Unexpected SEC Resource Constraints and Comment Letter Quality

Abstract

We investigate whether reviews of transactional filings by the SEC unexpectedly constrain SEC resources, leading to lower quality comment letters for periodic reports. The Sarbanes‐Oxley Act requires the SEC to review periodic reports (e.g., 10‐Ks) at least once every three years. However, the SEC also reviews transactional filings (e.g., initial public offerings and acquisitions), which are unpredictable and often occur in waves. We find comment letters for periodic reports are of lower quality (in terms of outputs, inputs, and firm responses) during periods of abnormally high transactional filings. We also find that comment letters issued during periods of abnormally high versus low transactional filings are associated with increased information asymmetry and lower earnings response coefficients in the quarter after the resolution of the comment letter. Overall, our results suggest that unexpected resource constraints affect the quality of SEC oversight of periodic reports.

Does Financial Statement Comparability Facilitate SEC Oversight?

“…Overall, Table 6 provides empirical findings consistent with the view that the SEC's monitoring resource constraints are positively associated with its reliance on cross-firm comparisons with high comparability peer firms during the filing review process. Moreover, this result suggests that comparable accounting systems across firms could help attenuate the negative oversight consequences arising from limited monitoring resources (e.g., Ege et al 2020).…”

“…Next, we evaluate how the SEC's monitoring constraints in the review process affect the extent to which financial statement comparability improves its detection of poor accounting quality. Prior studies demonstrate that monitoring constraints adversely impact the SEC's ability to oversee firms' financial reporting (e.g., Ege, Glenn, and Robinson 2020;Gunny and Hermis 2020). We conjecture that the reduced information costs that arise from the use of highly comparable peer benchmarks could help the SEC overcome the monitoring constraints it faces in filing reviews.…”

“…Thus, each industrylevel review employee was responsible for approximately 1,844 (671,304/364) filings per year. Filing data was its ability to oversee firms' financial reporting (e.g., Ege et al 2020;Blackburne 2014;Gunny and Hermis 2020). With respect to the monitoring constraints, Kedia andRajgopal (2011) andFiles (2012) show that the SEC is more likely to investigate a firm whose review costs are lower (i.e., the firm's location is closer to the SEC office and the upfront enforcement costs are lower, respectively).…”

“…To highlight the informational advantage of cross-firm comparisons in regulatory filing reviews, we explore how the SEC's monitoring constraints, captured by 1) resource limitations (section 5.1.1) and 2) the use of dissimilar filing formats (section 5.1.2), affect the role of financial statement comparability in improving the SEC's assessment of accounting quality. Prior studies show that the SEC's oversight over financial reporting is less effective when it is constrained (e.g., Gunny and Hermis 2020;Ege et al 2020;Blackburne 2014). Furthermore, Kedia and Rajgopal (2011) suggest that when constrained, the SEC is more likely to focus on monitoring firms that are 19 We also calculate how the likelihood of receiving an accounting comment letter changes for high and low comparability firms with poor accounting quality (defined as the 90 th percentile of Disc_Accr).…”

“…In doing so, this study addresses the call for more research into ways to improve the efficacy of the SEC's filing review process (Cunningham and Leidner 2020). Prior studies examine whether the overall quality of SEC oversight is adversely affected by various external constraints such as geographic distance (Kedia and Rajgopal 2011), seasonally compressed periodic filings (Gunny and Hermis 2020), and an influx of IPO and acquisition transitional filings (Ege et al 2020). Distinct from this line of prior research, we investigate the effect of a filing firm's relative attribute of financial reporting on the SEC's filing review process; finding that financial statement comparability enhances the SEC's evaluation of accounting quality.…”