Regulatory Scrutiny and Reporting of Internal Control Deficiencies: Evidence from the SEC Comment Letters

This study examines how regulatory oversight, specifically the Securities and Exchange Commission’s (SEC) review process, affects firms’ internal control weakness disclosures. The SEC’s comment letters on firms’ financial statements indicate that certain disclosure deficiencies exist with the firm’s financial reporting, in turn suggesting that some deficiencies could exist in internal controls. We hypothesize that comment letters would affect firms’ internal control disclosure decisions, and particularly so when the comment letters are directly relate to internal control disclosures. Our results indicate that comment letters addressing internal control disclosure deficiencies increase the target firm’s propensity to disclose material weaknesses in internal controls in the subsequent fiscal period. This regulatory scrutiny only affects firms that do not presently disclose material weaknesses. Comment letters addressing other financial statement issues do not appear to have any effect on material weakness reporting. We also provide some evidence that internal control-related comment letters have a spillover effect on the internal control weakness disclosures of peer firms that do not receive 10-K comment letters. Overall, these findings suggest that SEC scrutiny improves the effectiveness of internal control reporting. Our research contributes to the further understanding of the determinants of internal control reporting by registrant firms and the consequences of the SEC’s review process.