Problems in corporate financial reporting are dominating headlines. Orie Barron, associate professor of accounting in the Penn State Smeal College of Business, has co-authored four papers examining the SEC's Division of Corporation Finance. The papers on the DCF are the only academic research on the topic. The papers were co-authored with Charles Kile of the University of Alabama at Huntsville. Below is a Q&A with Barron & Kile on their research.
Q: Are material problems in corporate financial reporting isolated incidences or pervasive problems?
Answer: Pervasive problems. Our research suggests that the SEC's Division of Corporation Finance is continuously uncovering material financial reporting deficiencies through a review program it operates. These deficiencies do not concern mere formalities, because firms' stock prices change when firms are forced to correct the deficiencies.
Q: What, if any, financial reporting assurance does the SEC provide?
Answer: A surprising amount. Our research also shows that the SEC's Division of Corporation Finance (or DCF) continuously requires the correction of material financial reporting deficiencies. During a 4 1/2 year sample period like the current period that did not include a lot of IPO expansion, we find that the vast majority of traded corporations had their financial reports (or 10Ks) reviewed by the SEC. These reviews entail about 100 hours of effort by expert reviewers who have a type of warrant to probe for more information, and these reviews result in over twenty-five percent of sample firms amending their 10Ks as a result of a DCF reviews during the sample period. Although this review activity does not guarantee against financial reporting fraud, it should be doing something to deter such fraud.
Q: If the SEC does provide significant financial reporting assurance, then why have we been surprised by cases like Enron and World Com?
Answer: First, reviews do not provide complete assurance. Second, its staff of 300 reviewers receives over 400,000 filings per-year from roughly 12,000 publicly traded firms. The DCF then tries to review all 12,000 of these firms 10Ks on a regular basis, with the result being that small firms suck up a lot of reviewer time, both because there are so many small firms and because small firms have more reporting deficiencies to deal with. IPOs also take up lots of reviewer time during an IPO expansion. The net result of all of this is that very large firms like Enron and World Com do not get scrutinized as much as they would otherwise.
Q: Does this all mean that the SEC should bear little responsibility for the Enron debacle? And did the financial accounting complexities of Enron relieve the SEC of a responsibility for Enron's financial reporting failures?
Answer: No to both questions. First, for three consecutive years Enron was actually selected for a DCF review, but SEC officials overrode this selection. So the resources for a DCF review of Enron appear to have been available. Second, the accounting complexity excuse is problematic because the SEC had already taken a strong position about a means of dealing with limitations in financial accounting that are likely to arise on a case by case basis. Firms are supposed to explain themselves "through the eyes of management" in the Management Discussion and Analysis section of the 10K or MD&A as it is called. Further, the MD&A is not audited, but is reviewed by the DCF. In fact, DCF reviews focus on the MD&A and our analysis suggests clear deficiencies in Enron's MD&A. Unfortunately, Enron's MD&A never got scrutinized by the DCF, and it should have been according to the DCF's own position and standards.
SummaryOn the positive side, we think that the DCF does a surprisingly good job with its limited resources. There would be a significant return on investment from an increase in funding for DCF review activity. On the negative side, the DCF should be required to stick to its own internal review procedures and not override them when the accounting issues get tough.
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