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Vedder Thinking | Articles SEC Enforcement Moves Toward Automatic Detection of Possible Accounting Fraud

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Under the leadership of Chairman Mary Jo White, the SEC has continued to increase its focus on identifying and investigating accounting abuses at publicly traded companies. In order to accomplish this initiative, the SEC announced in 2013 that it would be utilizing a proprietary tool known as the Accounting Quality Model (AQM) in an attempt to automatically detect fraudulent or improper financial reporting. The SEC also created a Financial Reporting and Audit Task Force (Task Force) in 2013 to further focus its efforts in this area. The SEC hoped that its use of the AQM would lead to earlier detection of potential accounting issues and more rigorous examinations by SEC staff. Although the AQM has yet to fully revolutionize the SEC's detection of accounting fraud to the extent initially suggested, registered entities should anticipate SEC questions regarding any inconsistencies in their financial reporting, including unusual changes in financial accounting data or accounting treatments and the theoretical economic impact of such issues. The use of the AQM may result in increased self-reporting and disclosure of accounting anomalies to the SEC and to the public by registered entities.

The AQM is a set of quantitative analytic modeling tools designed to review public filings. The AQM searches publicly filed financial statements for indications of anomalies, which are then automatically flagged and reviewed by an examiner. The model attempts to identify firms with accounting practices that vary from a peer group. Theoretically, the AQM will identify any statistical anomalies, whether or not they represent a potential error, and invite additional scrutiny by the SEC prior to the discovery of more significant evidence of wrongdoing. One reported issue preventing more widespread use of the AQM by the SEC has been its identification of false positives. The Task Force was created in part to address this gap by combining targeted staff analysis with AQM results.

In order to determine which accounting anomalies to focus on for further review, the SEC, through the Task Force, will analyze the likelihood that a particular anomaly is indicative of fraud. The primary factor in this analysis is typically the potential economic impact of the anomaly. In other words, the SEC is motivated by the "materiality" of a potential error, or the substantial likelihood that a reasonable investor would consider it to be important information. The SEC may also scrutinize accounting anomalies that may not be accompanied by an immediate and clear stock price movement. The AQM allows the SEC to investigate potential anomalies prior to a corrective disclosure—for example, those situations in which a stock price remained steady, rather than falling as it might have if a proper disclosure had been made.

The SEC has shown no signs of abandoning its goal to increase the number of accounting cases and investigations. As the SEC's use of the AQM improves, registered entities should be aware of the potential for further SEC review of their filings if they present a potential anomaly. Specifically, if a company's financial reporting is out of line with past reporting or that of its peer group, the AQM may very well flag the filing for further review by the SEC, even if there
are legitimate explanations for the manner of reporting. Registered entities should analyze whether their financial reporting may (1) deviate from their own historical method of financial reporting; (2) be internally inconsistent, such that all financial statements are not fully aligned; and/or (3) differ from the typical method of financial reporting in their industry peer group. The SEC may evaluate various financial ratios arising from these factors in order to further refine
its investigation efforts. Although a significant portion of the SEC's financial fraud cases are likely to continue to arise from reactive sources such as restatements, tips and self-reporting, proactive tools such as the AQM will likely become more widespread and relied upon more frequently by regulators to detect investment and accounting fraud.

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Brooke E. Conner

Associate