Title: SEC REVIEW UNDER SECTION 408 OF THE SARBANES OXLEY ACT OF 2002: DOES IT MAKE A DIFFERENCE
1SEC REVIEW UNDER SECTION 408 OF THE SARBANES
OXLEY ACT OF 2002 DOES IT MAKE A DIFFERENCE?
- Sharad Asthana Jeff Boone
- ACCOUNTING, COB, UTSA
April 2009
2Motivation
- SEC. 408. ENHANCED REVIEW OF PERIODIC DISCLOSURES
BY ISSUERS. - (a) REGULAR AND SYSTEMATIC REVIEW. - The
Commission shall review disclosures made by
issuers reporting under section 13(a) of the
Securities Exchange Act of 1934 (including
reports filed on Form 10K), and which have a
class of securities listed on a national
securities exchange or traded on an automated
quotation facility of a national securities
association, on a regular and systematic basis
for the protection of investors. Such review
shall include a review of an issuers financial
statement. - (b) REVIEW CRITERIA. - For purposes of scheduling
the reviews required by subsection (a), the
Commission shall consider, among other factors - - (1) issuers that have issued material
restatements of financial results - (2) issuers that experience significant
volatility in their stock price as compared to
other issuers - (3) issuers with the largest market
capitalization - (4) emerging companies with disparities in price
to earning ratios - (5) issuers whose operations significantly affect
any material sector of the economy and - (6) any other factors that the Commission may
consider relevant. - (c) MINIMUM REVIEW PERIOD. - In no event shall an
issuer required to file reports under section
13(a) or 15(d) of the Securities Exchange Act of
1934 be reviewed under this section less
frequently than once every 3 years.
3MOTIVATION
- PRELIMINARY REVIEW
- (AT LEAST ONCE EVERY 3 YEARS)
- OUTCOME 1 NO ACTION
- OUTCOME 2 DETAILED REVIEW
- FINANCIAL REVIEW (F/S MDA)
- FULL REVIEW (F/S MDA BUS LEGAL INFO)
- TARGETED REVIEW (SPECIFIC ? DERIVATIVES)
- NO FURTHER COMMENT
- OR
- ACCOUNTING AUDITING ENFORCEMENT RELEASE (AAER)
4MOTIVATION (continued)
- The SEC states that
- Much of the Divisions review involves reviewing
the disclosure from a potential investors
perspective and asking questions that an investor
might ask when reading the document. - The mission of the U.S. Securities and Exchange
Commission is to protect investors, maintain
fair, orderly, and efficient markets, and
facilitate capital formation. - The laws and rules that govern the securities
industry in the United States derive from a
simple and straightforward concept all
investors, whether large institutions or private
individuals, should have access to certain basic
facts about an investment
5MOTIVATION (continued)
- DURING 2004-08, THE DIVISION OF CORPORATE
FINANCE (SEC) SPENT OVER 429 MILLION ON REVIEW
OF FILINGS. OF THIS, OVER 300 MILLION WAS SPENT
ON REVIEW OF 10-Ks. -
- DID THESE REVIEWS
- MAKE A DIFFERENCE?
RQ
6OBJECTIVE
- TO INVESTIGATE THE EFFECTIVENESS OF THE SEC
REVIEWS OF 10-Ks - - IN IMPROVING THE QUANTITY QUALITY OF
INFORMATION - IN EQUALIZING DISTRIBUTION OF INFORMATION AMONG
INVESTORS - THE EFFICIENCY OF THE REVIEWS IN PROVIDING
INFORMATION VALUE IN EXCESS OF REVIEW COSTS.
7RESULTS / CONTRIBUTION
- (1) SEC reviews result in changes in both the
length and content of 10-K annual reports and
trigger financial restatements - (2) This change in 10-K length and content
appears to increase the information content of
the 10-K as measured by return volatility and
trading activity - (3) The increased information content is
primarily concentrated among small investors - (4) The adverse selection spread component
declines following release of the post-review
10-K - (5) The SEC reviews produce information valued at
over 84 for every 1 expended in conducting the
reviews - (6) Contributes to the recent debate concerning
ex ante versus ex post regulation of financial
reporting.
8THEORY (1)
- Consumers perceive public goods to be "free.
