The SEC’s New AQM: Better Financial Reporting For Investors

by Dorsey & Whitney LLP

Since the announcement of the Financial Fraud Task Force and the Center for Risk and Quantitative Analytics last year many have expected an uptick in the number of financial fraud actions. While those actions were once a key staple of SEC enforcement, in recent years the number of financial statement fraud actions brought by the Commission has dwindled.

The new Task Force does not appear to have altered recent trends in terms of the number of financial fraud actions being brought. Whether over time it will change the number of cases being investigated and brought in the manner of Chairman Arthur Levitt’s famous “Numbers Game” speech in the late 1990s (here) remains to be seen. Improvements such as the passage of the Sarbanes-Oxley Act in 2002 and the creation of the PCAOB counsel against such a result. At the same time the driving force identified by Chairman Levitt – the pressure to make the numbers – remains. That suggests there are cases to be found.

As the Task Force moves forward one clear point is that the approach being crafted now differs from earlier years. While it seems apparent that the new Task Force will build on the work and lessons from past financial fraud cases (here), the development of the Accounting Quality Model or AQM may significantly alter how cases are identified and selected for investigation. Unlike the past, however, when issuers were largely in the dark about what might trigger an SEC investigation, the AQM gives companies and their advisers the opportunity to be out in front of the Commission.

The AQM is apparently still in development and its precise contours are unknown. A recent paper by NERA Economic Consulting offers some insight (here). NERA suggests that the model being developed by the Commission will focus on anomalies in financial reporting or unusual changes that may or may not reflect an actual misstatement but which could trigger an inquiry.

Using this approach the Accounting Quality Model will search for financial statements which “appear anomalous” and flag them for further review. “With the advent of an automated detection system, a statistical anomaly in a company’s financial statements – whether or not it represents a potential reporting error – may trigger scrutiny by regulatory authorities prior to more overt and clear evidence of a problem. In effect, the SEC is actively developing the capabilities to cast a wider net at the first stages of any efforts to detect financial accounting anomalies (in part, by screening financial reporting data as it is filed),” according to the NERA Report.

The flagging process will apparently be based on more than just an analysis of the issuer’s current data. It is also likely to include an analysis of trends in the issuer’s data over time and a comparison to the industry and the firm’s peers.

Once the initial flagging process is complete the Commission will have to sort the data to determine which leads to pursue. Some of the flagged items might be false positives while others could be simple errors. Still others might be an early indication of malfeasance. The screening process here will be important.

The overall approach being developed by the Task Force with its AQM is in many ways reminiscent of existing programs currently in use as part of the National Exam Program and by the Division of Enforcement. In part those programs seek to identify potential issues through the identification of anomalies in performance and results and by identifying deviation from disclosed policies and procedures. The collaboration of OCIE and Enforcement in this regard has resulted in a number of enforcement actions.

The idea behind the Task Force and its model , according to NERA, evidences an effort by the agency to be out in front of financial fraud– that is, identify potential issues and difficulties at an earlier stage, long an enforcement priority. At the same time the approach being developed gives issuers and their advisers the opportunity to be one step out in front of the SEC. By examining trends in their own data and industry and searching for changes, deviations and outliers the issuer may well be able to identify items which could draw regulatory scrutiny. In those instances the company can either make additional disclosures to explain the item or, have material prepared to give investigators if there is an inquiry, according to the Report. Either may well ward off what could otherwise be a lengthy and costly investigation.

Thus while the SEC is developing its new approach to identify possible financial reporting issuers at an earlier date, issuers would do well to develop their own internal approach to identify such items and be at least one step ahead of the Commission. Both efforts should result in better financial reporting for investors.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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