• The Economic Significance of Accounting and the Key Role of Integrity in the Profession

    By • Jul 14th, 2013 • Category: Audit Firm Management, You Can Quote Me On That

    I was invited last April to speak at Texas Tech University and the Rawls College of Business by accounting department chairman Robert Ricketts. The occasion was the school’s  “Strive For Honor Week”. My presentation can be found at this link:  “The Economic Significance of Accounting and the Key Role of Integrity in the Profession“. Here’s an excerpt:

    Cornerstone Research reported recently that class actions lawsuits for accounting fraud fell sharply last year following a one-time increase in 2011 attributed to a surge of Chinese reverse mergers.  Those cases typically name the audit as a defendant, at least initially. Even though the number of cases is down, accounting fraud cases brought larger settlements than most shareholder litigation. Of the top six class action settlements worth $100 million or more in 2012, five involved accounting fraud allegations, “For the third year in a row,” according to an article in Law.com, “most accounting fraud cases involved allegations or announcements of weaknesses in the internal controls required under Sarbanes-Oxley.

    And, for the second year in a row, more than one in three involved a financial restatement. 
Restatements were associated with an approximately 15 percent increase in the settlement amount, according to Cornerstone. I wrote about that in October in Forbes magazine. I asked SEC Enforcement director Robert Khuzami, “Is a stretched SEC neglecting accounting fraud?”

    In a statement to FORBES, SEC Enforcement Director Robert Khuzami argued that an accounting fraud task force he dismantled in a reorganization of enforcement priorities was no longer needed because accounting expertise exists throughout the agency, and the number and severity of earnings restatements (a flag for possible accounting fraud) has declined dramatically since the mid-2000s. Khuzami told me: “In a world of limited resources, we must prioritize our efforts. … The reorganization helped to focus us on where the fraud is and not where the fraud isn’t, while allowing us to remain fully capable of addressing cases of accounting and disclosure fraud.”

    I don’t think so. A recent report by Bloomberg says the SEC, under new Chairman Mary Jo White, is reconsidering that position including whether to dismantle or reorient some of the specialized units that were formed three years ago in a reorganization by former Enforcement head Robert Khuzami. Bloomberg says White has raised questions about a drop in the number of accounting fraud cases the agency has brought in recent years. Co-Enforcement head George Canellos said in February that investigators are looking into new ways of detecting accounting fraud, an area that has seen fewer enforcement actions in recent years. That will mean, inevitably, increased scrutiny of the auditors when those frauds happen.

    In early June I wrote about the “revision restatement” problem and suggested that this was a good place for the SEC to start looking for fraud again. Former SEC Director of Enforcement Robert Khuzami had claimed to me, in my November Forbes magazine article, that fewer restatements meant less accounting fraud and, therefore, 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, it does not undermine reliance on past financials and is less disruptive on the market, meaning the stock price doesn’t suddenly and precipitously drop. In early July the SEC announced the reestablishment of an Accounting Fraud Task Force.

    “The Financial Reporting and Audit Task Force dedicated to detecting fraudulent or improper financial reporting, whose work will enhance the Division’s ongoing enforcement efforts related to accounting and disclosure fraud.” “The principal goal of the Task Force will be fraud detection and increased prosecution of violations involving false or misleading financial statements and disclosures. The Task Force will focus on identifying and exploring areas susceptible to fraudulent financial reporting, including on-going review of financial statement restatements and revisions, analysis of performance trends by industry, and use of technology-based tools such as the Accounting Quality Model.”

    Someone up there, over there, out there is listening.

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