Investors may demand more frequent/ more intense
SEC reviews than would be demanded if they
purchased the reviews at a price determined by
market Demand/Supply dynamics (Chen and Johnson
2008)? the marginal cost of the SEC reviews
exceed the marginal benefit.
9THEORY (2)
- SEC reviews are an extra layer of financial
monitoring on top of that done by the independent
auditor. The auditor has significantly more
economic incentives than the SEC to detect
material misstatements in financial statements ?
SEC reviews are unlikely to result in meaningful
improvement in 10-K annual reports.
10THEORY (3)
- Audited financials can comply with GAAP and yet
lack an appropriate level of transparency if GAAP
is slow to respond to innovations in business
practices ? the SEC reviews can improve 10-K
annual reports by correcting accounting and
disclosure deficiencies arising from unsettled,
emerging accounting and disclosure issues
ineffectively addressed by extant GAAP
11PRIOR RESEARCH
- Ettredge et al. (2008) ? Examine comment letters
addressing non-compliance with auditor change
disclosures in Item 4 of Form 8-K ? the
probability of non-compliance is positively
associated with the 8-K containing bad news,
negatively associated with corporate governance
quality, and not associated with firm size.
12PRIOR RESEARCH
- Ertimur and Nondorf (2006) ? Examine comment
letters issued on registration statements of
initial public offerings ? Higher managerial
expertise is associated with fewer comments and a
faster review ? Little association between
corporate governance and number of
comments/review time ?. Hypothesize that firms
with fewer comments and faster review will have
lower under-pricing, greater depth, and narrower
bid-ask spreads.
13PRIOR RESEARCH
- Chen and Johnston (2008)? Examine the change in
earnings announcement for a sample of firms
receiving comment letters on a 10-K or 10-Q - SEC REVIEW ? PRECISION ? EARNINGS REACTION
- ___________________________________________(KIM
VERRECCHIA 1997)______ - UNANSWERED QUESTIONS
- ?10-K POST-REVIEW?
- ?QUANTITY OF INFORMATION?
- ?QUALITY OF INFORMATION?
- ?DISTRIBUTION OF INFORMATION
- ? LARGE V/S SMALL?
- COSTS V/S BENEFITS OF REVIEW?
- Ex Ante V/S Ex Post?
- DO RESULTS HOLD FOR LARGE SAMPLES (gt206)?
14SAMPLE
- 36,771 CL (MAY 1ST, 2005 JUNE 30TH, 2008)
- 16,987 (10-K RELATED)
- 10,414 (DATA ON COMPUSTAT CRSP)
- 3,572 CL FIRMS 3,754 NO CL FIRMS
15RESEARCH DESIGN
- POST-REVIEW 10-K CHANGES
- LENGTH ANALYSIS
16RESEARCH DESIGN
- POST-REVIEW 10-K CHANGES
- CONTENT ANALYSIS
- LEVENSHTEIN_DIFF
- LEVENSHTEIN (CL) - LEVENSHTEIN (NO-CL)
- ALSO USE LEVENSHTEIN_CHAR
17RESEARCH DESIGN
- POST-REVIEW 10-K CHANGES
- RESTATEMENT ANALYSIS
- H3A The number of SEC-triggered restatements is
greater than expected in the absence of an SEC
review - OR P(Rgtr) gt 0.10
18RESEARCH DESIGN
- POST-REVIEW 10-K CHANGES
- INFORMATION CONTENT ANALYSIS
- ?CAR CARPOST- CARPRE
- ESTIMATION PERIOD (-250, -5)
- TEST PERIOD (-1, 1)
- Fama and Frenchs (1993) model with the Carharts
(1997) momentum modification - H4A the mean/median value of ?CARgt0
19RESEARCH DESIGN
- POST-REVIEW 10-K CHANGES
- INFORMATION CONTENT ANALYSIS
- CAT S( )
- TRist Number of trades on day t for size
stratum s in firm i - ยต(TRist) Mean (TRist) in the period (-49, -5)
- s (TRist) Standard Deviation (TRist) in the
period (-49, -5) - Large ? gt50,000
- Small ? lt 5,000 (or lt 100share price if gt 50)
- ?CATsmall CATsmall,post CATsmall,pre
- H5A the mean/median value of ?CATsmall gt0
- H6A the mean/median value of ?CATsmall ?
