Rising stock prices may be correlated with increased risk of financial reporting fraud, the SEC’s David Woodcock said this week, and that creates urgency for him and the new task force he chairs at the agency.
Woodcock chairs the SEC Financial Reporting and Audit Task Force, which was unveiled in July. He said studies have shown that occurrences of financial accounting fraud increase as the economy improves, perhaps because incentives are higher.
In this environment, the SEC is using the new task force and a new tool to combat financial reporting fraud, with a goal of early detection.
“Regulatory oversight cannot remain at rest,” Woodcock said. “If we do what we did in the past, if we continue operating as if everything is OK, that’s when trouble comes.”
SEC officials at the AICPA Conference on Current SEC and PCAOB Developments this week gave detailed descriptions of how they plan to combat fraud with the task force and a new analytics tool called the Accounting Quality Model.
Although SEC officials wouldn’t divulge the exact formula that the Accounting Quality Model uses to identify anomalies in companies’ financial reporting, Woodcock revealed some of the areas the task force is monitoring closely for signs of fraud.
In general, the task force is watching for indications of fraud in non-GAAP measures, omissions from management discussion & analysis, and faulty internal controls over financial reporting, Woodcock said. In addition, the task force is watching trends or patterns of conduct that could be considered risk indicators.
- Use of an accounting policy that results in relatively high reported book earnings while the firm is simultaneously using a different method for tax treatment that minimizes taxable income. “I’m not saying there’s anything wrong with that in every case,” Woodcock said. “But it’s something that comes up on our radar.”
- A high proportion of transactions structured as off-balance-sheet. “Although most of the off-balance-sheet transactions are perfectly legitimate, many of the largest accounting scandals of the past have used off-balance-sheet [transactions] to hide poor financial performance,” Woodcock said.
- Instances where issuers have multiple revisions over a short period. “A pattern of multiple revisions sometimes in a very short period of time could be troubling not only because the issuers are not maintaining appropriate books and records, but they may suggest that the issuer has not established or maintained appropriate internal controls surrounding financial reporting,” Woodcock said.
The task force also is using the Accounting Quality Model to identify anomalies that might indicate financial reporting fraud. The model analyzes XBRL data to examine how public companies report their performance.
The model searches for specific elements in the financial statements that could be considered what SEC Chief Economist Craig Lewis called “aberrational deviations.” Lewis, who directs the SEC’s Division of Economic and Risk Analysis, said a deviation might generate just a comment letter to the filer from the SEC’s Division of Corporation Finance. But it might be an indication of an active attempt to distort reports of performance.
In addition to identifying specific items for investigation, SEC staff members will use “risk scoring” generated by the model to help prioritize which companies’ reporting needs to be examined, Lewis said. And whenever an SEC reviewer is scheduled to analyze the reporting of any firm, data from the model would help indicate what specific areas of that company’s reporting should be scrutinized.
“I just see it as not only a tool that [could be] used to schedule the review process, hopefully, but also has the potential to simply be a tool that an examiner or reviewer would use every single time,” Lewis said. “They would just pull up the model, understand what the model is saying, as a way of beginning … review of a particular filer.”
Using the latest tools is one goal of the Financial Reporting and Audit Task Force. The group also wants to develop a better understanding of financial fraud and where it should be expected; share information within the SEC and collaborate with other agencies; and engage academia and whistleblowers in combating fraud.
With the task force’s work in its early stages, Woodcock offered the following advice:
- Stay focused on internal controls. “Weakened internal controls can lead to material misstatements, including opening up the possibility for fraud,” Woodcock said. “So this is something we’re going to continue to examine closely.”
- The best weapons against financial reporting fraud are a robust compliance program, an appropriately skeptical auditor, and a diligent audit committee. “This is particularly true in areas of judgment, that have significant amounts of judgment in the financial disclosures,” Woodcock said.
Woodcock said there is no perfect model for the task force to use. But he said his goal is to use the latest tools and the best thinking to identify accounting fraud as soon as possible.
“We’re quite excited about the work, the mission, and the possibilities of doing something new in this area,” he said.
—Ken Tysiac (email@example.com) is a JofA senior editor.