The SEC Division of Corporation Finance (DCF) reviews financial filings of publicly traded corporations to ensure compliance with accounting standards and disclosure requirements. If the SEC has any questions after reviewing the financial reports, the SEC will send a comment letter asking about perceived deficiencies. Firm responses to SEC inquiries vary from simply answering questions posed via a response letter to amending their financial reports. According to the SEC, this comment process “deters fraud and facilitates investor access to information.”
Comment letters may focus on accounting practices, other disclosures in a firm’s financial report (risk factors, the quality of MD&A, Non-GAAP disclosures, etc.), or both. As an example of an accounting comment, the SEC issued the following comment to LCA vision:
“It does not appear that you defer any revenues. We understand that you have several different prices for procedures which may or may not include post-op exams, free enhancements for one year and free enhancements for life. Please provide us your analysis of why no revenue is required to be deferred because of the obligation to provide these services subsequent to the initial procedure. Please provide your analysis of supporting literature, including your consideration of, but not limited to, FASB Technical Bulletin 90-1 and EITF 00-21.”
LCA Vision responded to the SEC by acknowledging a deficiency in their accounting and agreed to restate their financial reports. Their restatement announcement states:
“LCA-Vision Inc. (“LCA-Vision” or the “Company”) today announced it will restate financial results for 2004, 2005 and 2006 to reflect a change in revenue recognition from the Company’s separately priced extended warranties. This action resulted from analysis performed following the Company’s receipt of a comment letter from the Securities and Exchange Commission (SEC) pursuant to their review of the 2006 10-K.”
In the case above, it is clear LCA Vision’s financial statements contained an error and that the SEC review detected the error. While SEC comment letters often focus on accounting issues, recently there has been an increasing focus on non-traditional topics. For example, the SEC has increasingly focused on disclosures associated with companies’ activities in, or with, nations designated as “state sponsors of terrorism” (SST) by the U.S. Department of State. SST comments focus on firms’ disclosures (or lack thereof) related to operations, or potential operations, in or with nations identified as states sponsors of terrorism. For example, the SEC commented to Marriott, the hotel chain:
“It appears from news reports that on November 22, 2010, the Marriott Hotel in Hamburg hosted the Iran Business Forum conference, which was attended by Iranian nationals.
Similarly, the SEC commented to Kraft Heinz:
“We are aware of an August 2010 news article indicating that Heinz ketchup is available in Cuba, and a March 2012 news article reporting that Heinz ketchup is available in Iran. In addition, you state on page 70 of your Form 10-K that you operate in Africa and the Middle East, regions generally understood to include Sudan and Syria. Cuba, Iran, Sudan, and Syria are identified by the State Department as state sponsors of terrorism, and subject to U.S. economic sanctions and export controls. We note that your Form 10-K does not include disclosure regarding contacts with those countries. Please describe to us the nature and extent of your past, current, and anticipated contacts with Cuba, Iran, Sudan, and Syria.
SST questions focus not only on information available from media sources or public filings but also reveal a meticulous scrutiny of non-traditional sources. For example, the SEC comments to Maxlinear, Inc:
“It appears from publicly available information that a person identified as a Co-Inventor in certain of your patent applications may be an Iranian National…Please address whether you may be deemed to have exported technology to Iran”
Former SEC Chairwoman Mary Jo White, among others, has expressed concern that political pressures to expand the boundaries of financial reporting regulation may have unintended consequences. Along these lines, we investigate whether the SEC’s focus on SST limits its ability to effectively review registrants’ financial reports for compliance with accounting standards.
We assess whether this is the case by examining the relationship between SST comments and the SEC’s ability to detect financial reporting errors. We measure the SEC’s error detection ability using error detection rates, where error detection is defined as the SEC identifying an error in the financial statements during the review process, as illustrated in the LCA Vision example. In contrast to error detection, an error missed occurs if the SEC reviews a filing yet fails to identify an error that is subsequently revealed by other means, such as a future financial statement audit.
If the SEC does not face a binding budget constraint, then we may find comment letters with SST questions continue to pose relevant accounting questions (such as questions related to revenue recognition), leading to no association between SST focus and error detection rates. In contrast, if effort spent on reviewing SST disclosure limits the time and effort spend on reviewing financial statements, we may find a negative association between SST effort and error detection.
Our results suggest that the SEC’s focus on SST disclosures reduces the quality of financial reporting oversight. For example, we find that the SEC’s financial reporting error detection rate decreases by 50 to 65 percent when a comment letter refers to SST. Moreover, we find that when SEC review team members ask a question about SST disclosures, they are less likely to ask a question about the firm’s accounting policies, the MD&A, or the appropriateness of non-GAAP performance metrics. The effects we document are unique to SST. When the SEC inquires about non-SST topics such as internal controls or risk factors, error detection actually improves and more questions are asked about accounting policies, the MD&A and non-GAAP. This implies that some topics that are investigated lead to error detection synergies, but SST is not one such topical area.
To better understanding the negative association between SST disclosure regulation and financial reporting oversight, we consider the possibility that DCF employees skilled in detecting financial reporting errors are systematically different from DCF employees who have the skills required for reviewing SST disclosures. Said differently, we posit that the individuals asking about, for example, FASB Technical Bulletin 90-1 might have a different skill set than an individual with knowledge of SST regulations. The DCF employs mostly accountants and lawyers, and we predict that accountants are better suited to focus on accounting issues. Using data from a Freedom of Information Act (FOIA) request, we find that the occupational mix of SEC reviewers has shifted over time to include more lawyers and fewer accountants. This shift coincides with an increased focus on SST comment letters and increased incidents of terrorism globally. We find accountants ask more questions on accounting topics and are more likely to detect financial statement errors. At the same time, lawyers are more likely to ask questions about SST activities, which limits the likelihood that the review detects errors.
Collectively, our findings suggest that DCF’s focus on SST disclosure comes at the expense of traditional financial reporting oversight. However, these findings speak to only one aspect of the DCF review process and we do not consider any potential benefits of SST disclosure review. For example, SST disclosure review may change how firms interact with nations designated as SST, which could help achieve foreign policy objectives. SST disclosures may also be particularly important for the investing public. Since we do not examine any of these potential benefits, we cannot draw any conclusions on the efficacy of the SEC’s focus on SST disclosure compliance. Our results do, however, suggest that careful attention should be paid to the labor mix at the SEC so as to ensure the requisite skills necessary to review all aspects of corporate filings are in place.
Bill Mayew is an accounting Professor at the Fuqua School of Business at Duke University.
Robert Hills is an Assistant Professor at Penn State University.
Matt Kubic is an Assistant Professor at the University of Texas at Austin.