New SEC Software Identifies Potential Fraud

By Cydney Posner

This article in The Wall Street Journal, reports that the SEC is "turning back toward Main Street, renewing their focus on accounting fraud and other financial-disclosure failings." While these cases used to be an SEC staple, recently the "financial crisis shifted attention and money elsewhere." Now, SEC Chair Mary Jo White and her staff "are expected to announce soon a broad shuffling of resources in the agency's enforcement division that will include an increased focus on accounting fraud, according to people close to the agency. The decision to hunt for wrongdoing by Main Street, as well as Wall Street, puts America's corporations in the SEC's cross hairs."

What's most interesting in the article is the report that the SEC will be applying a new technique to identify fraud -- new software that analyzes MD&A: "Officials say certain word choices appear to reveal warning signs of earnings manipulation, and tests to determine if the analysis would have detected previous accounting frauds ‘look very promising,' said [the] head of the SEC's office of quantitative research. Companies that bend or break accounting rules tend to play a ‘word shell game,' said … the SEC's chief economist and head of the division developing the model. Such companies try to ‘deflect attention from a core problem by talking a lot more about a benign' issue than their competitors, while ‘underreporting important risks.' If the word-analysis program works, officials say it will be added to a new ‘Accounting Quality Model' that SEC enforcement staff started using recently. The model trawls data from nearly 9,000 publicly traded companies. A similar computer-powered search for unusual performance patterns at hedge funds has led to seven enforcement actions in recent years."

The "fraud-detection software looks for big differences between net income and actual cash outflows available to investors, according to officials. It then looks for other warning signs, such as declining market share or weak profitability compared with rivals. The system also looks for companies with an unusually high number of off-balance sheet transactions." As you may recall, these structures were used in the past by Enron and others to hide debt and inflate earnings.

Auditor changes also signal potential trouble: "About 9% of companies that file financial reports with the SEC had their auditor leave last year, according to research firm Audit Analytics. Of the 866 companies that lost their auditor, 66 had two auditors depart, while two companies went through three auditors. "

Clearly, the use of suspicious language or numbers isn't necessarily illegal, but it would sound an alarm at the SEC: according to the SEC's Chief Economist, "something ‘kicked out of our model as being unusual' is ‘much more likely to be associated with a fraud' than to have a more benign explanation.

While these techniques might sound a bit Big Brother, according to an accounting professor cited in the article, "textual analysis is ‘fairly prevalent' in fraud detection. For example, insurers have concluded that people filing fraudulent claims tend to use ‘I' and ‘we' less often than honest policyholders. In annual reports, executives tend to refer to themselves more frequently when their companies are doing well, [another] accounting professor… said. Companies with poorer earnings often ‘file annual reports that are more difficult to read.'"

But won't the fraudsters be the first to figure out how to circumvent the new software?

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