Where Should SEC Start A Fraud Crack Down? Maybe Look At Fake Restatements


Posted by Mildred LIANG Bei Yan, Year 4 undergrad at the School of Accountancy, Singapore Management University

Where Should SEC Start A Fraud Crack Down? Maybe Look At Fake Restatements

It’s so good to hear that the Securities and Exchange Commission plans to refocus its enforcement efforts on accounting fraud. It would be even better for investors if the regulator used all the information already available – no need to resort to fancy computer algorithms – to prosecute accounting frauds and the executives, directors and third-party aiders and abettors like lawyers and auditors. Let’s stop waiting to be roused to action by private lawsuits.I worked very hard on my article for Forbes magazine last fall, Lying With Numbers: Is The SEC’s Ponzi Crusade Enabling Companies To Cook The Books, Enron-Style?

Trying to get a quote from SEC enforcement head Robert Khuzami for that article was like pulling teeth. Later in the year, when Khuzami resigned and others started questioning his legacy of limited financial crisis fraud enforcement, I was gratified. This recent Bloomberg piece says new Chairman Mary Jo White knows that accounting fraud enforcement in the last several years has been minimal.

White, who was sworn in last week…raised questions about a drop in the number of accounting fraud cases the agency has brought in recent years…

All the same, the number of such cases still in the pipeline has dwindled, and in recent months, the enforcement staff has formed teams to reevaluate how they are organized and what kinds of misconduct are most ripe for investigation. One consideration is whether to dismantle or reorient some of the specialized units that were formed three years ago by Robert Khuzami, who stepped down as enforcement director this year, the people said.

James Cox, a securities law professor at Duke University, said scrutiny of auditors and accountants is overdue.

“We have only seen the SEC be active against accountants with the Chinese reverse merger cases,” said Cox, referring to cases involving China-based companies that bought public shell companies in the U.S. and reported false financial results. Inspections of auditors “repeatedly show an amazing lack of professional skepticism by accountants who repeatedly defer to very questionable applications” of the industry’s accepted accounting principles, he said.
Another in the Wall Street Journal says that SEC officials will soon announce a “broad shuffling of resources” including an increased focus on accounting fraud.
”We have to be more proactive in looking for it,” Scott Friestad, a senior SEC enforcement official, told a legal conference last month. “There’s a feeling internally that the issue hasn’t gone away.”


Here’s the full text of Khuzami’s statement to me back in October: (Due to space considerations, the whole statement didn’t make it to print.)

“A separate task force was no longer needed since the SEC has deep accounting and disclosure expertise, including specialized accounting groups within our Division of Enforcement, and because the frequency and magnitude of restatements has declined dramatically since peaking in 2006. In a world of limited resources, we must prioritize our efforts to reflect current enforcement challenges; the reorganization helped to focus us on where the fraud is and not where it isn’t, while remaining fully equipped and vigilant to address cases of accounting and disclosure fraud,” said SEC Enforcement Division Director Robert Khuzami.

As Professor Cox told Bloomberg, Khuzami’s SEC Enforcement team and prior post- Sarbanes-Oxley enforcement efforts gave the auditors a pass, too. Even when SEC does address general accounting fraud, enforcement against auditors and especially against the largest audit firms is more and more rare. (Individual “rogue” partners, especially the epidemic of senior partners who are inside traders, get prosecuted fairly quickly.)

That’s in spite of rampant accounting fraud examples in the last ten years since SOx. The financial crisis mortgage fraud cases, corruption and bribery occurring on the auditors’ watch noted by growing number of FCPA cases, “rogue” traders exploiting poor internal controls at JPM, MF Global, UBS, Société Générale and Barclays, private litigation against auditors for negligence and malpractice, several recent alleged violations of auditor independence cited by me and other media outlets and recent fraud allegations by companies themselves such as HP/Autonomy and Caterpillar all provide opportunities for SEC and DOJ enforcement against auditors and individual executives. We’ve seen not much of either.

The Center for Audit Quality, an arm of the audit industry trade association the AICPA, recently commissioned the authors of a 2010 report, Fraudulent Financial Reporting: 1998–2007, An Analysis of U.S. Public Companies, to expand the study period through December 2010 and review the SEC enforcement actions against auditors. The study provides a descriptive analysis of those investigations where the SEC brought an enforcement action against either the auditor or the audit firm.
From 1998–2010, the authors identified 87 instances of SEC investigations of fraudulent financial reporting leading to sanctions against auditors. Only 11 of the cases occurred in 2003 or later, post- Sarbanes-Oxley Act of 2002.

