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Securities and Exchange Commission’s voting record on legal actions

Since tomorrow is election day in America I thought it would be appropriate to talk about the Securities and Exchange Commission’s voting record with respect to legal actions.

As a background, there are five Commissioners who are appointed by the President with the advice and consent of the Senate.  Terms of these Commissioners last five years and are staggered so that one Commissioner’s term ends on June 5 of each year.  The Chair and Commissioners may continue to serve approximately 18 months after terms expire if they are not replaced before then.  What’s interesting is that to ensure the Commission remains non-partisan, no more than three Commissioners may belong to the same political party.  The President also designates one of the Commissioners as Chair.  As of the time of this blog post there are three Commissioners, Mary Jo White, Chair, Kara M. Stein, and Michael S. Piwowar.  Two vacancies currently exist on the Commission.

The Division of Enforcement, whose activities are overseen by the Commission, has had a milestone year in terms of both enforcement actions and whistleblower awards.  Before the SEC staff brings enforcement actions the Commission must vote and approve the staff to take action.  To provide insight into this process the SEC posts voting results of the Commission on its website.

In analyzing these voting results following are some interesting trends:

  • Since January 2016, the Commission voted on 804 proceedings
  • Between January 1, 2016 and the date of today’s post, the Commissioners have nearly a 98% “Approved” voting record on these proceedings
  • In only 20 of the 804 proceedings did any Commissioner vote “Not Approved”
  • In every proceeding when a “Not Approved” vote was cast, a majority of the Commission voted “Approved”
  • In only 20 of the 804 proceedings did a Commissioner vote “Approved with Exception” (reasons for the exception included the amount of corporate penalty or the bar sanctions, for example)
  • When a Commissioner voted “Not Approved,” it was generally Commissioner Piwowar

With this in mind, there are multiple ways of thinking about potential explanations for the high rate of conformity in voting, such as large caseload juxtaposed against a lack of sufficient time to truly vet cases to bring or political pressure to increase actions.  Although interested parties may make different conclusions about these findings, they are, nonetheless, important to take note of.

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How forensic accountants can help fight discovery abuse

Not long ago I supported an expert witness in a civil dispute.  My team was hired by the defense.  Throughout the course of our engagement I saw first-hand some of the tactics that plaintiff’s counsel employed to portray the defendant in a manner that was inconsistent with the evidence my team reviewed.  Furthermore, I observed on numerous occasions the plaintiff counsel’s “abusive” tactics during the discovery phase.

Depending on one’s exposure to dispute matters, the spectrum of discovery abuse can range from “never seen it” to “seen it a lot.”  Due to the realities of discovery abuse and its implications for practitioners, today’s post will discuss some of the strategies that practitioners can assist counsel in responding to what I call “risk of discovery abuse,” or the risk that opposing counsel may employ abusive discovery tactics.

Establishing objectives

As a general matter, practitioners should quickly establish with counsel an agreed-upon objective for discovery.  Of course, the objectives may differ depending on the nature of the engagement (e.g., consultant vs. expert witness).  In any case, practitioners should obtain sufficient relevant data, including documents and other evidence already in the client’s possession.  On the surface this may seem straightforward, but in practice it can be difficult to do this, particularly in cases where the documents produced are voluminous or relevant documents may not yet have been produced.

Once sufficient relevant data is obtained, practitioners can then work with counsel to collect relevant information regarding opposing counsel’s work habits, style, and practices.  This step may or may not be cost-effective.  Recognizing this, at a minimum, it can inform both the practitioner and counsel of the risk of discovery abuse by opposing counsel.

Meaningful steps

There are a number of valuable resources on this topic, such as a 2013 publication by the Defense Research Institute and a December 2014 article published by Hopwood, Pacini & Young in the Journal of Forensic & Investigative Accounting entitled “Fighting Discovery Abuse in Litigation“, to name a few.  A condensed version of this 2014 article can be found in Essentials of Forensic Accounting, published by Crain, Hopwood, Pacini & Young, 2015.  This publication identifies number of ways in which practitioners and counsel may obtain relevant data to assess the likelihood and extent of potential risk of discovery abuse by opposing counsel.  Indeed, there are multiple ways to understand opposing counsel’s litigation techniques and practices.  Examples include:

  • Observation of opposing counsel performing direct and cross-examinations, lodging objections, and engaging in opening and closing arguments at trial.
  • Inquiry of lawyers who have litigated against opposing counsel.
  • Inspection of trial court files for cases handled by opposing counsel.

Based on findings from this research, both practitioners and counsel can gather answers to questions, such as:

  • What types of objections, if any, did counsel raise to various interrogatories?
  • Did counsel file any motions for a protective order?
  • Did counsel do a document dump or engage in otherwise abusive discovery practices?
  • Did counsel ever refuse to comply with a court order?
  • How did counsel respond to requests for admission?
  • Did counsel often have motions to compel filed against him or her?
  • Does counsel respond to discovery?
  • Has counsel been sanctioned for misconduct?

