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Does State Sponsor of Terrorism Disclosure Limit SEC Financial Reporting Oversight?

The Securities and Exchange Commission (SEC) regularly reviews financial filings to ensure compliance with accounting standards and other disclosure requirements.  The SEC review team analyzes firm’s financial filings and asks questions (in a comment letter) about perceived deficiencies.  A comment letter may request clarification regarding an accounting or reporting issue and may ask a firm to revise or update its financial reports.  According to the SEC, this comment process “deters fraud and facilitates investor access to information.”

Comment letters are publicly available on EDGAR, and both accounting and law firms monitor comment letters to ascertain where the SEC is directing its review effort.  For example, all of the Big Four accounting firms provide summaries of recent comment letter trends, and common topical areas include, for example, management’s discussion and analysis (MD&A), non-GAAP measures, fair value measurement, and revenue recognition.

Over the past decade, SEC comment letter reviews have increasingly focused on disclosures associated with companies’ activities in or with nations designated as “state sponsors of terrorism” (SST) by the U.S. Department of State.  In its 2018 report on comment letter trends, Ernst & Young (EY 2018) notes that 12 percent of comment letters reference a registrant’s disclosures associated with state sponsors of terrorism, making SST the seventh most common topic in 2018.

Despite this increase in SST comments, we have little understanding of these inquiries.  In a new study, we investigate whether the SEC’s focus on SST limits its ability to effectively review registrants’ financial reports for compliance with accounting standards.

We identify all SST comment letters from 2005 to 2016 and read them to understand the nature of SST comments.  In some cases, it appears the SEC reviews the firm’s financial reports and then asks questions regarding interaction with SST nations (such as Iran, Syria, Sudan, etc.).  For example, the SEC provided the following comment to Logitech International:

We also note the disclosure on page 5 and elsewhere in your form 10-K that you operate in regions including the Middle East and Africa.  As you know, Iran, Syria, and Sudan, countries located in those regions, are designated by the U.S. Department of State as state sponsors of terrorism and are subject to U.S. economic sanctions and controls.  Your Form 10-K does not include disclosure about contacts with those countries.

In other cases, SEC comments do not result from existing disclosures made in a financial report.  Rather, the SEC assesses whether disclosure is deficient based upon observing information from other sources, such as media reports.  For example, the SEC wrote to the toy manufacturer Mattel Inc.: “We note a 2012 news article that shops in Iran were selling Barbie Dolls.” Mattel responded by saying “Mattel’s records show no sales by Mattel, or any of its subsidiaries, of any Mattel products to any person or entity in Iran.”

Some contend that the SEC’s involvement in regulating SST disclosures is inappropriate and falls outside the scope of the SEC’s mission.  For example, representatives from the Securities Industry and Financial Markets Association stated, “The SEC should leave foreign policy and national security matters to the government agencies charged with, and possessing significant experience in, carrying out those matters” (Preston and Strongin 2008).  Others have suggested that the SEC’s particular focus on SST may result from political pressure, with former SEC Chair Mary Jo White acknowledging that political pressure may impair the SEC’s ability to regulate financial markets (White 2013).

Since the SEC faces a budget constraint, effort directed toward reviewing SST disclosures may come at the expense of financial reporting oversight.  To test for this possibility, we examine the relationship between SEC effort to review SST disclosures and the SEC’s ability to detect financial statement errors in the filings under review.  To determine whether an SEC review detects a financial statement error, we check for agreement between comment letter topics identified by the SEC and topics that underpin restatements of the financial statements under review.  Our results suggest that the SEC’s focus on SST disclosures reduces the quality of financial reporting oversight.  For example, we find that the SEC’s financial reporting error detection rate decreases up to 65 percent when a comment letter refers to SST.

To assess whether this decrease in error detection results from SST effort crowding out effort to oversee financial reporting, we examine how SST comments are associated with topical areas relating to the financial statements.  We find that when SEC review team members ask a question about SST disclosures, they are less likely to ask a question about the firm’s accounting policies, the MD&A, or the appropriateness of non-GAAP performance metrics.  This effect is unique to SST comments as we find non-SST comments complement SEC efforts to oversee financial reporting.

Finally, to understand how SEC review labor underpins our findings, we study the occupational mix of SEC examiners over our sample period.  Using data from a Freedom of Information Act (FOIA) request, we find that the occupational mix of SEC reviewers has shifted over time to include more lawyers and fewer accountants.  This shift coincides with an increased focus on SST comment letters and increased incidents of terrorism globally.  We find accountants are more likely to ask core accounting questions and detect financial statement errors. At the same time, lawyers are more likely to ask questions about terrorism-related activities, which limits the likelihood that the review detects errors.

Collectively, our results suggest that the SEC’s increasing focus on SST negatively influences financial reporting oversight.  While we do not directly examine benefits associated with the SEC’s focus on SST disclosures, our findings highlight an important cost related to the SEC’s focus on SST.  To the extent the SEC’s focus on SST disclosure is part of a more general push to expand disclosure regulation to encourage social change, our findings may be consistent with cautions voiced by Mary Jo White during her term as SEC chair. She stated:

Other mandates, which invoke the Commission’s mandatory disclosure powers, seem more directed at exerting societal pressure on companies to change behavior, rather than to disclose financial information that primarily informs investment decisions.

That is not to say that the goals of such mandates are not laudable.  Indeed, most are.  Seeking to improve safety in mines for workers or to end horrible human rights atrocities in the Democratic Republic of the Congo are compelling objectives, which, as a citizen, I wholeheartedly share.

But, as the Chair of the SEC, I must question, as a policy matter, using the federal securities laws and the SEC’s powers of mandatory disclosure to accomplish these goals.

We document one potential concern of expanding the boundaries of securities regulation; it might limit the SEC’s ability to achieve its mission of regulating financial reports to deter fraud and facilitate investor access to information.


EY. 2018. 2018 Trends in SEC Comment Letters. In SEC Reporting Trends.

Preston, D. L., and D. G. Strongin. Mechanisms to Access Disclosures Relating to Business Activities in or With Countries Designated as State Sponsors of Terrorism. SIFMA 2008 [Available from]

White, M. J. 2013. The Importance of Independence. 14th Annual A.A. Sommer, Jr. Corporate Securities and Financial Law Lecture, Fordham Law School.

This post comes to us from Robert Hills at Pennsylvania State University and Matthew Kubic and William J. Mayew at Duke University’s Fuqua School of Business. It is based on their recent article, “State Sponsors of Terrorism Disclosure and SEC Financial Reporting Oversight,” available here.

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