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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Current SEC Financial Fraud Developments

Remarks by

Commissioner Isaac C. Hunt, Jr.

U.S. Securities & Exchange Commission

At “SEC Speaks in 2000”
Washington, D.C.
March 3, 2000

Good morning, it is a pleasure and an honor to be here to address the legal financial service professionals who do the important and difficult work of representing SEC registered companies. The people in this room bear a heavy burden in assuring investor confidence, preventing financial fraud and generally supporting a fair and efficient marketplace. But, before I begin speaking about what the SEC views as the awesome responsibilities shouldered by many of you, I am obligated to state that the views I express here today are my own and do not necessarily reflect the views of the Commission, other Commissioners, or the Commission's staff.

Looking back before the issuance of Staff Accounting Bulletins and the develop of internal controls, we can judge just how far we have progressed in improving our capital markets and also just how much more capital is at stake. To combat the abuses that brought about the historic market decline in the early part of this century, Congress designed a registration and reporting system to provide investors with material information needed to make informed investment decisions. At the heart of this system is the credibility of disclosure documents filed with the Commission by public companies.

As we enter this new century, our capital markets are probably the most liquid and efficient in the world. But, I remain concerned that some industry practices may threaten this hard fought preeminence. Specifically, I am concerned with the reliability and integrity of financial statements filed with the Commission. The two issues that I wish to focus attention on today are first, the widely disparate accounting for business combinations and second, abuses in the area of revenue recognition.

Beyond embracing the guidance provided by the recent SABs on these two topics – SABs 100 and 101 – the financial service professionals also need to step up and take responsibility for continuing to improve their practices overall. One way to do this is to focus increased attention in the critical area of internal controls. A commitment to quality and good internal controls at the highest levels of an organization may avoid many financial problems. And that may be the best use of a professional's time and talents – preventing problems before they occur.

Despite the tremendous importance of full and open disclosure, over the years the Commission has continued to find that many registrants' filings do not meet the high quality and integrity standard envisioned by Congress. This problem has gone far beyond the point of mere sloppiness. And, while limited, the staff has even observed some filings that are downright misleading. This view is supported by the fact that nearly twenty percent of the enforcement cases brought in the last year involved financial fraud reporting. Of that amount, over half are directly related to revenue recognition.

What is so troubling from the Commission's standpoint is that these frauds are conducted by professionals – lawyers, accountants, and high-level managers. In fact, the recent Committee of Sponsoring Organizations ("COSO") Report of the Treadway Commission found that a staggering 83% of fraudulent financial statements involved the complicity of either the CEO or the CFO of the reporting company. This is unfortunate as it ultimately impacts the credibility of the entire community of financial professionals.

While we recognize that the vast majority of these financial professionals (and certainly the people gathered in this room today!) are committed to sound financial reporting, there remain too many professionals who push the envelope too far. This can harm unsuspecting investors. Even if the investors are sophisticated, they may be misled by the absence of transparency in a company's filings. As a consequence of this confusion, investors could lose confidence in the reliability of a registrant's financial information and that, in turn, would adversely impact the markets.

As an added incentive to maintain the integrity of the financial reporting process, Chairman Levitt has repeatedly reminded the financial community that financial fraud and reporting cases continue to be the Division of Enforcement's number one focus. On September 28, 1998, in a speech delivered at New York University, the Chairman raised serious concerns about the quality of financial reporting. In that speech, Chairman Levitt said, "our enforcement team will continue to root out and aggressively act on abuses of the financial reporting process."

In addition to the well-known enforcement cases, the Commission, the NASD, the New York Stock Exchange, and the American Stock Exchange have taken some important steps in returning "quality" to financial reporting.

In December 1999, the accounting staff of the Commission issued two Staff Accounting Bulletins (SABs) – SAB 100 on Restructuring and Impairments and SAB 101 on Revenue Recognition. The staff believes that these bulletins will help the industry "tighten up" what we see as sloppy financial reporting. These two bulletins are consistent with existing U.S. Generally Accepted Accounting Principals ("USGAAP"), but at the same time attempt to give clear and consistent guidance that registrants can easily understand.

Internal Controls

Before we get into the nuts and bolts of the Commission's recent SABs and enforcement cases, the message that I want to send to you today is that CEOs, legal counsel and auditors must focus attention and resources on the critical area of internal controls. In order to assure sound financial reporting and, consequently, a level playing field for all investors, good internal accounting controls are critical. These should form the bedrock on which all financial reporting is based.

Here are three good reasons why you should focus on internal controls: (1) to protect yourself against the unscrupulous conduct of employees; (2) to prevent and detect problems before they can hurt the registrant; and (3) because poor internal controls can lead to misleading financial statements.

Recent press accounts and enforcement cases have raised questions about financial reporting activities including money laundering, basic account reconciliations, and misappropriation of funds to manage earnings. These cases raise fundamental issues about the adequacy and effectiveness of a company's internal controls and the quality of work being performed by financial professionals. If the firms had strong internal controls in place, most of these problems would have been avoided.