Answers to these and other questions can assist practitioners and counsel in obtaining valuable information to assess the risk of discovery abuse.

Using precision when appropriate

In the discovery phase, depending on the nature of the information being sought, requests for evidence should be tailored sufficiently accurately and precisely so as to provide the highest likelihood of obtaining the information requested.  For this purpose practitioners can provide counsel meaningful input in the preparation of discovery requests (such as financial-related or technical evidence).

When using precision, the legitimacy of opposing counsel’s objection can be diminished.  Furthermore, this puts pressure on opposing counsel to offer precise or specific objections if the objections are to withstand judicial scrutiny.  As one would expect, precision in discovery requests tends to have a higher likelihood of surviving a motion for a protective order from the opposing side.

Courses of action

There are, of course, various means of addressing the risk of discovery abuse.  These can include keeping detailed records of requests, motions, and status, insisting that the counter-party provide a privilege log, seeking a protective order from the court, thereby placing limitations and conditions for violations, and seeking sanctions under the Federal Rules of Civil Procedure, Rule 37 for failure to cooperate in discovery.

As the saying goes, “an ounce of prevention is worth a pound of cure.”  With this in mind, to the extent that practitioners and counsel believe, in consultation with the client, that the potential benefits of conducting such research on opposing counsel may exceed the costs, practitioners can offer valuable assistance to counsel and their clients to effectively address discovery-related abuses.

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Payout trends in the SEC’s whistleblower program

In July 2010, the U.S. Congress enacted and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.   In connection with reform on investment protection, the Dodd-Frank Act provided for the establishment of a new whistleblower program.  The program provides for financial incentives for individuals to report potential federal securities laws violations to the SEC and provides for protection from employment retaliation.

Adoption of whistleblower rules

On May 25, 2011, the SEC adopted the new whistleblower rules, codified as Section 21F of the Securities Exchange Act of 1934, entitled “Securities Whistleblower Incentives and Protection.”  Pursuant to these rules, the SEC has ability to provide monetary awards to eligible individuals who come forward with high-quality original information that leads to an SEC enforcement action in which over $1 million in sanctions is ordered.  The range for awards is between 10% and 30% of the money collected.

The rules clarify that “original information” must be:

(i) Derived from your independent knowledge or independent analysis;

(ii) Not already known to the Commission from any other source, unless you are the original source of the information;

(iii) Not exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report, hearing, audit, or investigation, or from the news media, unless you are a source of the information; and

(iv) Provided to the Commission for the first time after July 21, 2010 (the date of enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act).  See Rule 21F-4(b)(1)

Furthermore, the rules state that information submitted to the SEC is provided “voluntarily” if:

…you provide your submission before a request, inquiry, or demand that relates to the subject matter of your submission is directed to you or anyone representing you (such as an attorney):

(i) By the Commission;

(ii) In connection with an investigation, inspection, or examination by the Public Company Accounting Oversight Board, or any self-regulatory organization; or

(iii) In connection with an investigation by the Congress, any other authority of the federal government, or a state Attorney General or securities regulatory authority.  See Rule 21F-4(a).

Discretionary payouts

As mentioned previously, the range of awards that the SEC will pay out is between 10% and 30% of the money collected, not of the monetary sanctions ordered.  With this in mind, the SEC considers the following factors to determine the size of the award:

  1. The significance of the information
  2. The assistance provided by the whistleblower
  3. Law enforcement interest that might be advanced by a higher award
  4. Whistleblower’s participation in internal compliance systems

In addition, the SEC considers the following factors to decrease the payout percentage of the award:

  1. Culpability
  2. An unreasonable reporting delay by the whistleblower
  3. Interference with internal compliance and reporting systems

SEC’s payout trends

From its inception through July 2016, the SEC’s whistleblower program has issued 24 final award orders and 51 final denial orders.  Of these 24 final award orders, the largest award amount disclosed was over $30 million (announced September 22, 2014) and the smallest award amount disclosed was $125 thousand (announced August 30, 2013).

Of the 19 disclosed award amounts, the median payout is approximately $700 thousand.

Furthermore, of the nine awards disclosing the payout as a percentage of the monetary sanctions collected, the SEC has ordered payouts of 30% on five occasions, a payout of 28% once, payouts of 20% twice, and one payout of 15%.  It should be noted that these figures represent the total payout percentages for each matter (regardless of the number of claimants).

Seven of the 24 final award orders mentioned more than one claimant for payout, with three of these awards naming two claimants and four naming three claimants.  The distribution of the payout to each of these claimants varied from equal proportion of the award among the claimants (33% or 50% to each claimant in final award orders naming three and two claimants, respectively) to as dispersed as 50% of the award to one claimant, 33% to another, and 17% to the third claimant within the same final award order.