These results track those I reported in Forbes magazine in October regarding SEC enforcement of accounting fraud cases, in general. The SEC filed only 79 accounting fraud and disclosure cases in 2012, 11% less than in 2011 when there were 89, the fewest, by far, in a decade. Less general accounting fraud enforcement by SEC means fewer sanctions against the auditors. One typically follows the other except in individual cases like auditor insider trading.

At least New York’s top banking regulator, Benjamin M. Lawsky, isn’t afraid to crack down on the auditors as consultants. Stunning news today from The New York Times:

Deloitte has agreed to a $10 million fine and a one-year ban from advising banks chartered in New York as part of a settlement with state officials, Gov. Andrew M. Cuomo‘s administration announced on Tuesday… The agreement on Tuesday — including the fine, the one-year ban and a mandatory “code of conduct” that forces the consultant to ensure the independence of its work — is a victory for Mr. Lawsky and the latest blow to the multibillion-dollar consulting industry.

The industry, which includes some of the world’s largest accounting firms, has become something of a shadow regulator of Wall Street.”

I’ve updated the CAQ data for 2011 and 2012 and the results are comparable to those findings. My further review noted eight SEC cases in 2011 involving audit firms and auditors and thirteen in 2012. Many cases involve multiple Accounting and Auditing Enforcement Releases (AAERs).

The numbers in 2011, eight AAERs against firms and eleven against individuals, are pumped up by some notable cases: Price Waterhouse India for Satyam; KPMG Australia for independence violations very similar to KPMG activities at GE that have not yet been sanctioned; and an enforcement order against Deloitte Touche Tohmatsu for its lack of cooperation in providing workpapers helpful to investigations of Chinese frauds.

Thirteen enforcement cases involving CPAs were found in 2012. Large firm AAERs in 2012 include one single order covering the Big Four and one more firm for lack of cooperation in the Chinese reverse merger fraud investigations and an independence violation by Deloitte South Africa involving a prohibited business relationship. The rest involve smaller firms and individual CPAs.

The SEC AAERs – and any actions by the audit regulator the PCAOB – are characterized in many cases by an enormous delay between the date of the violations in question and the resolution of the enforcement action. The most egregious example of that delay in my memory? The Ernst & Young case related to Bally’s – six years from last violation to enforcement.

But what about Khuzami’s primary claim – that fewer restatements mean less accounting fraud and, therefore, even less need to prosecute audit firms and auditors? According to research firm Audit Analytics, “revision restatements” were 64.69% of the restatements disclosed in 2012. This figure is the highest percentage since 2005 (the first full year the 8-K disclosure requirement was in effect).

A “revision restatement”, according to Audit Analytics, is one included in a periodic report without a prior disclosure in Item 4.02 of an 8-K. Thus, a “revision restatement”, presumably per Audit Analytics, does not undermine reliance on past financials and is less disruptive on the market, meaning the stock price doesn’t suddenly and precipitously drop. The word “presumably” implies there is some judgment and subjectivity involved in the decision to make a restatement and, in particular, a determination that the “error” does not undermine reliance on prior financial statements.

In the case of the largest “revision restatement” of 2012, JP Morgan’s $459 million adjustment for the “error” in calculating its reported loss in the 1stquarter for the “whale” trade as a result of a material weakness in internal controls over its valuation process, you have to wonder.

Who decides whether a restatement is required? Presumably management makes the right decision and the auditor agrees. A restatement is embarrassing to auditors, can trigger litigation against the company, its executives, directors and auditors and prompts compensation clawbacks.

From “Lying With Numbers”:

With a revision restatement executives’ prior pay isn’t at risk, auditors don’t have to retract their approval of earlier statements, and there’s usually little impact on the stock and so no investor lawsuits.

“The auditors are highly self-interested in accepting clients’ desire not to restate, and the quality of financial reporting suffers,” complains Salvatore J. Graziano, a partner at securities class action firm Bernstein Litowitz Berger & Grossmann. He says his firm has seen revisions used for “material writedowns to financial reserves, deferred tax assets or goodwill.”

And what happens if a company makes an easy-does-it “revision restatement” instead of a full restatement of prior financials after an independent investigation and full prior disclosure via an 8-K? Audit Analytics quotes the SEC’s Louise Dorsey in a speech before the 2006 AICPA National Conference on Current SEC and PCAOB Developments. Dorsey noted that “the trigger event is the decision that the financial statements are unreliable, not the completion of the restatement process,” and therefore if “a company files a 4.02 8-K on the same day it files an amended periodic report to restate its financial statements, it is highly likely that the staff would question the timing of the 8-K filing.”

In such instances, Audit Analytics says, the SEC would expect to find, after their own investigation, that the adjustment corrected a clerical error or other error that did not require an internal investigation.

Sounds like “revision restatements” are a good place for the SEC to start looking for accounting fraud and audit firms that roll over for management.

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