SEC and DOJ Actions May Lead to Reduction in Fraud and Improvements in Auditing Practices

IMGCAP(1)][IMGCAP(2)]It is widely acknowledged that fraud, including fraudulent financial reporting and other improprieties targeted against businesses, has become epidemic.

Indeed, the Association of Certified Fraud Examiners’ bi-annual Report to the Nations on Occupational Fraud and Abuse recounts that these acts consume some 5 percent of revenue for the average business enterprise, or some $3.5 trillion annually, if extrapolated to the entire world’s gross product. It is also known that many instances of fraud go undetected and, of those that are identified, a significant fraction (about one-third) are not referred to the authorities for criminal prosecution, in large part because companies wish to avoid the negative publicity that might result from being the acknowledged victim of such crimes. It is furthermore generally conceded that failure to prosecute serves to encourage yet other acts of fraud.

Early detection of fraud would limit the harm done to companies and their outside stakeholders, but many frauds go undetected for years and even decades, usually with the perpetrators becoming emboldened over time, taking ever-larger amounts from corporate coffers.
However, frauds involving bogus documents and/or collaboration among key personnel are notoriously difficult to spot, particularly during the early stages, and often go undiscovered by internal auditors, external auditors and senior management until the enormity of the damages suffered makes further concealment impossible. Late detection often means recovery will be very difficult, leaving the victim company seriously wounded. Indeed, being the victim of a business accounting or other fraud is strongly correlated to the victimized organization’s ultimate failure.

More attention will be paid to fraud in the future, thanks to separate actions being taken by the Securities and Exchange Commission and the Department of Justice, the effects of which hopefully will be compounded by inter-agency cooperation and, ultimately, with key private-sector actors, especially auditors, also embracing new fraud detection methodologies.

The SEC oversees financial reporting by publicly held companies (“issuers,” in the terminology of the Sarbanes-Oxley Act of 2002), and frequently brings civil actions against companies, individuals and outside auditors when fraudulent financial reporting has been discovered. Historically, the challenge has been to identify instances of such frauds, which, in the absence of overt events such as restatements of prior-period reports, withdrawals of auditors’ prior opinions, or bankruptcies, may go undetected for extended periods of time.

As one of several initiatives announced by the SEC in mid-2013, a newly constituted Financial Reporting and Audit Task Force will take steps to enhance the Enforcement Division's efforts related to accounting and disclosure fraud. A separate but related initiative involves the Center for Risk and Quantitative Analytics, whose efforts at creating and employing a new quantitative data and analysis model will profile high-risk behaviors and transactions with the aim of developing a methodology for the earlier detection of financial reporting misconduct. The ultimate goal is to identify a set of “red flags” that would trigger closer examinations of submissions for those entities deemed as having a higher risk of being the perpetrator or victim of financial reporting fraud.

If the SEC is successful in this undertaking, it is furthermore to be hoped that the resultant diagnostic tools would eventually be shared with private sector accounting professionals, particularly those engaged in auditing companies—both publicly held and private—so that fraud risk assessments and substantive auditing procedures could be similarly improved.

Despite decades-long protestations by the auditing profession that detection of fraud was not within the scope of routine annual audits, and that auditors were not necessarily well equipped to do them, it has long been clear that users of financial information do expect this to be done, and will seek damages from audit firms when frauds are later uncovered that visit harm on investors and other stakeholders.

If the SEC is able to advance the art of detection of fraudulent financial reporting, sharing such knowledge with private sector auditors will serve the SEC’s objectives and reduce the harmful effects now felt throughout the economy, as well as protecting investors.

In April, the Department of Justice announced that the U.S. Attorney’s Office in Chicago has created a new section to focus on prosecuting securities and commodities fraud, which may incorporate the criminal side of the financial reporting fraud pursuits of the new SEC unit to some extent. (The SEC has only civil enforcement powers and routinely refers matters it has identified to the DOJ for criminal prosecution, if circumstances warrant.)

Cooperation between these agencies will be important, and it may also be useful to tap into the private sector for input on possible approaches. Assistance may reasonably be sought from academia, where research on fraud deterrence and detection has long been pursued. It might also be sought from the auditing profession itself, which has seemingly struggled for decades in developing and creatively applying analytical techniques that could possibly enhance auditors’ effectiveness in conducting routine annual examinations where anomalies that could be “red flags” of improprieties now go largely unappreciated.

Both the SEC’s and the DOJ’s new undertakings are to be applauded. If private sector talent could be meaningfully involved in these efforts—and could be permitted to learn from the findings flowing from these agencies’ endeavors—there would be reason to hope not only that civil and criminal enforcement might be made more effective, but also that more effective auditing techniques might evolve, to serve as a longer-term deterrent impact to the scourge of corporate fraud.

Natasha Perssico, MBA, CPA, is a forensic accountant and litigation consultant at Cendrowski Corporate Advisors (CCA), a financial consulting and litigation support firm with offices in Chicago, Ill., and Bloomfield Hills, Mich. Natasha is a CPA licensed to practice in Illinois and earned an MBA from DePaul University in 2012 specializing in Forensic Accounting. She can be reached at nmp@cendsel.com. Barry Jay Epstein, Ph.D., CPA, CFF, a principal with Cendrowski Corporate Advisors, has more than 40 years of experience as an accountant, auditor, lecturer, writer and financial executive. Dr. Epstein specializes in the areas of white-collar defense, financial reporting fraud and securities litigation, accountants' liability and accountant malpractice, among others. He can be reached at bje@cendsel.com.

nmp@cendsel.com

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