Another interesting observation is that, of the 24 final award orders, the SEC disclosed the whistleblower profiles for 11 of them.  Of these 11 awards, two were in the compliance function, one was an officer, seven were non-descriptive insiders/employees, and one was an outsider.  There does not appear to be any correlation between the whistleblower profile and the payout percentage or amount of the award.

I have prepared a schedule that summarizes key information for each final award order.  This schedule includes all final orders through July 2016.

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The proliferation of forensic accounting

I had the pleasure of being a guest speaker last week at a university in Denver.  I presented to students enrolled in a forensic accounting course on the topic of litigation services and expert testimony.  The audience, consisting mostly of graduate students, was highly engaged during the presentation.

Certainly, I see a strong level of interest in the field of forensic accounting, not just within the professional world, but also within colleges and universities.  Contrast this with when I was in school.  Although it doesn’t feel like a long time, when I finished my university studies in 2005 there seemed to be less talk within the business school of forensic accounting careers.

Today, forensic accounting is a multi-billion dollar industry and its growth is expected to continue for the foreseeable future.

Where to begin

During my presentation, I could sense the eagerness of the students to find their career fit within forensic accounting.  At the completion of the discussion they asked me how I would recommend they tap into the field.  Of course, I was happy to respond because I was in their shoes at one point in my career and I’ve always appreciated meaningful career counsel.

First, I believe those interested in this field should find out what type of industry or practice-area they are most interested in.  It could be financial services, manufacturing, technology, communications, etc.  Next, I recommend they build a strong foundation in whatever industry or practice-area they choose by gaining at least a few years of diverse experience.

If they still desire to be a forensic accountant once they establish a strong foundation, then I recommended they search for the right fit with patience, relying as much as possible on their network of contacts.

Experience is critical

Unfortunately, too often I think college graduates do themselves a disservice when they seek to jump right into forensic accounting without any real-world experience.  Of course, this isn’t always the case, but I have worked with enough junior professionals within the industry to make this observation.

I make the following case to illustrate my point.  Auditors are trained to approach their work with “materiality” in mind.  Those in criminal justice approach their work with “beyond a reasonable doubt” in mind.  Statisticians often approach their work with “statistical significance” in mind.  Forensic accountants, on the other hand, may or may not approach their work with these concepts in mind.  Truly, the application of concepts or principles depends on the facts and circumstances of a case.

For this reason, I believe a forensic accountant should have sufficient experience so that he or she can appropriately apply professional judgment, no matter the circumstance.

With ever-changing regulations and increasing complexity of the world we live in, I believe the role we forensic accountants provide will become increasingly valuable.

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Effective interviewing techniques

Recently I attended a training by my local Association of Certified Fraud Examiners (ACFE) chapter addressing the topic of conducting interviews.  I thought the topic was interesting and certainly applicable in my line of business.  For this reason I’m writing today’s post on this topic.

To begin, television shows and movies too often seem to portray interviewing techniques that are wholly ineffective in most circumstances.  For example, in the movie L.A. Confidential the good cop-bad cop scene shows essentially every signal of aggression.  As expected, the bad cop plays really tough with the subject, who eventually submits to his wishes.  In reality, when faced with such drastic circumstances, an interviewee may say whatever the interviewer wishes, even giving a false or unreliable admission.  Experience dictates that this is not truly effective interviewing.

Rapport

Effective interviewing requires rapport building with the interviewee.  Indeed, there are various techniques to do this.  Examples include listening, asking follow-up questions, understanding the interviewee psychologically, saying “I want you to relax,” and asking the interviewee “tell me about your life/yourself.”

Of course, not having a checklist mentality is very important as well.  This is because a checklist mentality does not sufficiently accommodate for changes in plan or approach that often times are necessary on the fly.  I discuss the practice of check listing in another post.

Another key aspect of building rapport is deciding the best approach to take.  Appealing to reason or logic, rather than fear, is more likely to create an effective bond with the interviewee.  Moreover, the interviewer generally shouldn’t dominate the conversation, but rather seek to make the power neutral between the interviewer and the interviewee.

Interviewers should also think about what type of support network the interviewee may have.  For example, one might ask if there are other perpetrators or victims that may not already be identified.

What’s going on in the interviewee’s mind?

As a means of trying to anticipate potential issues or identify appropriate questioning techniques during an interview, interviewers should understand what is going on in the interviewee’s mind.  There are at least three things that an interviewee is thinking through, whether consciously or sub-consciously.  These include an interviewer assessment, a subject assessment, and asking him or herself “what about me” questions.

The interviewer assessment

  1. Do I like the interviewer?
  2. Do I trust the interviewer?
  3. Is the interviewer judging me?

The subject assessment

  1. Why is the interviewer talking to me?  The interviewer has responsibility to explain this up front.
  2. Do I have the information that the interviewer seeks?
  3. How much does the interviewer know?
  4. How much can the interviewer find out from other sources?

“What about me” questions

  1. What happens if I disclose the information?
  2. What happens if I do not disclose the information (fired, jail, fine, etc.?)
  3. Am I comfortable?

