Critics have accused the Securities and Exchange Commission of neglecting enforcement of laws to prevent financial and accounting fraud for the better part of the last decade. Now, the SEC says, those days are over.

The SEC is embarking on an initiative that will emphasize stamping out financial and accounting fraud as part of push led by new SEC chairman, Mary Jo White. This past April White promised a reallocation of the Enforcement Division's resources that would demonstrate a renewed focus on accounting fraud. Six months later, the foundation of this reallocation is now in place and features a newly established Financial Reporting and Audit Task Force.  Senior agency officials, including  White and Enforcement Division Co-Director Andrew Ceresney, continue to emphasize the SEC's effort to refocus on accounting fraud.

The number of SEC financial fraud enforcement actions began to wither steadily following the flurry of front-page lawsuits against companies such as WorldCom, Enron, Tyco, and Adelphia in the early 2000s.  Between 2008 and 2012, for example, the number of SEC financial and accounting fraud cases dropped every year, going from nearly 150 in 2008 down to just 79 in 2012. Similarly, the number of financial fraud and issuer disclosure investigations the Enforcement Division opened fell from 304 in 2006 and 228 in 2007 to just 124 in 2012.

Last month, in a speech on “Financial Reporting and Accounting Fraud,” Ceresney partly blamed the decline in financial fraud and accounting enforcement and investigations on the financial crisis. He said that the SEC's focus on bringing financial crisis cases involving collateralized debt obligations, residential mortgage-backed securities, and Ponzi schemes left limited resources to pursue accounting fraud.  On the other hand, he noted, public company restatements fell from a peak of 1,771 in 2006 to 768 in 2012, perhaps indicating better financial reporting under the Sarbanes-Oxley Act (and arguably less fraud for the SEC to pursue during that time).

Was there a drop in accounting fraud following SOX? And did this explain the major decrease in the SEC's investigations and cases in this area? Although SOX improved governance, Ceresney said he doubted it had radically reduced the instances of accounting fraud. “We have additional controls,” he said, “but controls are not always effective at finding fraud.” Ceresney stated that the SEC under White was of the view 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.”

Call In the Task Force

The SEC will be seeking to aggressively root out accounting fraud in a number of ways as part of its shift in focus. Most notably, in a move that has a bit of a “Back to the Future” feel to it, the SEC announced in July 2013 that it had formed the Financial Reporting and Audit Task Force and put David Woodcock, director of the Fort Worth Regional Office, in charge of it.  The SEC previously had a “Financial Fraud Task Force” from 2000 to 2010, but disbanded it around the time that the Enforcement Division created its specialized units.

The SEC formed the new Fraud Task Force under White, however, because it concluded that it was important to have a group of lawyers and accountants specifically focused on generating new financial and accounting fraud cases for the Enforcement Division. With the many new tools and resources available to the SEC in 2013, Ceresney compared the rationale for the Fraud Task Force to a famous scene in the movie “Apollo 13”:

The SEC's new-found commitment to devote the resources necessary to aggressively identify and pursue financial and accounting fraud is a major shift in direction for the agency and may take years to produce results.

Often, when you get a group of smart people in a room focused on a problem, you can find the answer.  Kind of reminds me of that scene in Apollo 13 where they bring all of the disparate tools available on the space capsule into a room, dump it on to a table in front of a bunch of smart people, and say find a way to fix the problem. And so we created the Financial Reporting and Auditing Task Force—what we like to call the Fraud Task force.  This is our Apollo 13 moment.

Indeed, some of the “disparate tools” that the Fraud Task Force will have access to were previously unavailable to the agency. These include technologies such as the “Accounting Quality Model” (also known as “RoboCop”). The AQM is a new way for the SEC to crunch the data provided in a company's financial statement to flag financials that appear anomalous or otherwise stand out from their industry peers.

John Carney and Francesca Harker of the law firm BakerHostetler, explained how the AQM works in a blog post on Forbes.com:  “Within 24 hours from the time a filing is posted to EDGAR, it is processed by the AQM and the results are stored in a database,” they wrote. “The AQM outputs a risk score which informs SEC auditors of the likelihood that a filing is fraudulent.  The SEC then uses this score to prioritize its investigations and concentrate review efforts on portions of the report most likely to contain fraudulent information.”

Another new resource for the Fraud Task Force that is just now beginning to bear fruit for the SEC is the flow of whistleblower tips that have come into the agency under the bounty program established by the Dodd-Frank Act. In October, the SEC announced its third bounty under the program—a massive $14 million payment to a single whistleblower who did not wish to be identified. Whistleblowers are expected to be an important source of information in financial fraud and accounting cases as the penalties in such cases may be hundreds of millions of dollars, with bounties as high as 30 percent of the money collected.

The Fraud Task Force will focus on generating cases in a range of high-priority financial fraud areas. Ceresney said that these areas include:

Reserves.  Individuals and entities cannot ignore “inconvenient truths” about losses and the need to increase reserves, Ceresney said.  While setting reserves requires the use of professional judgment, “we will not tolerate decisions that are reached in bad faith, recklessly, or without proper consideration of the facts and circumstances,” he added.

Revenue recognition. This remains a “staple” issue in the SEC's financial fraud caseload, Ceresney stated, and can take the form of sham transactions, premature recognition, and “pre-booking” schemes.

Auditor independence.  This applies not only to auditors for public companies but also for broker-dealers.  Ceresney predicted that the SEC would be investigating these types of broker-dealer-related conflicts of interest with increased frequency.

Auditors. Emphasizing the auditors' “public watchdog” role in the financial reporting process, Ceresney said that in each restatement the SEC will be scrutinizing the engagement partner, engagement quality reviewer, and the auditing firm as a whole to determine whether the auditors missed or ignored red flags, whether they have proper documentation and whether they followed professional standards.

The SEC's commitment to aggressively pursuing complex financial fraud cases has been legitimately questioned over the past few years by critics who assert that the agency has been unwilling to devote the necessary time and manpower. Instead, critics point out, the SEC has focused in recent years on  getting quick hits in actions such as insider-trading cases that do not require anywhere near the same level of resources.

The SEC's new-found commitment to devote the resources necessary to aggressively identify and pursue financial and accounting fraud is a major shift in direction for the agency and may take years to produce results. Squashing financial fraud is an important enough mission, however, that the SEC's return on investment in this area should be well worth the cost.