because Rob has already given you an overview of some important accounting fraud cases that we filed in the past year. I encourage you to visit the SEC website and check out the Accounting and Auditing Enforcement Release Section to learn more about these cases and others that we have brought.
- Two — because we all know frauds occur, but we tend to assume it will happen someplace else — not in our shop. After being on my side of the fence and having seen so many matters where things did go wrong on the accounting and auditing front — you gain an enhanced appreciation of the risks and rationalizations that occur.
The First common theme I’ll discuss is that — accounting frauds typically Start Small.
- At the outset of most accounting fraud schemes, from the massive ones that last many years to the smaller one of shorter duration, management likely did not sit in a room and set out to violate the law.
- Rather, management likely reacted to internal and external pressures that caused them to start being more aggressive with their accounting practices and more lax with their disclosures to the public.
- Perhaps they played with estimates to meet one quarterly target;
- They thought it was no big deal, a one-time event to get over a rough spot.
- As time passed, and pressures remained — there was a need to get even more aggressive, engage in more schemes and increase the dollar amounts involved to make up for the fact that results had already borrowed from future quarters,
- More people were required to sustain the fraud and cover it up
- And the scheme goes on until it eventually discovered or it’s simply collapses under its own weight.
Second, accounting frauds are not limited to little known small-cap companies trading in the pink sheets. Instead, the largest and most recognized corporations in the U.S. are among those that get caught cooking the books, all of whom had a large national or international audit firm certifying their books.
Third, the main perpetrators in accounting fraud cases very often are members of the Issuer’s senior management who have the access to the books and records and opportunity to change the numbers.
- Most accounting fraud matters involve accountants as the primary perpetrators, including CFO’s, Controllers and Chief Accounting Officers
- Therefore, it is crucial that all stakeholders in the financial reporting process — especially internal accountants, and internal and independent auditors to be vigilant about recognizing fraud risk factors and do their part preventing, detecting and deterring fraud
Fourth — noncompliance with GAAP and inadequate disclosures are a means to an end as there is always some underlying motive for engaging in accounting fraud.
- Whether it be to artificially portray financial stability
- smooth earnings to mute the impacts of business cycles; or
- Otherwise mask the true financial condition of the company,
There are always material facts left out or omitted or spun a certain way to conceal the essential information that investors had a right to know. The fraud involves a big picture deception that makes the overall presentation of the financial statements misleading and the notion of them being “fairly stated” a dream.
Somehow, notwithstanding all the internal controls and audit programs and efforts of those involved in the reporting process, corporate officials and sometimes independent auditors allow themselves to rationalize inadequate accounting and disclosure, half-truths and misrepresentations to be provided to investors in SEC filings.
This brings me to my fifth and sixth points relating to materiality and intent.
As you may know, when Enforcement investigates an accounting matter, we evaluate materiality and intent as both are needed to establish fraud charges. Often times materiality is evident and we spend the majority of our investigation establishing intent. Sometimes both materiality and intent are issues that need to be evaluated — especially when an issuer is reluctant to restate.
Materiality — as we well know generally means anything that investors would consider important or change the total mix of information available for making investment decisions.
- Accountants begin their analysis of materiality by looking at the magnitude and percentages of important accounting metrics like net income, EBITDA, revenue. However, as you all know qualitative materiality must be considered and I’m sure you have all read carefully read SAB 99.
- In connection with internal investigations and enforcement investigations, however, I have seen less than robust qualitative materiality assessments.
- I’ll make clear that in my view it is not sufficient for accountants to refer only to the qualitative factors listed in SAB 99, see that none of the ones listed are applicable and then determine that the error is immaterial.
- A proper analysis would require a robust evaluation of all relevant qualitative factors — not just those listed in SAB 99.
- Lately, I have also seen some arguments being made by companies that large errors are immaterial. Although the door may swing both ways, my view is that such instances would unusual.
Scienter as lawyers call fraudulent intent includes intentional or reckless conduct.