Voluntary disclosure

Of course we want the interviewee to voluntarily disclose information.  As such, an interviewer should take an approach that encourages the interviewee to do this.  Think of the art of persuasion, using the sales pitch to appeal by being genuine, compelling, and using logic and reason.

Awareness

Equally important to effective interviewing is situational awareness.  Sun Tzu, a 6th century BC Chinese military strategist, identified three attributes of awareness that are relevant to this topic and the ACFE training adapted these attributes to effective interviewing as follows:

Know yourself as an interviewer

As an interviewer, I need to identify my strengths and weaknesses, mold my techniques to my strengths, and create my style of interviewing.

Know your “enemy”

As an interviewer, I need to understand the interviewee’s motivations, strengths, and weaknesses.  Furthermore, I need to try to answer the 10 questions (listed above) on behalf of the interviewee beforehand.  Finally, I should acknowledge that every interviewee is different and that my approach should be fluid and flexible to accommodate changes in plan.

Know the terrain

As an interviewer, I need to understand the laws applicable to the facts and circumstances (e.g., employment law, criminal law).  In addition, I need to understand company policy and procedures as well as the corporate culture.  Ultimately, I need to understand the BIG picture in focus.

Application

When one gets into the details of effective interviewing, today’s post identified a number of factors to consider.  For some, thinking through each factor can be overwhelming.  With this in mind, consistent practice is what I believe makes an interviewer more effective.

I received permission from the authors of the training (Travis Boyd, CPA, Johnnie Bejarano, DBA, CPA, CFE, and Doug Laufer, PhD, CPA, CFE) to share the slide deck here.

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What an in-house fraud investigation looks like

Because in-house fraud investigations can vary in terms of structure, resources, and performance, sometimes we wonder what does an in-house fraud investigation typically look like.  Well, thanks to the Association of Certified Fraud Examiners (ACFE), we can answer this question.

Last year the ACFE released a report entitled Benchmarking Your In-House Fraud Investigation Team, which analyzed various engagement metrics from over 800 survey responses.  I think you’ll find the results quite interesting.

To frame today’s post, I’ll cover the report’s findings for each of the following critical components of a fraud investigation:

  • Oversight of fraud investigations
  • Outsourced vs. in-house investigation team
  • Time to resolution
  • Disciplinary actions against or prosecution of perpetrators, and
  • Recovery of fraud losses

Oversight of fraud investigations

As for structure, approximately half of survey respondents indicated that the investigation team reports either to internal audit leadership (28.3%) or senior management (22.1%).  Interestingly, only 6.4% reported to in-house legal counsel.  The below chart demonstrates that there is diversity in oversight of fraud investigations, perhaps dependent on the nature of the fraud (financial statement fraud, compliance fraud, asset misappropriation, etc).

SNAG-2

Outsourced vs. in-house investigation team

When it comes to in-house fraud investigations, overwhelmingly the survey respondents (68.2%) indicated they are always performed in-house as opposed to being outsourced.  Furthermore, approximately 23% of organizations outsource their investigations up to 25% of the time.  One reason for organizations infrequently outsourcing fraud investigations could be due to the fact that over 73% of survey respondents indicated their organizations had over 1,000 employees.   Perhaps larger organizations (those with over 1,000 employees) generally have sufficient personnel capacity to perform the investigations.

SNAG-3

Time to resolution

As practitioners understand, resolving investigations in a timely fashion is paramount to (1) effective detective internal controls and (2) setting an appropriate tone within an organization.  According to the report, nearly six in 10 fraud investigations (59.8%) were closed within 30 days.  Conversely, just over 10% of fraud investigations took more than one quarter to close.  Of course, the duration and extent of a fraud investigation is heavily based on the degree of complexity of the alleged fraud.

SNAG-4

Disciplinary actions against or prosecution of perpetrators

Although organizations prefer to prevent fraud from occurring, the reality is that fraud is impossible to completely eliminate from all organizations.  Therefore, when it comes to effective internal controls, management should strive to set a “zero tolerance” policy for fraud.  In essence, how management reacts to known or suspected fraud, therefore, is critical to setting an appropriate tone within the organization.

The following chart shows the percentage of investigations that resulted in disciplinary action.  Less than a third (31%) resulted in disciplinary action between 76% and 100% of the time.  On the other hand, approximately the same amount of investigations (31.6%) resulted in disciplinary action between 0% and 25% of the time.

SNAG-5

The next chart shows an interesting trend in prosecution referrals.  The majority of investigation teams (59%) decided to refer their case for prosecution between 1% and 25% of the time.  Conversely, 9.8% of investigation teams referred their case for prosecution between 76% and 100% of the time.  As one may expect, there are a number of factors involved with the decision to prosecute.  These may include sufficiency of evidence to prosecute, reputational risk, and cost vs. benefit analysis.  Hence, the decision to prosecute must be weighed carefully by an organization.

