SEC Comment Letters: An Unlikely Secret Weapon for Forensic Accountants, Short Sellers, and Other Financial Statement Users

Abstract

This paper is the first study to demonstrate strong informational content and economic significance associated with the issuance of SEC comment letters. Access to comment letters, for forensic accountants and investors, is a relatively recent phenomenon and little research has focused on the impact the letters have on security pricing. We construct a “red flag” forensic metric to examine the information content in SEC comment letters and analyze market performance surrounding the issuance event. The metric consists of five models that are developed to screen for and identify financial reporting problems. We document that SEC comment letters contain salient information about a firm’s financial condition, valuation, and future performance that is not only consistent with “red flags” but is apparently overlooked by investors and other financial statement users. Although the letters themselves do not evaluate the merits or investment potential associated with any reported transaction, they do reflect significant industry, accounting and disclosure expertise. We conclude that comment letters are a useful but unrecognized source of independent expert opinion regarding the quality of a firm’s financial reports.