Friday, May 31, 2013

SEC to Focus more on Financial Reporting Fraud

According to the Wall Street Journal, the SEC is ready to get back to work looking for financial reporting fraud. After the mortgage meltdown, the article states that the SEC turned its attention to cases related to the financial crisis and took its eye off of fraudulent financial reporting. Interestingly, the article identifies one new tool that the SEC plans to use to identify fraudulent financial statements...
Here is a description from the article of some tools the agency will be using:
(T)he SEC... is developing a computer program to sift language in financial reports for clues that executives might be misstating results...
An initial step in the SEC's new effort is software that analyzes the "management's discussion and analysis" section of annual reports where executives detail a company's performance and prospects.
Officials say certain word choices appear to reveal warning signs of earnings manipulation, and tests to determine if the analysis would have detected previous accounting frauds "look very promising," said Harvey Westbrook, head of the SEC's office of quantitative research.
Companies that bend or break accounting rules tend to play a "word shell game," said Craig Lewis, the SEC's chief economist and head of the division developing the model. Such companies try to "deflect attention from a core problem by talking a lot more about a benign" issue than their competitors, while "underreporting important risks."
If the word-analysis program works, officials say it will be added to a new "Accounting Quality Model" that SEC enforcement staff started using recently. The model trawls data from nearly 9,000 publicly traded companies. A similar computer-powered search for unusual performance patterns at hedge funds has led to seven enforcement actions in recent years.
Success won't be easy, partly because suspicious language or numbers in securities filings aren't necessarily illegal. Some companies and their lawyers are expected to respond to the crackdown by trying to outsmart the agency's computers.
In any case, the article quotes a senior SEC enforcement official as saying: "We have to be more proactive in looking for (financial statement fraud)...There's a feeling internally that the issue hasn't gone away."

Well, I bet that "feeling" is spot on. In fact, I tend to agree with a statement that I once heard Greg Jonas say (when he was a partner at Arthur Andersen) that went something like this: "Even Mother Teresa would commit fraud if given enough incentive and opportunity." In other words, even people of the highest moral character would get involved in fraud under conditions with tremendous pressure and opportunities.

Given the incredible incentives and pressures in today's business world and the opportunities that exist today this insures that fraudulent financial statements are still out in circulation. As such, saying that financial statement fraud hasn't gone away is a serious understatement and probably akin to saying "we have a feeling that the sun hasn't burned out even though we're in our basement with our eyes closed!"

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