SNAG-8

Recovery of fraud losses

In the end, just because investigation teams substantiate allegations of fraud does not mean the losses are automatically recovered.  In light of this, I believe the following chart is one of the most relevant statistics in this report.  According to the survey results, the majority of investigation teams surveyed (54.6%) indicated that less than a quarter of the fraud losses were recovered.  In contrast, 13.0% and 13.9% of investigation teams indicated that 51% to 75% and 76% to 100% of fraud losses were recovered, respectively.

SNAG-6

Final observations

These results are interesting, to say the least.  With a focus on continuous improvement, fraud investigation teams should think about how these findings could affect their existing structure, resources, and performance.

In the end, fraud investigation teams will vary in their look and feel, depending on the nature and complexity of the fraud being investigated.  Having adequate staffing of in-house investigations with the right level of experience and bandwidth will put teams in the best position to be efficient as well as thorough in their efforts.

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What others have said in the past and why it matters

In the past I’ve worked on a number of financial disputes dealing with improper accounting for liabilities, among other things.   In one such instance, the plaintiff alleged that the defendant understated certain liabilities and, as a result, the defendant’s historical financial statements were materially misstated.

To support his opinion, the plaintiff’s expert relied on certain documents produced in the litigation that my team believed were taken out of context.  What was somewhat comical about the situation was that the alleged understatement was so large that it left a number of us scratching our heads.  We wondered why would anyone have gone into that particular business at the time if they “knew” (using the plaintiff expert’s words) they had to record certain liabilities as large as what the plaintiff’s expert claimed.  Indeed, no company in the industry at the time was recording liabilities anywhere near the extent that the plaintiff’s expert alleged should have been recorded by the defendant.

As experienced forensic accounting practitioners and expert witnesses understand, hindsight provides a clear picture of what took place and whether or not it was reasonable.  On the other hand, hindsight can be difficult to justify its reliance.  In particular, if the facts and circumstances known to an entity at the time were the best available information, then they may be considered reliable and reasonable.

Contemporaneous understanding

This brings me to my topic for today, that of understanding what others were saying and doing at the time.  More specifically, to follow my story through I will discuss the importance of identifying (generally speaking, without disclosing confidential information) what the plaintiff in this case was saying at the time and why it matters in a dispute.

For privately-held businesses, obtaining contemporaneous information may prove to be a challenge.  This is because private companies tend to disclose less (or sometimes no) information to the public.  In contrast, publicly-traded companies are held to a higher standard of public disclosure through various means.  These public disclosures can prove to be a treasure chest of information.

Back to my story of the plaintiff, which happened to be a publicly-traded company and a user of the defendant’s financial statements.  The plaintiff’s expert claimed there were all sorts of red flags at the time that the defendant prepared its financial statements.  Further, the plaintiff’s expert alleged that the defendant “should have” noticed these red flags and incorporated them into its accounting decisions.

What I find intriguing is that during the time period in dispute the plaintiff publicly disclosed that it believed the market factors affecting these accounting liabilities were not of big concern.  This was important because the plaintiff’s public statements lent credence to the liability accounting decisions made by the defendant.  Were we able to find these public statements by the plaintiff in the plaintiff’s complaint?  Of course not.

When an entity is in the public light, it provides information to the public in multiple ways.  So, knowing where to look for these types of public statements made our job easier.

SEC resources

A fabulous resource for identifying public statements is the SEC’s website.  For those less familiar, the SEC’s website archives various public filings.  In my experience, the following resources are helpful in identifying historical public statements:

  • Form 10-K – This is probably the most commonly known SEC form.  SEC registrants are required to file this annual report with the SEC, including annual financial statements, related schedules and various textual information.  SEC registrants also include discussion and analysis of financial trends within a section called Management Discussion and Analysis (MD&A).
  • Form 10-Q – SEC registrants are required to file this quarterly report with the SEC, consisting primarily of the company’s quarterly financial statements.  These forms also include a section on MD&A.
  • Form 8-K – These SEC forms can contain a wealth of information.  SEC registrants are required to file these forms with the SEC when certain significant, reportable events occur.  Examples include: quarterly press releases, major acquisitions, material contracts, and legal proceedings.
  • Comment Letters – Generally, the SEC publishes comment letters that it sends to SEC registrants, which can be identified by filtering for “UPLOAD.”  Similarly, the SEC publishes letters it receives from registrants on the SEC’s website, which can be identified by filtering for “CORRESP.”  Because the SEC is a regulator with a heavy hand, what a company writes to the SEC matters greatly.  Therefore, practitioners should pay specific attention to letters between the SEC and registrants.

Other resources

I have found the following other resources to also be worthy of digging through in search of relevant information:

  • Company website – Companies issue press releases and post them on their website.  Practitioners should be aware that not all company press releases are filed with the SEC via Form 8-K.
  • Industry news and reports – Depending on in which industry a company operates, there may be industry publications from reputable sources.  Again, these sources can provide reliable information that was known or communicated at the time.
  • General media communications – Media outlets may overlook or de-emphasize some aspects of company press releases.  In order to attempt to have a degree of control of the narrative, companies often have relationships with major media outlets.  Running web searches of public statements made by company personnel can generate interesting results.

