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Review of Accounting Studies

13-02-2024

The spillover effect of SEC comment letters through audit firms

Authors: Kenneth L. Bills, Ryan Cating, Chenxi Lin, Timothy A. Seidel

Published in: Review of Accounting Studies

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Abstract

This study examines whether auditors serve as a conduit for disseminating Securities and Exchange Commission (SEC) views on reporting and disclosure matters as the result of being privy to clients’ SEC comment letters. This examination is important because auditors’ involvement in and private access to clients’ comment letters can enhance the timeliness of dissemination and constrain reporting or disclosure choices that diverge from SEC views. Among clients with a greater expectation of impaired goodwill that do not receive a comment letter with a goodwill-related comment, we find a greater likelihood of goodwill impairment when the audit firm serving the client is exposed to more goodwill-related comments received by other clients. Further examination of the channels of dissemination through the audit firm indicates that the results are driven by auditor exposure through other clients of the audit office in the same industry, the channel with the greatest exposure to the audit team, and clients in different audit offices in different industries, the channel with the broadest potential for spillover (i.e., the greatest number of other audit firm clients). Importantly, we observe these effects after controlling for alternative sources of spillover and when auditor comment letter exposure is not yet publicly available, suggesting that auditors’ private access to client comment letters facilitates timely spillover. Further analyses indicate that spillover through industry clients within the audit office is also apparent in goodwill footnote disclosure.

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Throughout the study, a comment letter refers to a complete, unique comment letter conversation. Following Cassell et al. (2013), a comment letter conversation includes a minimum of three total letters, including the initial letter from the SEC and the final “no further comment” letter to end the conversation. Following Cassell, Cunningham, and Lisic (2019), we remove letters seeking an extension, letters with no substantive information, cover letters, duplicate letters, and “Tandy letters.”

In Cassell et al.’s (2013) sample, the average duration of a conversation is approximately 80 days.

While we recognize that not all comment letters request accounting changes and are often requests for additional clarification or disclosure, we argue that an auditor’s exposure to these requests leads to an increased likelihood of identifying evidence for the need to impair at-risk goodwill, which increases the likelihood that the auditor will deem an impairment necessary.

In our arguments, we assume that the receipt of an SEC comment letter increases the risk of restatement or of an SEC enforcement action. We validate this assumption by examining the association between the receipt of a comment letter and subsequent restatement announcements and SEC Accounting and Auditing Enforcement Releases (AAERs). Consistent with this assumption and prior evidence (Blackburne et al. 2021), we find a positive association between comment letters and subsequent restatements and SEC AAERs. We provide the results of this examination in Appendix 1.

Figure 2 provides information on trends of highest-ranking topics included in comment letters covered during our sample period based on data from Audit Analytics. These trends are consistent with several Big 4 publications (Deloitte 2017; EY 2017; EY 2018; EY 2019).

Audit partner data from the PCAOB Form AP database is only available for a small portion of our sample period (2016 through 2020). After obtaining and merging this data with the sample for our tests, we note descriptively that although 53.3 percent of the audit partners in our sample have more than one public audit client, only 3.4 percent have more than one public audit client with at-risk goodwill.

SOX 408 mandate that these periodic reviews must include a review of Form 10-K.

The number and composition of these offices have changed over time (see https://www.sec.gov/corpfin/announcement/cf-disclosure-program-realignment).

Ayres et al. (2019a, b) include a dummy variable for expected impairment and an interaction term between their variable of interest and their measure of expected impairment rather than dropping observations not expected to impair. We find, in an untabulated robustness test, that the inferences from the test of our hypothesis are similar if we use this alternative specification; however, the inclusion of numerous interaction terms with the various dissemination paths in our models leads to significant multicollinearity issues. We find high VIFs (above 10) on most of our interaction terms and several control variables when we use this alternative specification.

Since the market and book value of assets are computed at the consolidated entity-level and impairment decisions are made at the reporting unit level, using these measures to identify expected impairment could exclude companies whose goodwill is impaired at the reporting unit level but is not expected at the consolidated level. However, this potential measurement error is a limitation of this and other goodwill studies because of the unavailability of reporting unit-level data. In a robustness test discussed in Section 5, we limit our sample to companies with one business segment and find consistent results with those in our main analyses, except that the significance on SameAF, DiffAO, and DiffAO_DiffInd become significant at the p < 0.10 level (two-tailed). Additionally, we find similar results using alternative measures for expected impairment.

We recognize that a comment letter conversation that becomes public after fiscal year-end but before filing could provide some limited public exposure before completion of the audit. However, we argue that these comments would be known by and could inform the audit firm. Still, we recognize that any disclosure after year-end and before the issuance of the audit report, even with a short window of public exposure, could influence impairment decisions, and, as such, we determine the robustness of our findings to this design choice. To do so, we alternatively capture private and public comment letter exposure as of a nonrecipient client’s audit report date. We find similar results in both sign and significance using this alternative measurement date.

For each of these measures of publicly available comment letter exposure, we include goodwill-related comments received by other clients of a company’s audit firm that are publicly available. We acknowledge that this choice removes some of the comment letter exposure through the audit firm from the respective audit firm measures of exposure to goodwill comments. Although this choice could work against our finding support for our hypothesis, it tightens the identification of exposure through the audit firm. We find, in untabulated results, that inferences are similar if we include all comment letter exposure (private and public) from the past year in the measures of goodwill-related comment exposure through the auditor. These results are consistent with auditors being responsive to comments received by other clients of their firm, whether those comments are public or private.

In an untabulated analysis, we find that results are similar in sign and significance if we instead define industry based on two-digit SIC codes.

To determine the sensitivity of our results to winsorization, we re-estimate our tests without winsorization and find results similar in both sign and significance.

However, the results are similar in sign and significance with the inclusion of these observations.

This materiality threshold is consistent with quantitative materiality levels used by eight of the nine largest U.S. audit firms (Eilifsen and Messier 2015). The results are similar in sign and significance with the inclusion of these firm-year observations.

Inferences are unchanged if observations during the financial crisis (2008) and COVID-19 (2020) are excluded from the model.

Calculated as the estimated regression coefficient of the explanatory variable times the standard deviation of the explanatory variable divided by the mean of the dependent variable per (Mitton 2023) [(0.031*1.257)/0.345 = 0.113].

We recognize that sometimes companies provide limited disclosure about goodwill and impairment in the significant accounting policies footnote. Given the limited disclosure around goodwill in this note and the difficulty of properly capturing “goodwill-related disclosure,” we have focused our analysis on companies that provide a specific footnote pertaining to goodwill.

In additional untabulated analysis, we partition each of the four variables of interest (SameAO_SameInd, SameAO_DiffInd, DiffAO_SameInd, and DiffAO_DiffInd) based on whether the comment letter(s) to which the auditor is exposed in these channels requests additional disclosure or additional information. We note that 54.9 percent request more financial statement disclosure while 48.4 percent request additional information in the comment letter response letter (15.1 percent request both). We find a positive and marginally significant coefficient on SameAO_SameInd_MoreDisclose (p < 0.10) but an insignificant coefficient on SameAO_SameInd_MoreInfo. These results suggest that greater exposure to comments requesting more goodwill-related disclosure received by other office clients within the same industry increases the likelihood of textual changes in the goodwill footnote.

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Title: The spillover effect of SEC comment letters through audit firms
Authors: Kenneth L. Bills
Ryan Cating
Chenxi Lin
Timothy A. Seidel
Publication date: 13-02-2024
Publisher: Springer US
Published in: Review of Accounting Studies
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-023-09819-z