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 ‘Financial reporting’
I understand today’s participants include a number of trustees and asset managers for some of the country’s largest public and private pension funds. Without a doubt, pension funds play an important role in our capital markets and the global economy. This is due, in part, to the fast growth in pension fund assets, both in the public and private sectors.
For example, since 1993, total public pension fund assets have grown from about $1.3 trillion to over $4.3 trillion in 2011. Over that same period, total private pension fund assets more than doubled from roughly $2.3 trillion to over $6.3 trillion by 2011. As of December 2013, total pension assets have reached more than $18 trillion. This growth was fueled by many factors, including the rise in government support of retirement benefits, and the increased use by companies of pension plans as a way to supplement wages.
The SEC today has about 4,200 employees, located in Washington and 11 regional offices across the country, including one in San Francisco that is very ably led by Regional Director Jina Choi, who is here [June 23, 2014]. Many of you have likely had some contact with our Division of Corporation Finance, which, among other things, has the responsibility to review your periodic filings and your securities offerings. Some of you that work for or represent a company that we oversee know our staff in our National Exam Program, and I imagine a few of your companies know something about our Enforcement Division staff. Our other major divisions are Investment Management, Trading and Markets and the Division of Economic and Risk Analysis.
So that is just a quick snapshot of the structure of the SEC and as you undoubtedly know, the SEC has a lot on its regulatory plate that is relevant to you—completion of the mandated rulemakings under the Dodd Frank Act and JOBS Act, adopting a final rule on money market funds, enhancing the structure and transparency of our equity and fixed income markets, reviewing the effectiveness of disclosures by public companies, to name just a few. But what you may not be as focused on is the mindset of the agency on some other things that are also relevant to you as directors.
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.
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. 
Five months after regulators released the final Volcker rule, banks are pressing ahead with their implementation efforts, but are still waiting for promised guidance to clarify the rule’s many ambiguities.
Reminiscent of last year when banks were expecting the final rule, industry commentators have already sounded false alarms regarding this guidance’s imminence.  Also, despite establishing an interagency taskforce this year to reconcile supervisory views, the five regulators are again having difficulty coordinating. The only regulatory guidance issued so far has come from the OCC acting alone (through the unusual approach of a “Dear CEO” letter),  which merely confirmed the rumored September 2, 2014 metrics reporting due date for the largest firms.
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.
“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.
In our paper, Executives’ ‘Off-the-Job’ Behavior, Corporate Culture, and Financial Reporting Risk, forthcoming in the Journal of Financial Economics, we examine how and why two aspects of top executives’ behavior outside the workplace, as measured by their legal infractions and ownership of luxury goods, are related to the likelihood of future misstated financial statements, including fraud and unintentional material reporting errors. We investigate two potential channels through which executives’ outside behavior is linked to the probability of future misstatements: (1) the executive’s propensity to misreport (hereafter “propensity channel”); and (2) changes in corporate culture (hereafter “culture channel”).