Relevance

As one can gather from my story, it certainly doesn’t help the plaintiff’s case when it was disclosing to the public a certain narrative at the time, but then it switched gears and makes contradictory allegations later in support of its lawsuit.  Therefore, when looking to the correct sources, experienced forensic accountants can find valuable information.  This information can help to obtain a more full, or correct, understanding of the facts and circumstances at the time to assist their clients in all types of dispute matters.

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Fraud auditing, a new trend

We all know that fraud is alive and well in today’s society.  On a daily basis, it seems, we hear unpleasant fraud statistics and read eye-catching news headlines about new fraud schemes or deceptions.  Indeed, businesses today are no less vulnerable to fraud than before.

Because of its ever-presence in today’s business world, a new trend of fraud auditing is becoming more and more popular.  So, what is it?  In essence, fraud auditing is a two-phase exercise.  First, one designs a fraud risk assessment to identify areas where a company may be susceptible to fraud.  Second, in response to findings of this assessment a monitoring and reporting program is put in place as a tool for management oversight.

Preventive vs reactive measures

When I was a former Big 4 auditor I incessantly heard complaints from my clients about audit fees being too high.  Indeed, financial statement audits can be expensive because they are designed to cover all aspects of the financial statements.  In contrast, fraud auditing doesn’t have to be expensive.

Moreover, as a preventive measure, one of the benefits of fraud auditing is that the cost of such an assessment can in large part be determined by the company’s management.  Conversely, as it relates to reactive measures, the cost will depend greatly on the motivation by the company for having the fraud audit conducted in the first place.  Examples of motivations imposed on a business may include: response to fraud already identified within the company, restatement of financial statements, or a decision to bolster internal controls because of restrictions imposed by a regulator, to name a few.

We can probably agree that human nature tends to be more reactive than proactive at different phases of life, such as wellness and personal finance.  In a similar vein, too often companies wait to respond to fraud risks until they manifest themselves through fraud or abuse.  Said another way, companies often do not perceive sufficient value in conducting a meaningful fraud risk assessment and, therefore, they wait until the stakes are much higher.  Oh, how relevant today is Benjamin Franklin‘s famous adage that “an ounce of prevention is worth a pound of cure!”

Consideration examples

Next, I wish to give some definition to the look and feel of a fraud risk assessment.  Depending on the nature and extent of a fraud audit, following are some examples for consideration to begin to understand risks and exposure:

  1. Domination of management by a single person or small group.  This gets at the heart of the tone within an organization.  Regardless of the extent of internal controls (even at the transactional level), if there is management domination by one or a few individuals, this can have a pervasive effect on the organization as a whole.
  2. A practice by management of committing to analysts, creditors, or other third parties to achieve aggressive or unrealistic forecasts.  One can see that being overly aggressive can be an area of risk and exposure.  Conversely, for businesses not beholden to outsiders (such as creditors or investors) this, of course, is irrelevant.
  3. Ineffective communication, implementation, support, or enforcement of the entity’s ethical standards by management or the communication of inappropriate ethical standards.  This really goes without saying. If management doesn’t enforce its own rules, then why have them in the first place?
  4. Recurring negative cash flows from operations while reporting earnings and earnings growth.  Financial pressures placed on management to generate favorable results should be considered when assessing the adequacy and effectiveness of business performance reviews.
  5. Rapid growth or unusual profitability, especially compared to that of other companies in the same industry.
  6. Significant, unusual, or highly complex transactions, especially those close to the period end.
  7. Significant related-party transactions not in the ordinary course of business.  A review of an entity’s financial statements or records can reveal the nature and extent of transactions with related parties.
  8. Recurring attempts by management to justify marginal or inappropriate accounting based on materiality.  Although this one may be difficult to assess, an effective fraud audit should incorporate inquiries of multiple company personnel at varying levels within an organization.
  9. Restrictions on the limitation of access to people, information, or communication by the board of directors or those charged with governance.  

I adapted the above points from the PCAOB’s AU 316, Consideration of Fraud in a Financial Statement Audit.  Although the above list is not exhaustive, it can be a good start to identify areas of heightened risk exposure for a company.  Equally important is that AU 316 was specifically designed to apply to external auditors in connection with the performance of financial statement audits.  Despite this, I believe the principles and guidance within this AU can apply to a variety of circumstances and not just financial statement audits.

Checklisting

It seems that in more recent years auditors have gravitated more toward a “checklist” mentality to discharging of their professional duties.  I believe this is heavily influenced by feedback from regulators.  Of course, checklisting has its place within a professional service engagement to mitigate legal and regulatory exposure.  However, as one can gather from my post above, it is important to exercise professional judgment by inserting a healthy degree of flexibility between checklisting activities and allowing free thinking and creativity.  After all, thinking through the “what ifs” of a situation is always an effective way to identify areas of risk and exposure.  To add to this thought, because risk factors can vary greatly depending on the industry and company-specific factors, it is imperative to tailor the nature and extent of a fraud audit to the needs of an organization.

