Irregularities in financial statements lead to inefficiencies in capital allocation and can become costly to investors, regulators, and potentially taxpayers if left unchecked. Finding an effective way to detect accounting irregularities has been challenging for academics and regulators. Responding to this challenge, we rely on a peculiar mathematical property known as Benford’s Law to create a summary red-flag measure to capture the likelihood that a company may be manipulating its financial statement numbers.
Posts Tagged ‘Accounting’
On June 10, 2014, The Public Company Accounting Oversight Board (“PCAOB”) adopted new and amended auditing standards that expand audit procedures required to be performed with respect to three important areas: (1) related party transactions; (2) significant unusual transactions; and (3) a company’s financial relationships and transactions with its executive officers. The standards also expand the required communications that an auditor must make to the audit committee related to these three areas. They also amend the standard governing representations that the auditor is required to periodically obtain from management.
The modern quest for an “Esperanto” of business has been underway for nearly half a century. And though it was initiated by the United States, after 48 years, it has yet to gain our full support. That is unfortunate, because the promise of a global standard is truly dazzling.
An international language of disclosure and transparency would significantly improve investor confidence in global capital markets. Investors could more easily compare issuers’ disclosures, regardless of what country they came from. They could more easily weigh investment opportunities in their own countries against competing opportunities in other markets. And a single set of high-quality standards would be a great boon to emerging markets, because investors could have greater confidence in the transparency of financial reporting.
The US is the last major economy that has not yet adopted International Financial Reporting Standards (IFRS) while, from Europe to Canada, from Australia to China, around 120 countries are already requiring or permitting IFRS; this figure will likely rise to 150 countries in the near future. The introduction of IFRS has been debated in the United States for several years. The Securities and Exchange Commission (SEC) first issued a paper that includes a plan for possible implementation, and several SEC Staff Reports followed up until the July 2012 Final Staff Report with regard to the work plan. However, whether domestic issuers should be permitted to use IFRS is still very controversial.
Although US Securities and Exchange Commission (SEC) enforcement actions related to financial fraud and issuer disclosures have been on a decline since 2007, recent statements and actions suggest that the SEC is likely to re-focus its efforts on detecting, pursuing, and preventing accounting fraud.  Since her confirmation as Chair of the SEC, Mary Jo White has made it clear that her administration will focus on identifying and investigating accounting abuses at publicly-traded companies.  Among the recent initiatives announced by the SEC are the increased focus on the whistle blower program and the establishment of the Financial Reporting and Audit Task Force, the Microcap Fraud Task Force, and the Center for Risk and Quantitative Analytics. 
The number of accounting case settlements in 2013 increased for the second year in a row, but remained low compared with the previous 10 years, according to Cornerstone Research’s latest report, Accounting Class Action Filings and Settlements—2013 Review and Analysis. While the number of securities class action filings that included accounting allegations (47) remained relatively constant in 2013 compared with 2012, the market capitalization losses associated with these filings more than doubled.
The proposed enhancements to the auditor’s reporting model would be the first change to the standards in more than 70 years. Furthermore, they could significantly impact the content and format of auditors’ reports; the treatment of that information by investors and other users of financial statements; and the relationship and structure of interactions among management, audit committees and auditors as they have developed since the enactment of the Sarbanes-Oxley Act of 2002.
While hundreds of research papers discuss earnings quality, there is no agreed-upon definition. We take a unique perspective on the topic by focusing our efforts on the producers of earnings quality: Chief Financial Officers. In our paper, The Misrepresentation of Earnings, which was recently made publicly available on SSRN, we explore the definition, characteristics, and determinants of earnings quality, including the prevalence and identification of earnings misrepresentation. To do so, we conduct a large-scale survey of 375 CFOs on earnings quality. We supplement the survey with 12 in-depth interviews with CFOs from prominent firms.
On January 24, 2014, the Securities and Exchange Commission (“SEC”) issued an order instituting settled administrative and cease-and-desist proceedings against KPMG LLP (“KPMG”) for violating auditor independence rules in its relationships with affiliates of three of its SEC-registered audit clients.  At the crux of the SEC’s order are its findings that:
- KPMG provided prohibited non-audit services to affiliates of its audit clients;
- KPMG hired a former employee of an affiliate of one of KPMG’s audit clients and subsequently loaned him back to the affiliate to do the same work he had done as an employee of the affiliate;
- Certain KPMG employees owned stock in KPMG’s audit clients or affiliates of its audit clients; and
- KPMG repeatedly represented in its audit reports that it was “independent.”
KPMG settled the charges for approximately $8.2 million.
“One of our goals is to see that the SEC’s enforcement program is—and is perceived to be—everywhere, pursuing all types of violations of our federal securities laws, big and small.”
— Mary Jo White, Chair of the SEC, October 9, 2013
“In the end, our view is that we will not know whether there has been an overall reduction in accounting fraud until we devote the resources to find out, which is what we are doing.”
— Andrew Ceresney, Co-Director of the SEC Division of Enforcement, September 19, 2013
“The SEC is ‘Bringin’ Sexy Back’ to Accounting Investigations”
— New York Times, June 3, 2013
Much has changed since the collapse of Enron in 2001 and the ensuing avalanche of financial fraud cases brought by the SEC. For example, Sarbanes-Oxley raised auditing standards, imposed certification requirements on public company officers and required enhanced internal controls for public companies. The Public Company Accounting Oversight Board (PCAOB) was formed “to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit
reports.”  In pursuit of that goal, the PCAOB has conducted hundreds of audit firm inspections, adopted numerous auditing standards and brought dozens of enforcement actions against auditors for violating PCAOB rules and auditing standards.