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By Paul R. Brown, PhD, CPA, is an associate professor, and Jeanne A. Calderon, J.D., Esq., an assistant professor, both at Stern School of Business, New York University

In these times when accountants are especially sensitive to professional liability concerns, all accountants can benefit from an understanding of the Securities and Exchange Commission's (SEC) application of its disciplinary rule. Although auditors and staff accountants of publicly-held companies will be particularly interested, the SEC's disciplinary activities will prove to be instructive to all accountants because the SEC decisions focus on fundamental principles. The same issues faced by accountants associated with multimillion dollar enterprises can be faced by accountants working with privately held companies, not-for-profit organizations, or governmental entities. In addition, many of the accountants' problems culled from the SEC's disciplinary decisions are of the same type that accountants are held responsible for in the courts.

Over a 60-year period, a rich source of data has evolved that details disciplinary actions taken against accountants by the SEC, and, importantly, the rationales for those actions. This archival data is highly diffuse, however, and it is difficult to discern any patterns by simply a cursory reading of the decisions. Our in-depth analysis of the decisions seeks to remedy this problem.

SEC Disciplinary Rule 2(e)

The SEC maintains its control over the competence and integrity of accountants who practice before it pursuant to Rule 2(e) of its Rules of Practice. While there has been some debate about the SEC's authority to regulate the affairs of accountants and the accounting profession, the SEC has been largely successful in meeting these challenges. However, as a result of a recent D.C. Circuit Court of Appeals decision, Checkosky v. SEC, it is uncertain whether the SEC is authorized to discipline accountants for merely negligent conduct in contrast to more serious misconduct such as gross negligence, recklessness, and fraud.

The SEC used Rule 2(e) sparingly before the 1970s. SEC activity in this area intensified in the 1980s and gained even more momentum during this decade. [We published an analysis of Rule 2(e) decisions by the SEC prior to this decade in The CPA Journal, July 1993.] Furthermore, the decisions released in this decade represent new and developing trends by the SEC.

Rule 2(e) decisions are published in SEC Releases. A total of 247 decisions (excluding those involving ministerial issues) concerning accountants were released by the SEC between 1935 and 1994. Over one-third of these were released in the 1990-94 period.

Several factors point toward an even greater acceleration of SEC activity in the future. For many years, the SEC and the courts have viewed accountants as important representatives of the investing community. The SEC, with its small staff and limited resources, has sought to rely upon the accounting profession to protect the investing public. In recent years, SEC officials have stressed even more the importance of holding accountants accountable to the public. The SEC has become more "enforcement minded," imposing harsher sanctions on disciplined accountants. For example, while the SEC permanently barred 28 accountants from SEC practice in the 1970s, and 16 in the 1980s, during the first half of this decade (through 1994) 42 accountants have already been permanently barred.

Furthermore, in an effort to shorten the process of investigating and litigating Rule 2(e) actions, the SEC transferred responsibility for disciplinary proceedings against accountants from the General Counsel's Office to the Division of Enforcement. According to George Diacont, the chief accountant in the enforcement division, as a result of this change, experienced SEC accountants and attorneys carry out investigations and related litigation with greater efficiency.

Virtually all Rule 2(e) matters arise out of an investigation of an SEC registrant company. Inevitably, the SEC investigates the conduct of both the company's corporate accountants and its independent auditors. The Enforcement Division initiates actions against accountants triggered by a wide range of sources--questionable financial statements issued by a company, referrals from other Federal agencies or other divisions within the SEC, and disgruntled employees, to name just a few.

Following extensive due process procedures that allow for accountants to defend themselves, the SEC issues its Rule 2(e) decisions. The decisions have varied significantly over the last sixty years in their level of detail, types of sanctions imposed on accountants, parties named in the rulings, and degree of background provided surrounding the decision. In analyzing the decisions by type of misconduct, however, a relatively small number of basic issues dominated.

Analysis of Rule 2(e) Releases

Each of the SEC Rule 2(e) releases was analyzed in depth to discern 1) characteristics of the accountant(s) named in the release (corporate accountant, auditor, firm affiliation, etc.); 2) types of misconduct alleged by the SEC against the accountant(s); and 3) sanctions imposed on the accountant(s) by the SEC. Of the 247 SEC releases, 91 were issued between 1990-94, 73 between 1980-89, 64 between 1970-79, and 19 prior to 1970. Our analysis and conclusions benefitted from extensive conversations with George Diacont, who graciously found time for our inquiries.

For purposes of analysis, we separated our findings into two categories: auditing-related and accounting-related errors. Although the distinction between accounting and auditing is not always clear, this categorization facilitated analysis of the releases.

Auditing-Related Problems

Three general and related categories of auditing-related problems were cited extensively in the 1990s:

* Lack of skepticism by the auditor related to one or more transactions or aspects of the audit.

* Lack of sufficient evidentiary matter gathered and documented by the auditor.

* Improper reliance placed on management during the course of the audit.

Four additional auditing-related problems were cited by the SEC during this same period that, while cited to a lesser extent than the aforementioned three, still dominated the releases relative to other problems:

* Lack of independence by the auditor.

* Failure to adequately document audit evidence in work papers.

* Failure to find or insist on disclosure of related-party transactions.

* Lack of adequate supervision of staff working on the audit.

An important theme emerges when reviewing these seven categories of frequently-cited problem areas. Even as accounting and auditing concepts become more complex, and even as the business environment becomes more sophisticated, it is still the basic tenets of auditing that dominated SEC decisions. Auditors were grappling with many of these same audit issues 30 or 40 years ago!

