As part of the SEC’s efforts under chairman Mary Jo While to refocus the agency’s efforts to detect and pursue accounting fraud, the agency has undertaken a number of initiatives, including the formation of a Financial Reporting and Audit Task and the creation of the Center for Risk and Quantitative Analytics. As part of these efforts, the SEC has stated that it intends to employ “data analytics” to detect indicia of accounting fraud, through the implantation of what the agency calls the “Accounting Quality Model” (AQM) and what the media have dubbed “Robocop.”
As discussed at length in a prior post, the agency’s planned implementation of the AQM means that reporting companies could face more frequent inquiries from the SEC on substantive items in their financial reports. In a May 19, 2014 article entitled “Automated Detection in SEC Enforcement: Anticipating and Adapting to Emerging Accounting Fraud Enforcement Strategies” (here), NERA Economic Consulting takes a look at the SEC’s anticipated quantitative approach and suggests strategies for companies to adopt in anticipation of the agency’s forthcoming analytic scrutiny.
In its study, NERA states that the SEC’s use of analytic tools to identify reporting anomalies “alters the landscape on a fundamental level.” NERA suggests that reporting companies “would be well advised to anticipate SEC questions and identify anomalies in their financial reporting.” The report defines “anomalies” as “unusual changes in financial accounting data and/or accounting treatments.” The report also notes that “developing an understanding of the theoretical economic impact of any potential reporting anomalies will also be important.”
The presence of a statistical anomaly in a company’s financial statements – “whether or not it represents a reporting error” — may “trigger scrutiny by regulatory authorities prior to more overt and clear evidence of a problem.” According to NERA, the SEC is “actively developing the capabilities to cast a wider net,” as a result of which it is “important for companies to assess and anticipate what the SEC will consider to be red flags potentially warranting further investigation.”
In discussing how companies should anticipate the SEC’s heightened scrutiny, the report notes that the agency’s automated detection means that “any statistical anomaly (regardless of whether it is a misrepresentation) might be identified and ‘red-flagged’ by the SEC.” Accordingly it is important for companies to evaluate whether their current-period financial data are “out of line compared to industry peers”; deviate from their own historical patterns; or are “internally inconsistent” (such that, for example, their balance sheet, income statement and cash flow statement do not fully reconcile with one another).
In addition, various key financial ratios are “likely to matter both in their absolute levels and based on how they have changed over time.” The report suggests that the SEC will not simply look at individual accounting measures in isolation but would develop a model in which weights are assigned to anomalous measures across different accounting data, to arrive at a summary indicator of potential accounting issues.
The report suggests that companies can attempt to preempt SEC scrutiny by address apparent accounting anomalies through adequate pubic disclosures. Similarly, companies that are flagged by the SEC may be able to explain in public filings any accounting anomaly to the extent it is due to a company-specific factor. This kind of information might be disclosed either in an anticipatory public disclosure or in response to SEC inquiries.
In summary, the report suggests, the anticipated analytic scrutiny has important implications for all public companies. Companies need to be aware of “what may trigger scrutiny in order to anticipate it and to be prepared to explain legitimate financial reporting anomalies that may appear suspicious.”