Less rigorous is still better than nothing

In ideal circumstances companies want to get to the right answer from the beginning.  While this sounds good, the reality is that, as I touched upon earlier, many businesses do not place fraud auditing as an area of focus until they are forced to.

One way to assist companies in overcoming the resistance to a full blown fraud audit is to perform a less rigorous fraud risk assessment.  As a valuable resource the Association of Certified Fraud Examiners (ACFE) offers a Fraud Prevention Check-up.  While I recommend any such assessment be performed with the assistance of experienced professionals familiar with the issues, this check-up exercise could, in theory, be performed by the business itself.  In any case management should take the assessment seriously, standing ready to take action should there be cause for concern.  Additionally, I strongly recommend that, if possible, general counsel be aware of and participate in this process for legal protection to the company.

Altogether, companies that take seriously their obligations to protect company assets and stakeholder value should equally take seriously their oversight and monitoring of financial fraud risks.  Fraud audits provide an excellent means of fulfilling these obligations.

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Changing the U.S. GAAP hierarchy over time

As accounting practitioners, we live and breathe accounting standards.  Without them we wouldn’t have a basis to record transactions or take supportable accounting positions.  So, it goes without saying that reliance on accounting standards are necessary for fair, consistent presentation of financial statements.  Those less familiar with accounting standards and the history behind them may make the mistake of assuming that any and all accounting standards are equally authoritative.  This is simply not the case and for this reason I will focus today’s post on the hierarchy of U.S. GAAP and how it has changed over time.

History

To begin, a little history lesson may be helpful.

1975

Way back in 1975 the AICPA issued SAS No. 5, The Meaning of “Present Fairly in Conformity With Generally Accepted Accounting Principles” in the Independent Auditor’s Report (SAS 5).  Beginning at ¶ 5, the Auditing Standards Board of the AICPA explained that there is no single source for U.S. GAAP standards, but that there are a number of resources, with Rule 203 of the AICPA Code of Professional Conduct requiring compliance with FASB standards, APB opinions, and AICPA accounting research bulletins.  The degree of authoritative GAAP sources trickled down from there.

1992

Next, in 1992 the ACIPA issued SAS No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles (SAS 69).  This auditing standard clarified the GAAP hierarchy by introducing four levels, (a) through (d).  As auditing practitioners implemented SAS 69, criticisms began to surface for a variety of reasons.  First, this standard, similar to SAS 5, only really applied to auditors, not preparers of financial statements.  Second, this standard was complex.  And third, the GAAP hierarchy ranked the FASB’s Financial Accounting Concepts (CON), which are subject to the same level of due process as FASB SFASs, below industry practices that are widely recognized as generally accepted but that are not subject to the same due process (see ¶ 10 and 11).

2008

In response to these criticisms, in May 2008 the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162).  The purpose of the standard was two-fold.  First, it was designed to improve financial reporting by identifying a consistent hierarchy for selecting accounting principles to be used in preparing financial statements presented in conformity with U.S. GAAP (for non-governmental entities).  Second, it was directed to entities (and not auditors) because it is the entity (not the auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.  In a manner similar to SAS 69, SFAS 162 identified four levels in the hierarchy of U.S. GAAP standards, beginning with level (a) and ending with level (d), as depicted in the chart below.  Once SFAS 162 was issued, the Auditing Standards Board of the AICPA withdrew SAS 69.

GAAP Hierarchy

Just looking at the above chart can spin one’s head because let’s assume, for instance, that a widely recognized and prevalent industry practice is identified.  This falls within level (d), the lowest level, in the above SFAS 162 GAAP hierarchy.  However, in order to perform a thorough due diligence of the matter, one needs to either be familiar with or go searching for other applicable guidance that may be more authoritative, falling into levels (a), (b), or (c).

2009

Only a year later, the FASB rolled out the Accounting Standards Codification (ASC), with an effective date for interim and annual periods ending after September 15, 2009.  Of interest is that the ASC makes it clear which accounting standards are “authoritative” and which are not.  Simply put, if an accounting standard is included in the ASC, then it is “authoritative.”  Conversely, if an accounting standard is not included in the ASC, then it is “non-authoritative.”  An exception to this is that SEC-issued rules and regulations, applying only to SEC registrants, are authoritative even if they are not included in the ASC.

Understanding the way things were

As a forensic accountant, I deal with litigation involving accounting issues from the past.  As I previously blogged about (see “Understand what standard or guidance was applicable at the time”), it’s imperative to put into context the accounting decisions that were made by knowing what accounting standard(s) applied a the time and, if multiple standards were in effect, which was/were most authoritative.  I think it’s helpful to frame the issue by asking some relevant questions:

  1. What time period(s) is/are relevant to the accounting or disclosure issue?
  2. Depending on the answer to question 1, which of the above U.S. GAAP hierarchy standards was in effect at the time?
  3. If the issue relates to transactions post-ASC implementation, have there been any Accounting Standards Updates (ASUs) related to the standard?  Although ASUs are not authoritative standards, it’s important to be aware of them.

