The Effect of SEC Reviewers on Comment Letters and Financial Reporting Quality

Consistency is one of the key principles of effective regulations. When the same violation is sanctioned in materially different ways, such practices might significantly diminish public trust and confidence in regulators. Further, expectations of differential treatment could also affect compliance with the regulations. Despite the importance of this issue, it is only recently that empirical researchers started establishing evidence of differential implementation of regulations by U.S. regulators.

In our recent paper, we draw on the literature showing the importance of individual characteristics in decision making processes, and examine whether the idiosyncrasy of individual employees of U.S. financial regulators significantly explains the variation in regulatory outcomes.

We use the review of corporate filings by the SEC (comment letters) as a setting to examine the issue of regulatory inconsistency due to idiosyncratic styles of government officials. This filing review process provides an advantageous setting to examine the influence of individual SEC reviewers on review/regulatory outcomes. Namely, SEC registrants cannot go regulator-shopping, because they cannot choose reviewers. In addition, the comment letter is prepared without registrants’ input, allowing us to observe the regulatory outcomes unaffected by registrants’ efforts to reduce regulatory costs.

During our sample period of 2004 to 2013, we examine whether SEC reviewers’ idiosyncratic style - i.e., reviewer fixed effects - incrementally explains variation in filing review outcomes. Following the methodology of Bertrand and Schoar (2003) and similar studies, we construct a sample where each reviewer reviews at least two firms and each firm is reviewed by at least two reviewers. We consider three measures of SEC filing review outcome: the number of issue topics identified, the number of letters exchanged between the SEC and the recipient firm, and the number of days between the letter date and the date of the filing review closure. Our findings suggest that individual reviewers exert significant influence on SEC filing review outcomes. The adjusted R2 increases significantly for all outcome measures when reviewer indicator variables are added to the right-hand side of a baseline regression that includes firm and year fixed effects. Compared to a reviewer at the 25th percentile of the reviewer fixed effect distribution (RFED), a reviewer at the 75th percentile identifies 2.52 more issue topics per letter. Since the average number of issue topics in a SEC comment letter is 5.94, this difference is substantial. It also takes, on average, 1.07 more letter exchanges and 33.13 days longer when the letter was issued by a reviewer at the 75th percentile of the RFED. 

Additional analyses reveal that individual SEC reviewer style is persistent across firms and time. We further find that the reviewer fixed effects explain more variation in review outcomes than any observable characteristics of the reviewer. We also find that reviewer style is associated with improved financial reporting quality. For all three review outcome variables, we find that reviewer fixed effects are positively associated with the likelihood of a restatement during the comment letter process (i.e., a ‘cleaning up’ of prior financial statements). Firms examined by a reviewer in the top 30% of the RFED are at least twice as likely to restate their financial statements compared to those examined by a reviewer in the bottom 30%. We also find that the strictness of the current reviewer is negatively associated with the severity of future filing review outcomes. E.g., if a firm is reviewed in the current period by a reviewer in the top 30% of the RFED, the firm is likely to receive 0.98 fewer issue topics in their next comment letter.

To summarize, we find that SEC reviewers’ individual style has a significant impact on the number of issue topics identified in a comment letter and the amount of effort and time required to resolve those issues. Further, firms reviewed by a more thorough reviewer are more likely to restate their financial reports during the review process and also tend to have less severe filing review outcomes the next time they receive a comment letter. Together, these findings suggest that SEC reviewers’ idiosyncratic style plays an important role in the processes through which financial reporting and disclosures are monitored by the SEC, potentially creating regulatory inconsistency.

Matthew Baugh is an Assistant Professor at the W.P Carey School of Accountancy, Arizona State University.

Kyonghee Kim is Associate Professor of Accounting and Information Systems at the Eli Broad College of Business, Michigan State University.

Kwang J. Lee is an Assistant Professor at the Korea Advanced Institute of Science and Technology (KAIST).