So, what constitutes effective internal controls? Effective internal accounting controls are:

  • Supported at the top of the organization,

  • Reflected in the structure, functions and risks of the organization,

  • Delegated effectively,

  • Codified in writing,

  • Checked periodically, and

  • Enforced.
I encourage registrants, their accountants, and their counsel to put renewed focus and emphasis on the existence and effectiveness of internal controls to assure compliance with both USGAAP and the Foreign Corrupt Practices Act.

As mentioned, the Commission staff has recently provided important guidance to legal and accounting professionals in the form of two very important Staff Accounting Bulletins.

SAB 100

SAB 100 focuses on restructuring changes, impairments, inventory valuation allowances and liabilities assumed in connection with business combinations. This bulletin expresses the staff's view on how these transactions or the consequence of certain events should be reported in a consistent and comparable manner. This way investors have more complete information about the economics of the particular transaction to assist them in making investment decisions. The staff's view for each of the issues addressed in SAB 100 is that registrants must exercise appropriate judgment in applying GAAP to assure reliability and consistency. Two reasons for this position are as follows:

  • The balance sheet amounts must reflect management's best judgment – i.e., be reliably and appropriately based.

  • Financial statement users must be able to rely on the transparency of the reported and disclosed amounts to track the subsequent performance of the investment.
In short, investors should not be put in the position of comparing apples and oranges. There should be comparable financial reporting so that everyone is playing by the same set of rules.

SAB 101

SAB 101 focuses primarily on revenue recognition. As I mentioned earlier, a very large number of enforcement cases have arisen from firms recognizing revenue too early. Once again, SAB 101 does not depart from GAAP. It merely provides more guidance for accounting professionals to improve their financial reporting. Specifically, SAB 101 spells out the basic criteria that must be met before registrants may record revenue. These criteria reflect the recurring revenue recognition themes found in the existing accounting rules. These criteria are:

  • persuasive evidence that an arrangement exists,

  • evidence that delivery has occurred or that services have been rendered,

  • a showing that the seller's price to the buyer is fixed or determinable, and

  • Collectibility of the price or fee is reasonably assured.
The SAB provides a number of examples of how the staff applies these criteria to specific fact patterns. Moreover, the SAB addresses the following important income recognition issues:

  • Whether income should be presented on a fee or commission basis or at the full transaction amount when the seller is acting as a sales agent or in a similar capacity.

    What disclosure registrants should make about their revenue recognition policies and the impact of events and trends on revenue.

Recent Enforcement Actions – Financial Fraud

To reinforce the importance of accurate financial disclosure, I'd like to run through a number of recent enforcement cases that have hinged on financial reporting fraud. As I stated earlier, financial fraud cases constitute almost one fifth of the cases brought by the Division of Enforcement in the last year. As you listen to the following summary of recent enforcement cases, remember that almost all of these frauds could have been avoided had registrants had good internal controls in place.

Intentional Misstatements

The Division of Enforcement gives the closest scrutiny to intentional misstatements by senior managers. Last year, the Division brought 18 actions alleging that the purposes of these frauds was to engage in earnings management for the purpose of meeting projections and compensation benchmarks. In one particularly egregious case, the CEO of Unison Healthcare handed the company comptroller a piece of paper and said "here's the numbers we need to get to" and "I don't care how we get there."

Obviously, the Commission does care how companies arrive at their numbers.

Revenue Recognition

Enforcement brought about one-third of its financial fraud actions – 32 of the 90 – for improper income recognition. Another 12 cases involved the booking of fictitious sales. The issuance of SAB 101 is particularly timely given the large number of these type cases.

Asset Valuation

On the balance sheet side, 17 cases involved fraudulent asset valuations. An additional 12 cases featured improper capitalization of expenses.

“Barter” Cases

In the high-technology arena, the Commission has seen some of the most creative methods of "cooking the books." Last year, we sued 4 such companies who greatly overvalued legal or professional services received by paying out disproportionately large options or equity interests. Simply put, these transactions were not accounted for on an arm's length or dollar-for-dollar basis.

Individuals Charged

Last but not least, the Commission is increasing its sanctions against individuals who commit fraud on behalf of the corporation. Last year, 120 corporate officers and employees were charged with participating in financial fraud. Moreover, we have not limited ourselves to pursuing only senior officers. Because there are frequently multiple participants in fraudulent activity, we look up and down the chain of command. For example, in a recent action against KnowledgeWare, we charged 11 individuals ranging from the CEO down to 3 district sales managers. In the Livent theater fraud case, we charged 8 officers. Finally, in an action against W.R. Grace, we charged seven.


In conclusion, the staff of the Commission has given the financial industry both the incentive and the guidance to provide accurate disclosure. But there is still much work to be done. In this fast-changing financial world, the SEC and investors must be able to rely on legal and accounting professionals proactively protecting both clients and investors. To accomplish this, legal counsel and auditors should continue to focus on good internal controls and follow the guidance set out in the recent SABs. These proactive steps will go a long way in improving financial reporting standards, avoiding entanglements with the Division of Enforcement and helping our markets continue to grow to meet the challenges of the new millennium.

Good luck and thank you.