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Why the SEC Decides to Issue a 10-K Comment Letter

Merrill Disclosure Solutions | May 19, 2014


Abstracted from: Reviewing The SEC's Review Process: 10-K Comment Letters And The Cost Of Remediation
By: Prof. Cory Cassell, Lauren Dreher, and Prof. Linda Myers
Sam M. Walton College of Business, University of Arkansas
Accounting Review, Vol. 88, No. 6, Pgs. 1875-1908

What is the SEC's duty as a critic?  How do the factors considered by the SEC - when it does its triennial review of public companies' 10-K filings - affect the probability of it issuing a comment letter? To answer this question, accounting professors Cory Cassell and Linda Myers, with doctoral candidate Lauren Dreher, focused on comment letters issued in 2004-2009 to companies with assets of at least $1 million. Under Section 408(a) of the Sarbanes-Oxley Act, the SEC must review every registrant's Form 10-K at least every third year and send a comment letter if the 10-K is either materially deficient or unclear. Although the SEC does not divulge its standards for choosing review targets, Sarbanes-Oxley Section 408(b) specifies factors to consider. It also allows the SEC to add any others the regulators deem relevant.

When does a 10-K review lead to a comment letter?  Three of the factors specified in Section 408(b) - the issuance of a financial restatement, higher stock volatility, and greater market capitalization - increase the likelihood of receiving a comment letter, the authors discovered. Having an auditor that the Public Companies Accounting Oversight Board must inspect yearly - a Big 4 or a second-tier firm - and using outside financing decrease the likelihood. There is some correlation between receiving a comment letter and showing several corporate traits: weaker corporate governance, greater age, disclosure of losses, greater chance of bankruptcy, and greater M&A involvement. Of the companies in the study, anywhere from 23% to 37% annually did not receive a comment letter during the three-year review cycles that ended in their 2006-2009 fiscal years.

How do the metrics pan out?  A number of comment letters correlated with one Section 408(b) factor, i.e., the need for a restatement. Several of the discretionary factors - having an auditor other than a Big 4 firm, a briefer auditor tenure, disclosure of losses, a more complex corporate structure, weaker corporate governance, more M&A involvement, and more business segments - also triggered comment letters. The authors used two proxies to evaluate the costs of remediation after receiving a comment letter: the company's response time (the number of days between receiving the first comment letter and the final “no further comment” letter from the SEC); and the number of rounds (the number of letters received between the first and last). Response time correlated with several of the Section 408(b) factors (such as restatement issuance, higher stock volatility, and greater market capitalization), but the number of rounds correlated only with greater market capitalization. Response time and number of rounds both correlated with an auditor other than a Big 4 or second-tier firm, disclosure of losses, and weaker corporate governance.

Who might face higher costs?  The authors also looked at how the cost of remediation might differ depending on the topics in each comment letter. Both response time and number of rounds are highest for accounting topics; among accounting topics, the costs are highest for questions of classification and fair value. The harshest result of an SEC review is finding a material deviation from GAAP or a disclosure violation, either of which require a restatement. This result is more likely when the company is smaller, is closer to bankruptcy, operates in a more litigious business, has a CEO of longer standing, or uses an auditor other than a Big 4 or second-tier firm.

Abstracted from Accounting Review, published by American Accounting Association, 5717 Bessie Drive, Sarasota FL 34233. To subscribe, call (941) 921-7747; or visit>

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