Fried Frank

SecMail® No. 99-10-14(2)
October 14, 1999

Recipe for Avoiding SEC Accounting Fraud Enforcement

One year ago, SEC Chairman Arthur Levitt announced an SEC crackdown on fraudulent accounting practices. Shortly thereafter, SEC Director of Enforcement underscored the SEC's commitment to this priority by announcing 1999 as the "Year of the Accountant." On the first anniversary of the Chairman's announcement, the SEC announced a sweep of 30 enforcement actions against 68 individuals and companies alleging fraud and related misconduct at 15 different public companies. The SEC stated that "[t]ogether, these actions allege a veritable cookbook of recipes for fraudulent accounting and reporting." In addition to underscoring the SEC's "zero tolerance" of deviations from GAAP, the proceedings suggest several steps corporate officials and others can take to lessen the likelihood of SEC enforcement action.

  1. Expect Scrutiny of the CEO. The SEC charged more companies' chief executive officers than chief financial officers in this sweep: 11 of the 15 companies faced charges against current or former CEOs, and 8 of the 15 faced charges against current or former CFOs. Mr. Walker warned that the SEC would prosecute the most senior officials of companies that fail to satisfy the SEC's financial reporting standards, "because they are the ones who set the tone and create the culture for the company." Indeed, he asserted that, even when senior management has not actively participated in a fraudulent scheme, the SEC will consider whether they nevertheless bore responsibility for a deficient system of internal accounting controls that allowed a fraud to occur.

  2. Set the Right Tone at the Top. All 30 cases alleged departures from GAAP, and one-third charged lying to, or hiding things from, the auditors. In the wake of the SEC's sweep, CEOs should consider announcing internally that they will not tolerate any departures from GAAP or inaccurate communications with auditors, and that any employee observing questionable accounting practices should report them to an internal ombudsman. Establishing a culture of integrity, and providing an avenue for reporting problems, will serve CEOs well, particularly in the event of later scrutiny of their companies' financial reports.

  3. Review Internal Controls. A majority of the cases allege a lack of adequate internal controls. The SEC alleged that corporate officials who oversaw accounting control systems should have instituted checks on employees to prevent misconduct. Corporate officials, therefore, should take this opportunity to review the adequacy of current internal controls. In addition, the SEC's allegations are of particular interest given the SEC's recent focus on the auditor's role in detecting fraud, as well as SEC rulemaking efforts, announced just last week, to encourage corporate audit committees to engage in more active and effective oversight of the financial reporting process. If a fraud or error occurs, the SEC will be more likely to bring an enforcement action if it believes that these new - but compulsory - review mechanisms have been intentionally circumvented.

  4. Be Alert to Independence Concerns. While outside directors may be misled by corporate insiders, several of the SEC's actions call into question whether the companies in question had effective, or fully functioning, audit committees. Taking this one step further, last week the Commission proposed new disclosure rules relating to the independence of corporate directors who serve on audit committees. Clearly independence, in its various aspects, is the flavor of the month - and public companies should take note.

  5. Watch for Revenue Recognition Issues. Last year Walter Schuetze, Chief Accountant of the SEC Enforcement Division, remarked that there was "nothing new under the sun" in terms of accounting fraud and that "[p]remature revenue recognition appears to be the recipe of choice for cooking the books." Consistent with Mr. Schuetze's observation, most of the cases in the recent sweep involved allegations of improper revenue recognition. When reviewing internal controls, companies should do more than simply review their procedures manuals. For example, "spot checks" to confirm that procedures are being followed not only would potentially uncover problems requiring prompt attention, but also would underscore management's commitment to proper financial reporting practices.

  6. Treat All SEC Staff Comments as Seriously as an Inquiry from the Enforcement Division. The SEC Staff is poised to pursue any indication of financial irregularity, or aggressive accounting. While an initial comment or request for information may originate with the SEC's Division of Corporation Finance or the Office of the Chief Accountant, always remember that co-workers are the best source of enforcement referrals within the SEC! In the current environment, companies should pay particularly close attention to all comments received from the SEC Staff on accounting and financial reporting issues, and respond to them thoughtfully, even when they consider them unwarranted or based on incorrect assumptions.

Harvey L. Pitt
David E. Birenbaum
David B. Hardison
Dixie L. Johnson
Robert C. Westerfeldt
Julie J. Panigrahi