Motivated by calls for increased compliance, size-based regulation, and continued exemption of small firms from internal control reporting requirements, we assess the incremental effects of firm size, corporate governance quality, and bad news on disclosure compliance. We examine compliance with the disclosure requirements of an SEC-mandated filing that requires no computations or complex judgments but is nonroutine and may reveal value-decreasing information (bad news) that otherwise would not become public. The disclosures studied are those that firms provide in Form 8-K Item 4 when changing external auditors. We find that noncompliant firms have lower quality corporate governance and less need for external financing but are not smaller than compliant control firms. Additional analyses indicate that compliance is negatively associated with bad news.
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Recommendations made by the Advisory Committee on Smaller Public Firms are reflected in the SEC’s (2008) Final Rule: Smaller Reporting Companies Regulatory Relief and Simplification Act. This amendment to the Securities Act of 1933 and the Securities Exchange Act of 1934, which became effective in February 2008, expands the number of firms that qualify for scaled disclosure and streamlines regulation by moving scaled disclosure requirements from Regulation S–B into Regulation S–K. It also allows smaller reporting firms to comply with scaled financial and nonfinancial disclosure requirements on an item-by-item basis.
SEC Comment letters were first posted to the SEC EDGAR website on May 12, 2005. The majority of the originally posted letters relate to 8-K Item 4 omissions.
Other studies have investigated tax compliance (Slemrod 1992; Andreoni et al. 1998; Davis et al. 2003; and Martinez-Vazquez and Rider 2005). These studies consider the tax decisions of individuals, not corporations. Hammersley et al. (2010) examine firms that fail to comply with requirements to remediate previously identified internal control deficiencies. They are more concerned with documenting the consequences of noncompliance than the reasons for noncompliance.
A 2007 interview with an SEC staff member provided the following information about the comment letter process. The staff undertakes several types of reviews: full review, financial statement review (including footnotes), and targeted (limited scope) reviews. The subjects of targeted reviews change over time. The criteria for selection of filings for review are not made public because doing so might prompt firms to take steps to avoid review. The SEC neither confirms nor denies that the SEC staff reviews all 8-K Item 4 s that are filed. However, we examine 225 8-K Item 4 s submitted by control firms that did not receive SEC staff comment letters. (See discussions of control samples in Sects. 4.1 and 6.2) All contained the required disclosures. We are confident that the SEC review process does not result in failure to challenge significant numbers of 8-K Item 4 s that lack required disclosures.
A May 2007 interview with an SEC staff member indicated that if a registrant does not respond to a comment letter, a staff member follows up with a phone call. Historically, non-response has not been a problem. Referral to the enforcement division is not common because registrants usually acquiesce to the SEC’s suggestions.
Audit Analytics now provides a database of SEC comment letters.
A May 2007 interview with an SEC staff member confirmed that the SEC intentionally posted letters dealing with auditor change disclosures first, as a trial effort.
The primary method for initially identifying noncompliance is firm receipt of an SEC staff comment letter. We scrutinize 8-K Item 4 s of all noncompliant firms to determine the nature of the information omitted. We study the 8-K Item 4 s of all matching, compliant firms to ensure that all information items are present.
The SEC currently designates firms with less than $75 million public float as smaller registrants. The previous threshold was less than $25 million in public common equity and less than $25 million in annual revenue. The change in threshold is expected to increase the number of smaller reporting firms to 4,976 from 3,395, an increase of 47%. Firms without calculable public float are considered small reporting firms if the previous year’s revenues were less than $50 million.
Non-accelerated filers are still required to perform their own assessments of internal control, and those assessments are now subject to liability under securities laws. However, non-accelerated filers need not provide an external auditor’s Sect. 404 internal control assessment (KPMG 2010).
The enterprise risk management process, as defined by COSO, is designed to achieve (among other objectives) “the reliability of the entity’s reporting including both internal and external reporting of financial and non-financial information” (COSO 2004, p. 124).
COSO (2004, p. 87) states that the CFO “influences the design, implementation, and monitoring of the firm’s reporting systems.” According to Deloitte & Touche’s CFO Management Framework (D&T 2006), the CFO’s finance department should “prepare accurate, validated reporting to meet statutory, SEC, and shareholder needs in a timely fashion.”
A 2006 SEC study of restatements of financial reports found that the majority of errors restated arise from mistakes. The deputy chief accountant of the SEC stated, “Internal-control structures are missing things, corporate-finance staffs are missing things and auditors are missing things” (Reilly 2006). If these factors also are causing 8-K Item 4 errors, our corporate governance quality variables should be positively associated with full disclosure, but bad news auditor-change circumstances should have no explanatory power.
In some cases, the SEC posted firms’ response letters at the web site without posting the SEC comment letters that provoked the responses. We include such firms in the sample since the contents of the comment letters are evident from the responses.
Several examples illustrate the nature of these types of matters. Many such examples concern essentially clerical errors, e.g., “your initial filing of the Item 4.01 Form 8-K did not contain the printed name and title of the person signing the report or the date of the report. Please file an amendment to the Form 8-K including this information”, and “We read that you appointed Danziger & Hochman as your new accountants. Please revise your filing to refer to this firm by the complete name under which they have registered with the PCAOB.” Other examples seek clarification, e.g., “Please clarify what you mean by ‘or any later period’ as the statement is vague. The interim period should be specified as the interim period through [date of resignation, declination or dismissal].”
Under Item 304 of Regulation S–K, reportable events include (1) the auditor advised the client that internal controls are inadequate, (2) the auditor is unwilling to rely on management’s representations or to be associated with the financial statements, (3) the auditor advised the client of the need to expand the scope of the audit, or (4) the auditor advised the client that information has come to light that materially affects the fairness or reliability of a prior audit report or of the current financial statements.
We determine director independence based on firm classifications provided in proxy statements.
This expectation is consistent with the negative association between CEO duality and the high quality governance practice of managerial turnover following restatements (Desai et al. 2006).
We code audit committee existence rather than percentage of independent audit committee members because our sample includes firms with shares quoted on the OTCBB and Pink Sheets, which are not subject to exchange listing requirements and have not voluntarily created audit committees.
For smaller firms not subject to SOX Sect. 404, we use internal control information reported under SOX Sect. 302.
Tabled results of within sample tests will be provided upon request.
This sample includes the 64 analyzed in Sect. 5, plus an additional 97 that omitted required items from 8-K Item 4 s but whose omitted information did not constitute bad news.
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We appreciate the comments and suggestions provided by workshop participants at the University of Alabama, University of Kansas, Central Florida University, University of Wisconsin-Madison, and the 2007 annual meeting of the American Accounting Association. We thank the two anonymous reviewers and Katherine Schipper for helpful guidance. Johnstone acknowledges support from the University of Wisconsin Arthur Andersen Center for Financial Reporting and Control.
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Ettredge, M., Johnstone, K., Stone, M. et al. The effects of firm size, corporate governance quality, and bad news on disclosure compliance. Rev Account Stud 16, 866–889 (2011). https://doi.org/10.1007/s11142-011-9153-8
- Auditor change
- Mandatory disclosure
- SEC staff comment letters
- Size-based regulation