The Spillover Effect of SEC Comment Letters on Qualitative Corporate Disclosure: Evidence from the Risk Factor Disclosure

Abstract

In this study we use the recently mandated risk factor disclosure to examine the spillover effect of the Securities and Exchange Commission (SEC) review of qualitative corporate disclosure. We find that firms not receiving any comment letter (“No‐letter Firms”) modify their subsequent year's disclosures to a larger extent if the SEC has commented on the risk factor disclosure of (i) the industry leader, (ii) a close rival, or (iii) numerous industry peers. We refer to this effect as “spillover.” Further, we find that after SEC comments on the industry leader's disclosure, No‐letter Firms also provide more firm‐specific disclosures in the subsequent year. The increased disclosure specificity reduces these firms’ likelihood of receiving SEC risk disclosure comments on their new filings. Our evidence suggests an indirect effect of the SEC review of qualitative disclosure.

Does Securities Commission Oversight Reduce the Complexity of Financial Reporting?

“…This signal psychologically increases the perceived cost of opportunistic managerial behavior (Cassell et al, 2019). 2 The perceived cost of op-portunistic managerial behavior will be sufficiently high because the close monitoring of the company may draw the attention of regulator to other significant problem, and reveal new deficiencies (Brown et al, 2018;Francis, 2011). Consequently, the increase in the perceived cost of opportunistic managerial behavior reduces opportunistic managerial behavior (Rennekamp, 2012).…”

“…Third, prior studies show that the receipt of a comment letter may lead to undesirable outcome for managers (Francis, 2011;Brown et al, 2018). For example, Gietzmann and Isidro (2013) provides evidence that the receipt of a comment letter serve as a negative signal of financial reporting quality and find evidence that shareholder negatively react to comment letter by sailing their shares.…”

“…In addition, higher corporate governance quality may also complement the securities commission oversight by incorporating the signal from comment letter in determining other oversight process such as the oversight process of institutional investors, directors, audit committees or external auditors (GAO, 1991;Bens et al, 2016). Further, higher corporate governance quality may draw directors and auditors attention to new major problems, and reveal new deficiencies (e.g., Ryans, 2019;Brown et al, 2018). Thus, the higher corporate governance quality may improve the corrective action of managers (Mishkin, 1997) in response to comment letters and beyond the scope of comment letters.…”

The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters

“…They further find that the disclosure improvements are associated with lower information asymmetry and reduced litigation risk. Brown et al (2015) examine spillover effects of one company's comment letter on its industry peers' qualitative disclosure changes related to risk factors. They provide evidence that a company's disclosures become more consistent with their peers after going through a comment letter review.…”

“…Cassell, Dreher, andMyers (2013, p.1902) call for future research on the benefits of the comment letter process, including whether it leads to "improved subsequent reporting quality." Most of the extant literature on the benefits of the comment letter process focuses on the impact of disclosure changes following the receipt of a comment letter (e.g., Johnston and Petacchi, 2014;Bens, Cheng, and Neamtiu 2015;Bozanic, Dietrich, Johnson, 2015;Brown, Tian, Tucker 2015). These studies provide evidence that comment letters lead to improved disclosure, greater cross-firm consistency, more transparent information environments, and lower information asymmetry.…”