A George Mason University accounting professor explains how information on the behavior of companies that have been under SEC investigation reveals a variety of changes and opens the way for a step forward in accounting research.
Everybody acts differently while they are being watched, especially by those with authority. Whether it's your boss sitting in the next cubicle next door or a cop car driving behind you, observation leads to behavioral changes. A new paper from Bret Johnson, associate professor of accounting at Costello College of Business George Mason University, finds that large corporate entities are also susceptible to the so-called “regulatory observer effect.” Recently published in Review of Accounting Studies, the paper uncovers how being under SEC investigation likely impacts a company's behavior, whether or not action is taken against it.
Johnson’s co-authors were Terrence Blackburne of Oregon State University, Zahn Bozanic of Florida State University, and Darren Roulstone of Ohio State University.
“Prior research observed only enforcement actions, but now we are getting a larger pool of those at least suspected of misconduct,” Johnson says. He estimates that a mere 20 percent of SEC investigations result in a penalty.
The researchers used Freedom of Information Act requests to construct a unique dataset identifying publicly traded companies that were investigated by the SEC’s Division of Enforcement, the start and end date of each investigation and whether the company was ultimately found guilty and penalized. In all, they analyzed 4,754 investigations over the period 1983-2016.
“We also found that companies under investigation were more likely to have litigation or comment letters and restatements from the SEC. This is yet another way that investigations distract folks from their day-to-day operations and investing in the future. It’s not illegal to make these business decisions, but if they’re not being transparent with investors, the investors are not going to know that they’re making these short-term decisions as the expense of long-term profitability.”
— Bret Johnson, associate professor of accounting at the Costello College of Business at George Mason University
Once companies knew they were being investigated, they were more likely to implement a number of changes to their accounting practices. For example, the data showed a modest pull-back on accruals-based earnings management activities, or estimate adjustments designed to help companies hit performance targets. Companies also sought to revert their accounting to the mean, reducing divergence across the board. Additionally, investigated companies had a lower-than-average M-Score and F-Score—well-established measures for detecting earnings manipulation.
No longer able to use accounting techniques to reach performance targets, companies catching heat from the SEC pivoted toward real earnings management. As a practical matter, this meant significant reductions in R&D investment (9.2 percent lower) and capital expenditure (4.5 percent lower).
Organizations under SEC scrutiny also experienced higher turnover at the C-suite level. The likelihood of the CEO being replaced increased by 39 percent during an investigation; for the CFO, the probability of turnover was a whopping five times greater.
For Johnson, the totality of these findings paints a coherent picture suggesting some degree of upheaval behind the scenes as executives scrambled to appease regulators and prevent penalties. “We also found that companies under investigation were more likely to have litigation or comment letters and restatements from the SEC. This is yet another way that investigations distract folks from their day-to-day operations and investing in the future. It’s not illegal to make these business decisions, but if they’re not being transparent with investors, the investors are not going to know that they’re making these short-term decisions as the expense of long-term profitability.”
Longer-term implications aside, however, these remedial actions were effective at achieving their immediate goal: staving off government sanction. “I was surprised how strong the effect was among the majority of companies that did not receive an enforcement action. We found very strong evidence within that group of significant behavioral changes,” Johnson says. A seemingly potent factor was the elevation of accounting expertise into the senior executive suite—i.e. appointing a chief accounting officer, or a CEO or director with accounting experience—which reduced the likelihood of an enforcement action by up to 8.2 percent.
Johnson underscores that the “regulatory observer effect” shouldn’t be seen as automatic proof after the fact of actual wrongdoing. “We kind of leave it up to the reader to determine, ‘Is this a good thing? Is this cooperation? Is it that they were guilty and now they’re cleaning it up?’ The change in behavior could also be due to turnover, someone coming in and inheriting the problem, trying to wipe the slate clean and show good faith with the SEC.”
Whatever the explanation, Johnson believes that documenting the “regulatory observer effect” will help fill relevant knowledge gaps. Drawing upon his background as a former staff accountant and academic fellow with the SEC, he says, “I don’t think the SEC is aware of this effect. It might help them be more cognizant that when they launch an investigation, the costs go beyond the dollar amount of assigning a certain number of agency staffers. There are costs they’re imposing upon companies as well.”