Intentional errors are easy recognize and typically involves clear indicia of fraud such as booking fictitious revenue, fabricating or alter books and records or misrepresenting facts.
Recklessness usually involves motives to cook the books combined with red flags that create inferences of fraudulent intent.
- One example might be making unsubstantiated top-side adjustments that appear to have permitted a company to meet earnings expectations;
- Another example would be releases from reserves of amounts which enabled the same result without any other reasonable explanation for such release.
Particular areas of concern to me are when the accounting and disclosure appear to follow the form of a transaction and not the substance: Examples that you all know about are:
- Abusive SPEs,
- "Round-trip" transactions and
- Debt masking type activities.
Other practices that bother me are when companies
- Make changes to their accounting policies,
- Change their methods of applying certain accounting principles or
- Reclassify balance sheet or income statement items
ALL without disclosing the dollar impact of such changes when investors would have considered that information material.
So, even when there are not fictitious transactions or fabrications of accounting records and real counterparties are involved; and even if there are colorable arguments that GAAP has technically been complied with, if the financial statements taken as a whole are misleading and are not fairly presented, Enforcement will be investigating and you can expect us to recommend charges to the Commission if the evidence suggests that investors were materially misled and the persons acted with the requisite intent.
Believe it or not, in making such recommendations, we do understand the real world of financial reporting and auditing and we are very good at evaluating the reasonableness of professional judgments based upon the contemporaneous analysis of the relevant facts and circumstances and we are very experienced — based on the evidence — at making distinctions between good faith accounting and diligent auditing procedures and otherwise.
So, when companies, counterparties and auditors rationalize aggressive accounting practices and do not provide adequate disclosure to investors it will undermine a defense that GAAP was being applied in good faith.
My message as Chief Enforcement Accountant is for you to continue to remind those who would play three card monty with a public company’s accounting and disclosures, that they face heightened risk — reputational, regulatory and legal risk
Moreover, even if companies do get their auditors to agree at the time; or later can hire an accounting expert to say that the company technically complied a particular provision of GAAP, that it may be insufficient to deflect fraud charges — or 102(e) proceeding because fair presentation and adequate disclosure are also required.
To highlight a court case on the topic of fair presentation, I’d like to spend a few minutes discussing an oldie but a goodie, a 1969 2nd Circuit Case U.S. v Simon
In US v. Simon, the 2nd Circuit upheld a criminal conviction of three accountants for conspiring and knowingly drawing up and certifying false and misleading corporate financial statements.
In a nutshell, the company being audited had a receivable outstanding from an affiliate. The company disclosed that the receivable was from an affiliate and stated that the value of the collateral exceeded the receivable. Nothing was said about the makeup of the collateral, that it had been posted because of an inability of the affiliate to repay, and that the affiliate had re-loaned the money to an officer of both companies who used the money for his own personal purposes. The auditors issued an unqualified opinion even though they knew that the issuer’s receivable had collectability issuers and they were aware of the related party relationships and money flows. The accountants claimed the receivable complied with GAAP and that all informative disclosures reasonably necessary for fair presentation of the financial position had been made.
The Court held that there was evidence that the accountants knew of looting by the individual and that a receivable was questionable as a result.
The Court indicated that proof of compliance with GAAP may be very persuasive evidence but not necessarily conclusive of good faith or that that the facts as certified were not materially false or misleading.
The court stated that if: “certification does not at least imply that a corporation has not been looted by insiders, so far as accountants know….it would mean nothing and the reliance placed on it by the public would be a snare delusion.” I wonder what Judge Friendly would say about some the transactions we’ve seen in the past decade.
More recently, the 2nd Circuit in 2006 issued its opinion in a case involving fraud charges against Bernie Ebbers, the former CEO of WorldCom. The Ebbers opinion addresses the U.S. v. Simon point quite clearly. Specifically, the Ebbers opinion cited U.S. v. Simon and said that it did not see a reason to depart from it.
