Examining the Examiners: SEC Effectiveness in Identifying Financial Reporting Errors

• In Event: Earnings Management I

Abstract

Enforcement of securities laws plays an important role in financial reporting outcomes. In the United States, examiners in the SEC Division of Corporate Finance (DCF) enforce compliance with accounting and reporting standards through the comment letter process. I examine the effectiveness of the DCF comment letter process. In a sample of 17,624 financial statement reviews covering 2005 to 2014, the DCF review process identifies an error that results in a restatement in 6.3% of cases, and in 7.0% of cases fails to identify an error that results in a restatement. I use the ratio of errors identified to total errors as a measure of effectiveness (47.6%). The DCF is more (less) likely to detect severe errors and errors related to long-term assets and financial statement presentation (income taxes). SEC enforcement intensity increases the likelihood of detecting a financial reporting error, while errors are more likely to be missed during periods of above average workload. The economic reward to a DCF examiner for identifying an error is less than $1,000 per error and individual examiners substantially differ in their ability to detect financial statement errors.

Author

• Matthew Kubic, Duke University