The S.E.C. Is ‘Bringin’ Sexy Back’ to Accounting Investigations

In April 2003, a New York Times article discussed the push by federal prosecutors to crack down on accounting fraud in which one expert said, “These have become the hot, sexy cases.”

What followed were the convictions of chief executives including Jeffrey K. Skilling of Enron, Bernard J. Ebbers of WorldCom and John J. Rigas of Adelphia Communications.

The attraction seems to have worn off. The number of corporate accounting cases at the Securities and Exchange Commission has dropped to its lowest level in a decade, with only 79 such cases filed in the most recent fiscal year.

But The Wall Street Journal is reporting that Mary Jo White, the S.E.C.’s new chairwoman, wants to turn the agency’s attention back to what was once seen as its core mission of policing corporate disclosure to ensure investors are protected.

In the past, the S.E.C. relied mainly on the market to flag accounting problems at companies that would lead to an investigation. Enron’s demise, for example, began when questions were raised about its complex reporting of various off-balance-sheet transactions amid a rapidly falling stock price, which led to the issuance of subpoenas to the company and its outside auditor, Arthur Andersen.

Today, the S.E.C. wants to be more proactive by using risk modeling to analyze corporate filings to identify companies that might be outliers in reporting their results. In a speech in December, Craig M. Lewis, director of the agency’s division of risk, strategy and financial innovation, talked about a new “accounting quality model” that could help the S.E.C. “assess the degree to which registrants’ financial statements appear anomalous.”

This analysis will even look at the wording in financial reports about the company’s results and future prospects, which usually appears under the heading “management discussion and analysis.” Of course, no one ever admits to engaging in accounting shenanigans, but the kind of notoriously opaque statements used by Enron can give a clue about possible violations lurking inside a company’s books.

The challenge for the S.E.C. is that accounting fraud cases have never been “sexy” by any stretch of the imagination. Financial misstatements do not simply happen overnight, unlike insider trading that usually takes place within a narrow time frame before the information hits the market.

Developing evidence of violations means digging through years’ worth of complex financial records and trying to reconcile whether a company properly reported its results under the accounting rules. The resources that must be committed to building a case are much greater than in other types of investigations, which often do not require the kind of expertise that accounting fraud does.

Add to that the problem of proving there actually was a violation when the accounting rules – called generally accepted accounting principles, or GAAP – can be maddeningly vague. That can give corporate management a basis to claim the company acted in good faith, even if it might have been overly aggressive.

In an accounting fraud prosecution in California involving a high-tech company, the United States Court of Appeals for the Ninth Circuit overturned the conviction of the company’s chief financial officer because the government could not prove that aggressive accounting in recognizing revenue violated GAAP. The appeals court said the government’s evidence about how he tried to meet sales targets showed he was just “doing his job diligently.”

Outside auditors are usually loath to admit that anything improper happened because it could expose the firm to potentially significant liability. Thus, in accounting investigations the S.E.C. has to overcome the “circling the wagons” approach of management and the accountants that can lead to a fight at every turn, stretching out a case.

In 2002, the accounting scandals at Enron and WorldCom galvanized support for the Sarbanes-Oxley Act, which required companies to institute stronger internal controls and strengthened the hand of outside auditors to require compliance with accounting standards. That has made it more difficult for companies to engage in the kind of brazen violations that came to light a decade ago.

Thus, if the S.E.C. wants to return its focus to accounting fraud, it will need a long-term commitment to developing cases because the violations are unlikely to be quite as spectacular as those seen a decade ago. Investigations may not produce results for a few years, and some inquiries will end without any enforcement action being taken.
Putting resources into accounting cases may be a problem in the current environment, with Congress cutting budgets and questioning whether the S.E.C. is being too aggressive in how it regulates businesses. Greater scrutiny of corporate financial disclosures is sure to ruffle more than a few feathers in executive suites, and those complaints have a way of showing up on Capitol Hill.

Yet, this is the time to make the push to scrutinize financial statements for potential fraud and not just sit back and wait until a corporate accounting scandal comes to light.
Accounting fraud usually starts small, as a company tries to meet earnings and revenue projections, so managers may fudge the numbers a little bit in the hope that the next quarter will let them make up for any questionable entries in the books. What begins with cutting a few corners takes on a life of its own as the next quarter is never quite enough to correct the imbalance.

Warren E. Buffett famously said, “You never know who’s swimming naked until the tide goes out.” With widespread reports that the economy is improving, the financial tide is rising, which means some companies may be doffing bathing suits to make sure their results look good.

Don’t forget that Enron’s chief financial officer, Andrew S. Fastow, received an “Excellence Award for Capital Structure Management” during the bull market in 1999, just two years before the company started to implode.

This is when the S.E.C. should start looking for signs of accounting chicanery, before it blows up a company and inflicts damage on investors and employees. Whether Congress and corporate America will go along with such a push will be a more difficult question to answer.