The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases
Abstracted in the Journal of Economic Literature, September 1992
36 Pages Posted: 31 Jul 2008 Last revised: 28 Nov 2018
Date Written: 1991
This paper was nominated for the American Accounting Association's Seminal Contributions to the Accounting Literature Award. As the first published precursor to the Sarbanes-Oxley Act of 2002, Section 704: Study of Enforcement Actions, it explores three questions related to the SEC's accounting enforcement program: (1) what types of accounting and auditing problems motivate enforcement actions, (2) what are the consequences of investigations on targets' financial statements, managers, and auditors, and (3) how do investors and other market agents view the SEC's actions? The SEC enforcement program, which consists of investigations and subsequent injunctive actions or administrative proceedings against offending registrants and auditors, is designed "to concentrate on particular problem areas and to anticipate emerging problems" (SEC, 1989, p.1). The potential for SEC enforcement action provides incentives for corporate officers and independent CPAs to avoid unacceptable practices whose "effective prosecution is essential to preserving the integrity of the disclosure system" (SEC, 1989, p.81).
The SEC summarizes its accounting-based enforcement actions in the Accounting and Auditing Enforcement Releases (AAERs). We examined 224 AAERs, issued between April 1982 and April 1989, describing the results of investigations against 188 firms. In the sample period, the SEC most often pursued overstatements of accounts receivable and inventories resulting from premature revenue recognition and delayed write-off, respectively. These two accounts make up 70% of the investigations. The income effects of these financial disclosure violations average more than 50% of reported income. We find that the disclosure of these reporting violations changed expectations of targets' future earnings as reflected in financial analysts' reduced earnings estimated after the disclosures.
Disclosures and investigations of reporting violations have other consequences. Typically, targets' managers settle enforcement actions by consenting to an injunction that prohibits future violations of securities laws. Subsequently, more than 72% of the enforcement targets fired or forced the resignations of top managers and 81% were sued by their shareholders. In 42% of our sample, the SEC also censured the target's auditor; criticisms and penalties were more likely for smaller audit firms.
In exploring how market agents react to the enforcement process, we focus on market returns around disclosures of alleged reporting violations, investigations, and final settlements. Disclosures of reporting violations are associated with average two-day abnormal returns of -13%; the magnitude of these returns is highly correlated with the earnings impact of the disputed accounting. We also observe abnormal returns of -6% at disclosures of investigations, even when the accounting errors were announced earlier. These negative returns imply substantial incentives for managers to avoid these investigation. We do not observe any changes in targets, share values at the investigations' final settlement.
Section 2 describes the SEC enforcement process. Section 3 documents the effects of the SEC investigations and settlements on firms' financial statement, managers, and auditors. Section 4 addresses the stock market's reactions to the disclosure of reporting violations, investigations, and settlements. Section 5 provides conclusions and policy implications.
Keywords: SEC; Financial Accounting; Forensics; SOX2002; Deception; Finance; Audit; Capital Markets; Market Efficiency, Market Microstructure, Financial Economics; Political Economy; Economics of Regulation; Earnings Management; Fraud; Accounting and Economics; Corporate Governance; Law, Financial Maleficence
JEL Classification: G10, G14,G15, G18, G28, G32, G30, G38, L51, M49, M40, M41, M49, K1, K22, K23, L51, N20, P16
Suggested Citation: Suggested Citation
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