Keep in mind that the FASB began issuing ASUs after the Codification went into effect.  ASUs are numbered in the following format:  Year first, then ASU number for that year (e.g., ASU 2009-14 was the 14th ASU to be issued in 2009).

By keeping the above understanding in mind practitioners can successfully apply the relevant GAAP standards to a historical transaction.

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The FASB’s comment letter process and why we need to understand it

Today I’m writing about the Financial Accounting Standards Board’s (FASB) comment letter process.  Prior to issuing authoritative accounting and disclosure standards, the FASB interacts with its constituents in a variety of ways to gather information that it may not have already considered.  Having a strong understanding of this process can provide practitioners with meaningful context to assist companies in their application of the FASB’s standards.

To begin, the FASB is a private organization overseen by the SEC.  The FASB sets standards, which become a part of U.S. GAAP accounting standards serving the broad public interest.  To note is that since September 15, 2009 the U.S. GAAP accounting standards have been codified in what is known as the Accounting Standards Codification (ASC).  In connection with setting these standards, the FASB has adopted an open decision-making process that provides for interaction between the FASB and its constituents.  This interaction takes many forms, including comment letters.  The FASB explains:

Comment letters are received from constituents in response to Discussion Papers, Exposure Drafts, and other discussion documents that are released to the public for comment.  Comment letters, which become an important part of a project’s public record, are an important source of information regarding constituents’ views on and experiences related to issues raised in a discussion document.

Comment Letter Process

The following summarizes the FASB’s standard-setting process, which is governed by the FASB’s Rules of Procedures:

The part I want to focus on in the above graphic is step number five.  When the FASB seeks to issue new authoritative accounting guidance, it commences by issuing exposure documents to solicit input.  These exposure documents may include Exposure Drafts (ED), Discussion Papers, Preliminary Views, and Invitations to Comment.  Often times the FASB issues an ED, but in some cases it may issue a Discussion Paper to obtain input in the early stages of a project.

The FASB typically issues EDs with a designated timeframe for respondents to reply, often in the form of comment letters, but also via public roundtable discussion and other due process activities.  Depending on the nature and extent of the feedback it receives, the FASB may redeliberate the proposed provisions to accounting and disclosure standards.  This, according to the FASB, is done at one or more public meetings.

Once all key concerns and issues have been considered and addressed, the FASB nears completion of its standard-setting process by issuing a final standard, in the form of an Accounting Standards Update (ASU).  The ASU describes the amendments to the ASC.

Resources

When litigation cases or accounting consulting engagements involve the interpretation or application of accounting and disclosure standards, it is critical to understand the thought process surrounding the decisions that become part of a standard.  Having a strong understanding of the FASB’s standard-setting process and knowing where to locate relevant information is key to building a strong position.

Practitioners have at their fingertips access to a host of FASB resources that can assist them in preparing arguments, opinions, or positions on a variety of accounting and disclosure topics.  Some helpful resources include:

  • Exposure documents previously issued by the FASB for comment, but are now closed for comment, unless otherwise stated.  This link includes FASB documents issued after 2002.
  • Responses received by the FASB in connection with its online comment letter process.  One can read specific comment letters the FASB receives from constituents, including public accounting firms, SEC filers, and other organizations taking a keen interest in the FASB’s exposure documents.
  • Unsolicited online comment letters from constituents.  This link includes related documents dating from 2002.
  • Exposure documents currently open for comment.  I suggest these types of documents are less valuable to preparing arguments, opinions, or positions.  However, understanding current deliberations may be applicable in certain engagements.
  • ASU documents.  Perusing certain aspects of these ASC amendments is a good way to obtain color and context to them.  I have found the following ASU sections to be particularly helpful in obtaining the understanding I may be seeking:
    • Why Is the FASB Issuing This Accounting Standards Update?
    • Who Is Affected by the Amendments in This Update?
    • How Do the Main Provisions Differ from Current U.S. Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?
    • Background Information and Basis for Conclusions

Application

I once worked on an engagement with a Fortune 1000 company that had become the center of a wave of negative media attention.  In a move that was anticipated, the external auditor raised challenging questions about the company’s application of a particular ASU in light of the negative media attention the company had received.  As an engagement team, in order to effectively address the external auditor’s concerns, we decided it was important to understand the details behind the ASU, including reviewing the comment letters the FASB received prior to issuing the ASU.  This exercise shed meaningful light on the implementation issues that multiple constituents predicted would, and indeed had occurred with the company.  Because of our ability to quickly look to relevant sources for reliable information, my firm was able to assist our client in navigating this challenge effectively and provide credible, supportable arguments to the company’s external auditor.

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