Speech by SEC Staff:
Remarks to the Panel on Audit Effectiveness
by Richard H. Walker
Director, Division of Enforcement,
U.S. Securities & Exchange Commission
New York City
October 9, 1999
Financial fraud cases have long been one of the most important components of our enforcement program. As the Second Circuit Court of Appeals has aptly noted, false financial statements and the accountant's certificate accompanying them "can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar."1 Close to 20% of the 450 to 500 cases we bring in any given year charge wrongdoing in the preparation, dissemination, or audit of financial statements or reports whether by issuers, their management or employees, their independent auditors, or others. This past year was no exception. We brought close to 100 cases in this area.
By now, most of you are aware that the Commission announced the filing of 30 enforcement actions just last week against 68 individuals and companies for engaging in fraudulent misconduct in the accounting, reporting, and disclosure of financial results by 15 different public companies. Among those named by the Commission are the current or former chief executive officers at 11 of the 15 companies. These cases demonstrate our continuing commitment to vigorously protect the credibility of our financial reporting process.
The companies involved in last week's announcement run the gamut from small microcap companies to large sophisticated companies traded on the NYSE.
The actions allege a veritable cookbook of recipes for fraudulent accounting and reporting, including:
Unquestionably, as our Division's Chief Accountant Walter Schuetze has noted and as these cases confirm, fraudulent revenue recognition is the recipe of choice for cooking the books. And in most cases, it has been the overstatement of receivables that drives fraudulent revenue recognition. The audit of receivables is an area where it is imperative that auditors pay closer attention.
- recognition of revenue on shipments that never occurred or for products not yet manufactured
- hidden "side letters" giving customers the right to return product
- characterization of consignment sales as final sales
- premature recognition of sales that occurred after the end of the fiscal period
- shipment of unfinished product
- shipment of product before customers wanted or agreed to delivery
- creation of fictitious invoices
- backdating of agreements
- the list goes on and on.
It is not just investors who rely on auditors to detect fraud. The Commission looks to auditors as well in its efforts to combat fraud. The Second Circuit Court of Appeals has remarked: "The Commission, with its small staff and limited resources, cannot possibly examine each of the many financial statements filed. Recognizing this, the Commission necessarily must rely heavily on the accounting profession to perform its tasks diligently and responsibly."2 In short, auditors are the first line of defense.
This Panel was created in response to a growing concern that the accounting profession should critically examine issues that may have led to a deterioration in the effectiveness of audits. This sense of concern has been heightened by recent high profile frauds causing the investing public to question, in the words of my predecessor Judge Stanley Sporkin: "Where ... were the outside accountants?"3
One of the reasons, perhaps the most important reason, that our capital marketplace is so vibrant and strong is that investors believe the financial information they receive. There are between 14,000 and 15,000 public companies in the United States. The percentage of these companies charged each year with financial fraud is small. However, when those cases involve large enterprises and result in investors incurring significant market losses, as has been the case in the recent past, investors will factor another risk into their calculus when they offer to buy securities. This risk is the risk that the financial information they must rely on in making their investment discisions is not correct. Investors will, without notice, bid lower prices than they would were they not skeptical of the financial information published by issuer registrants. So, other things remaining the same, P/E ratios may become 32 instead of 33, or 23 instead of 25. And no one will ever know why. It will spread like carbon monoxide.
What we will know is that total market capitalization has declined. When that happens, the results will be real and potentially severe: the value of the assets in our 401(k) plans will decline, companies will be able to raise less capital to grow their businesses and fewer people will be employed by American business. We cannot allow that to happen because of poor auditing. For our markets to remain preeminent, there can be no room for investors to lack confidence in financial information.
1U.S. v. Benjamin, 328 F.2d 854 (2d Cir. 1964).
2Touche Ross & Co. v. SEC, 609 F.2d 570 (2d Cir. 1979).
3Lincoln S&L Ass'n v. Wall, 743 F. Supp. 901 (D.D.C. 1990).