Many of the releases cited several problems in the same release. The first three identified above--lack of skepticism, lack of sufficient evidential matter, and improper reliance on management--often were linked. A problem with the audit of inventory, for example, could be traced to too much reliance placed on management assertions. In other words, the auditor was not skeptical enough--and the result was too little test work. The audit of loans and accounts receivables also broke down through a combination of these three problem areas.

The SEC tied together these three mistakes when it was clear from the work papers that the auditor knew of a problem but did not resolve the issue adequately. With impairment of assets, whether it be obsolete inventory, idle long-lived assets, or uncollectible receivables, the SEC often concluded that these three errors, when combined, resulted in problems not adequately resolved.

The SEC found an auditor to lack independence when, for example, his relationship with the company's management was closer than should be maintained by an outside auditor. In several releases, an auditor was held to be lacking independence because loans were secretly received from the audited company during the audit period.

Accounting-Related Problems

Three accounting-related problems in addition to the general assertion of materially misstated financial statements were cited extensively:

* Improper accounting entries were recorded by the audited company that were not questioned by the auditor.

* One or more important disclosures were missing from the financial statements issued by the audited company.

* Generally accepted accounting principles for recognizing revenue were violated in preparing the financial statements.

Similar to the auditing-related issues, the accounting-related issues cited by the SEC in its releases were straightforward, rather than complex. In other words, the recurring problems revolved around the basic themes of accounting and auditing. Our research revealed that the same fundamental problems were the focus of SEC attack in the prior periods as well, with the emphasis shifting only slightly from decade to decade.

Although the issues cited most often are general in nature, obviously they are based on specific audit and accounting situations.

Typical income misstatements included 1) overstatement of sales, 2) understatement of costs of goods sold, and 3) understatement of various expense categories. Revenue recognition rules were violated by both prematurely recognizing revenue ("front-ending" revenue) and by inadequately reserving for returns related to revenue already recognized. Cost of goods sold often was understated because inventory that should have been written off was not, or because inventory did not even exist.

Balance-sheet misstatements involved either understatement of allowances for potential losses on assets or understatement of known liabilities. Typical allowances/liabilities either understated or missing entirely included 1) allowance for bad debts, 2) allowance for sales returns, 3) warranty liabilities, 4) litigation liabilities, and 5) accrued liabilities for unresolved obligations of the audited

As disclosure is fundamental to the U.S. reporting system, its prevalence as a citation is not surprising. Disclosures involving related-party transactions, dominant sales transactions, third-party guarantees, revenue recognition policies, and long-lived asset valuations, among many others, were cited as either improperly discussed or missing entirely. The SEC clearly views violation of disclosure rules as egregious as violation of measurement rules.

The Latest Trend

As indicated above, the 1990-94 period was one of heightened activity by the SEC--a trend we believe will continue. Of the 91 releases in the 1990-94 period, approximately two-thirds addressed the misconduct of accountants functioning as auditors, with the remaining involving corporate accountants employed by publicly-held companies. However, it is important to note that significantly more corporate accountants were disciplined in the 1990-94 period than in prior periods.

For the auditors cited in the releases, a major difference emerged between this and earlier periods. In this decade, the trend has been to name and take action against individual auditors only, as opposed to individual auditors and their firms. In fact, no accounting firm alone was named in the 1990-94 period--as opposed to seven firms named in the previous decade. We believe this trend will continue, with evidence of firmwide culpability necessary before the SEC names an entire firm. It also should be noted that a significant majority of the auditors cited in the decisions were either sole practitioners or auditors working within small or mid-sized firms.

As indicated earlier, the SEC archival data base analyzed is highly diffuse. Furthermore, the high turnover rate for attorneys in the Enforcement Division often results in releases highly general both in their wording and identification of issues. This problem also made comparisons across releases difficult at times. According to George Diacont, however, this problem should not be construed as lack of commitment or vigilance on the part of the SEC.

The general nature of problem areas identified by the SEC obviously drives the general nature of our analysis. It is important to note, however, that the level of specificity in the releases varied significantly in the discussion of the 1) audit situation under investigation, 2) operations of the company audited, and 3) the environment in which the audit took place. SEC decisions currently are published in Accounting and Auditing Enforcement Releases (AAERs), and a review of several of them to further learn from the problems of others--in the context of the specific audit situation under investigation--would be a productive exercise. We particularly recommend AAERs 554, 601, and 619 because of the large number of problems identified by the SEC in these releases.

Lessons for All Accountants

Although the number of accountants disciplined by the SEC has drastically increased in recent years, it should be noted that they still remain an extremely small percentage of all accountants practicing before the SEC. However, our analysis reinforces the fact that accountants must comply with basic accounting and auditing principles or subject themselves to potential liability from different sources. With respect to the SEC, the consequences can be severe as our analysis demonstrates that harsh sanctions are being imposed in this decade.

The SEC emphasizes fundamentals in its releases--just as is often the case with the courts. Accountants need to recognize that it is not the complexity of situations that usually leads them astray, but, rather a lapse from the basics.

Finally, note that so many of the problems identified relate to the "human" aspects of an audit. Healthy skepticism, independence in fact as well as appearance, proper guidance for less-than-seasoned auditors' undue reliance on management, all involve judgment. Sound judgment is one of the most important assets of accountants, and often problems arise because this prized trait is
forgotten. *

A copy of the comprehensive analysis of the SEC decisions from 1935 to
1994 is available by contacting
the authors.


Douglas R. Carmichael, PhD, CPA

Baruch College

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