According to an October 16, 2014 press release, the U.S. Securities and Exchange Commission ("SEC") reports a "record 755 enforcement actions covering a wide range of misconduct, and obtained orders totaling $4.16 billion in disgorgement and penalties..." for the fiscal year-end ending in September 2014. One reason given for this increase from prior years is the "enhanced use of data and quantitative analysis.

From what I have read, these technology-focused tools include "proprietary risk analytics to evaluate hedge fund returns," part of the SEC's Aberrational Performany Inquiry initiative. The idea is that reported returns should comport with the underlying investment strategy and selection of benchmark. If returns appear inflated, inquiries are likely to follow. Asset managers that are legitimately managing money in accordance with their stated approach may want to check the extent to which their calculations are transparent and effectively communicated to investors.

The Accounting Quality Model ("AQM") is another technique that is described by the Association of Certified Fraud Examiners as having "real potential to be a game-changer." In "SEC Announces Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis" (July 2, 2013), the Financial Reporting and Audit Task Force is said to expand and strengthen its focus on fraud detection and poor auditing procedures. Stated areas of emphasis include financial statement revisions, how a company performs relative to industry peers and whether proper disclosures are being made to investors.

Attorney Andrew J. Morris with Morvillo LLP gives readers some helpful insights about the AQM in his article entitled "A Look Inside The SEC's Accounting Quality Model" (Law360, January 6, 2014). Using its vast library of company data, the SEC wants to systematically identify financial reports that suggest inferior earnings quality, "caused by inappropriate accounting judgments." Since filings must now be formatted using eXtensible Business Reporting Language ("XBRL"), the SEC can take advantage of the uniformity of data fields to automatically parse what its algorithm determines as an outlier. As Mr. Morris points out, company management has a certain amount of accounting latitude. A regulatory model may generate what he calls a false positive because it does not consider that flexibility. Should that situation occur, a company will have to expend time and money to justify its accounting policies. His recommendation is to thoroughly document these judgement calls ahead of time. Examining how other companies in an industry determine important metrics is another good thing to do. Auditors play a vital role by "conducting thorough analytical reviews that resolve all anomalies" and then reconciling any problem areas that arise as a result of that ex ante assessment.

As BakerHostetler partner John Carney and associate Francesca Harker point out, the SEC has a powerful agent in its corner now. As the SEC computer trawls continuously uploaded financial data, it will generate a risk score to "determine whether a filing is given a quick, unsuspecting review, or whether it is thoroughly dissected by an SEC exam team, possibly leading to an expensive audit." Besides benchmarking financial reporting against industry norms, Mr. Carney and Ms. Harker urge companies to check their work since RoboCop cannot distinguish between honest errors and "oddities." They further opine that the use of off-balance sheet transactions should be deemed reasonable and that discretionary accruals should be conservative. See "Corporate Filers Beware: New 'RoboCop' Is On Patrol" (Forbes, August 9, 2013).

My firsthand knowledge of financial statement analysis is that one must understand the different ways that numbers can be assembled and what the end results truly represent. It is necessary to be a financial detective. I have taught multiple financial statement analysis courses. I have worked with external and internal company auditors. I have rendered opinions of value and reviewed appraisal reports done by others. I have served as a forensic economist on multiple dispute matters that entailed taking a deep dive into how specific metrics are computed. The work is far from trivial and can be quite complex. A company that provides specificity about its policy choices is typically in a far better position than when an objective third party is forced to second guess why one approach was selected over another. It is a lot easier to give a company the benefit of the doubt when ample policy breadcrumbs exist. Good documentation is less disruptive when employees leave and others are asked to assume their responsibilities.

I could write volumes about earnings quality and ratio techniques. There is so much to say. For now, let me suggest that companies and their attorneys may want to likewise perform a Dupont analysis on a regular basis. It is a technique that, if applied correctly, enables a financial statement user to better understand different aspects of how a company is run and to ask appropriate questions

Plato said that "A good decision is based on knowledge and not on numbers." That makes sense but does not change the fact that regulators are watching the numbers.