- The court indicated that good faith compliance with GAAP will permit professionals who study the firm and understand GAAP to accurately assess the financial condition of the company. This can be the case even when the question of whether a particular accounting practice complies with GAAP may be subject to reasonable differences of opinion.
- The court gave an example of revenue used to “close the gap” although it could have been proper under GAAP, if the company had never used such revenue before and it was a one-time addition, then investors would not have been alerted to the fact that revenue as had been previously calculated had actually gone down.
- The court said that such an intentionally misleading financial statement would violate the law. In this regard, the court indicated that if the government proves that a defendant was responsible for financial reports that intentionally and materially misled investors, it was not also required to prevail in a battle of expert witnesses over the application of individual GAAP rules.
The court also indicated that in a real sense, by alleging and proving that the financial statements were misleading, the government did, in fact, allege and prove violations of GAAP. The court indicated that according to the GAAS, the “[f]inancial statements are materially misstated when they contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects, in compliance with GAAP.” Thus, GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.
Again, the take away point is that we will be investigating and prosecuting cases where investors are misled, notwithstanding arguments that because GAAP was followed.
To conclude, I’ll give you my high level views on how to be vigilant in preventing, deterring and detecting accounting fraud and hopefully stay out of trouble with the SEC. First, wherever you sit in the financial reporting process, I urge you to:
- Continue to do your part in looking out for the fraud risk factors that will inevitably present themselves.
- Make your fraud risk assessments meaningful and seek out input from those who have fraud expertise. Make these assessments a priority and don’t develop a "checklist" mentality
- Continue to resist the pressures to rationalize improper accounting.
- If you find yourself rationalizing overly rosy forecasts, making changes to the models or assumptions to achieve a specific result, not being consistent with the objectives of the particular accounting standards, or other things, you might want to take a step back and consider the implications.
- Continue to tell bosses and clients that certain accounting treatments are just unacceptable, even in the absence of accounting literature that specifically prohibits it;
- As skeptical and inquisitive as you think you have been, be even more skeptical and inquisitive. Ask even more probing questions and more follow-up questions.
- Think about how have you demonstrated professional skepticism — have you challenged management assertions and representations.
- Have you questioned the business purpose for a transaction or considered why a client may have ambiguous disclosures
- Have you considered alternative audit procedures or sought other types of evidence
- Consider how your accounting judgments will look if the SEC Enforcement Division is evaluating them
- Can your analysis withstand rigorous scrutiny or do the justifications barely pass the laugh test;
- If you are involved in an internal investigation, evaluate the credibility of the investigation; should the company’s internal OGC or internal auditors conduct the investigation or should the audit committee hire independent counsel? Has the scope of the investigation been unduly limited as far as issues or evidentiary sources (especially electronic evidence)
- Notwithstanding pressures to file your 10K or 10Q or sign an audit opinion in time to meet our normal release schedule, resist the temptation to see events through any style or brand of rose colored glasses;
- Don’t forget about qualitative materiality and remember that investors care about quarterly financial results so avoid downplaying the quantitative impact of an error on quarterly results
- Resist temptations to play with reserves, estimates and judgments to achieve results; or to structure transactions where the primary motive is to achieve a particular accounting result that is not consistent with the economic substance
- Carefully consider what is not disclosed or omitted from the financial statement footnotes and MD&A. Ask whether investors are being provided with meaningful and transparent disclosures or if an important fact is being obscured. if there is an important disclosure or accounting issue ask yourself:
- Is there some important information that you or your client is bending over backwards not to disclose or to obscure — when you know that investors would really want to know the facts
- Don’t forget that your ultimate clients are investors and don’t allow them to be misled by accounting gimmicks even if there is a speck of a legitimate business purpose or a plausible argument under GAAP.
- Remember that accountants can be charged with aiding and abetting an accounting fraud even if they are not the masterminds themselves and that the SEC can suspend accountants and auditors
I hope this provided you with some useful insights. Thanks again for listening and remain diligent in your efforts to protect investors.