?CATlarge - Repeat with ?CAS (Cumulative Abnormal Shares)
H7,8
20RESEARCH DESIGN
- CHANGES IN INFORMATION ASYMMETRY
- ASC ADVERSE SELECTION COMPONENT
- ?ASC ASC(0 to 59) - ASC(-60 to -1)
- H9A The mean/median value of
- ?ASCPOST ?ASCPRE ?0
21Jeff to discuss results
22RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
- Test 1 examine change in length of 10-K
- Test 2 change in content of 10-K
- Test 3 restatements
23RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
- Test 1 examine change in length of 10-K
- Test result
- Mean 10-K length increased by about 6 (Table 5
Panel A)
24RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
- Test 2 change in content of 10-K
- Test result
- Greater change in 10-K content (post-review
versus pre-review 10-K) among CL firms as
compared to industry/size matched No CL control
group (Table 5 Panel B).
25RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
- Test 3 restatements
- Test result (Table 5 Panel C)
- 4.5 restatement rate among CL firms
- 4.5 162 restatements out of 3,572 CL firms
- 1.5 restatement rate among No CL firms
- Probability of observing 162 or more restatements
given a 1.5 base restatement rate (absent SEC
review) is very small (prob lt 0.001).
26RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
- Conclusion
- Significant increase in length of 10-K
- Significant change in content of 10-K
- More restatements than expected by chance.
- Answer to RQ Yes.
27RQ Does new information in 10-K
- Add to the information set used by investors?
- Equalize the distribution of information among
investor classes?
28RQ Does new information in 10-K add to the
information set used by investors?
- Test 1
- Compare return volatility during post-review and
pre-review 10-K filing event (-1,1) - Compare trading activity during post-review and
pre-review 10-K filing event (-1,1) - Test result (Table 6 Panels A-C).
- Increase in return volatility (Table 6 Panel A)
- Increase in number of trades (Table 6 Panel B)
- Increase in number shares traded (Table 6 Panel
C) - Answer to RQ Yes
29RQ Does new information in 10-K equalize the
distribution of information among investor
classes?
- Test 1
- Compare trading activity associated with new
information between large and small investor
classes. - Test result (Table 6 Panels B and C)
- Small investors showed greater increase in
trading activity than large investors. - Suggests that new information in 10-K had
greater information content for small investors,
potentially because larger investors already had
obtained at least some pre-disclosure knowledge
of the information through private information
search. - Could also mean that the new information was
commonly interpreted by large investors but was
subject to varying interpretation by small
investors. - Spread analysis will help distinguish between
these two competing explanations..
30RQ Does new information in 10-K equalize the
distribution of information among investor
classes?
- Test 2
- Use adverse selection spread component as
observable indicator of information asymmetry - For both post-review and pre-review 10-K filing
events - Measure mean adverse selection spread component
during 60 days following the 10-K filing event. - Subtract mean adverse selection spread component
during 60 days preceding the 10-K filing event to
control for across-time changes in spread levels.
- i.e., 60 day mean less -60 day mean).
- Mean spread during 60 post-filing period
(controlling for mean spread preceding the
filing) should be lower than means spread during
corresponding pre-review 10-K period if new
10-K information equalized the distribution of
information among investors. - (slide continues)
31RQ Does new information in 10-K equalize the
distribution of information among investor
classes?
- Test 2 (continued)
- Test result
- Mean spread during 60 post-filing period
(controlling for mean spread preceding the
filing) was lower than mean spread during
corresponding pre-review 10-K period. - Spread analysis suggests that difference in
trading activity among investor classes was due
to equalizing distribution of information among
investors. - Answer to RQ Yes
32RQ Is the information value of SEC review
greater than review cost?
- Test
- Determine net change in equity values around
comment letter issuance dates (two dates
delivery of letter to registrant and uploading of
letters to EDGAR) using (-1,1) window. - Measure net information value of review as summed
net change in equity values. - Compare net information value of review to review
cost per SEC budget. - Test result
- 7 billion decline in equity values during
comment letter issuance event. - 87 million cost in conducting reviews
- 84 information per 1 spent on review.
33Takeaway
- SEC reviews are substantive.
- Provides new information
- Mitigates information asymmetry among investors.
- Probably not an instance of overregulation.
- All of the above surprises me.