REGULATORY OVERSIGHT OF FINANCIAL REPORTING:

SECURITIES AND EXCHANGE COMMISSION COMMENT LETTERS

RICK JOHNSTON,* University of Alabama at Birmingham

REINING PETACCHI, MIT Sloan School of Management

December 9, 2015

Acknowledgements

We appreciate the helpful comments and suggestions from Mary Harris Stanford (Editor) and two
anonymous referees, as well as Andrew Karolyi, Cathy Schrand, Ro Verrecchia, and workshop
participants at the 2009 AAA Financial Accounting and Reporting Section meeting, the AAA
Annual Meeting, the 2010 LBS conference, and the 2010 HKUST conference and the following
universities: City University London, MIT, National University of Singapore, The Ohio State
University, University of Illinois at Chicago, University of Pennsylvania, and University of
Technology Sydney. We thank Akash Kumar, Anthony Meder, Shannon Nurse, Paul Ordyna,
KoEun Park, Wei Xiang, and Yunyan Zhang for data assistance. Special thanks to Srinivasan
Sankaraguruswamy for his SEC amended filings and S filings data, and Sundaresh Ramnath for
his assistance with comment letters. Johnston conceived of this project and completed an early
draft while at The Ohio State University.

* Corresponding author: rickj@uab.edu

Abstract:

The Securities and Exchange Commission (SEC) reviews company filings (10Q, 10K,

S1, etc.) submitted to them. If a review identifies potential deficiencies, the SEC staff sends the

company a comment letter seeking clarification, additional information, and ultimately perhaps,

revision of the filing or future filings. We examine the content, resolution, and ensuing

informational consequences of SEC comment letters. The content analysis shows that nearly half

of all comments involve accounting application, financial reporting, and disclosure issues. More

than 17 percent of our sample cases result in immediate amended filings to resolve the issue(s)

arising from the comment letters, and financial statements and/or footnotes are frequently revised.

Following comment letter resolution, the adverse selection component of the bid-ask spread

declines and Earnings Response Coefficients (ERCs) increase. Our results provide little support

for the conjecture that the market interprets the receipt of a comment letter as a signal that the firm

has poor reporting quality. Finally, we find no evidence that comment letter firms increase the

quantity or change the type of voluntary disclosure, thereby eliminating a possible competing

explanation for the improved information environment. We conclude the SECs oversight has

beneficial informational effects.

JEL Classification: G12, G14, G18, M48

Key words: Securities and Exchange Commission (SEC), Comment Letter, Disclosure,
Regulation
1. Introduction

The Securities and Exchange Commission (SEC) has an oversight role of financial reporting

through its review of company filings (10Q, 10K, S1, etc.). Their stated goal is to enhance

compliance with the applicable disclosure and accounting requirements.1 If a review identifies

potential deficiencies, the SEC sends the company a comment letter seeking clarification,

additional information, and oftentimes revision of the filing or future filings. These reviews

consume valuable resources; for example, in 2006 the division responsible for them represented 14

percent of the Commissions operating costs.2 Recent research, using cross country analyses, finds

that public enforcement of securities laws has little value (La Porta et al. 2006; Djankov et al.

2008), raising the question of whether the SEC review process is beneficial. However, investor

interest in comment letters, in part, contributed to the SECs decision to make them public

beginning in 2005, thus suggesting some informational benefit.3 Unlike prior research which has

relied on indirect constructs of enforcement across different countries, comment letters provide a

unique opportunity to investigate the monitoring role of the SEC in the United States and its

economic consequences. In this paper, we examine the comment letters content, resolution, and

ensuing informational consequences, for the reviewed firms.

We investigate two informational consequences of SEC comment letters. First, if the

comment letter process results in substantive reporting and disclosure changes, it could improve

the firms information environment. Prior studies provide evidence that increases in voluntary

disclosure levels reduce information asymmetry, increase stock liquidity, and reduce a firms cost

1
http://www.sec.gov/divisions/corpfin/cffilingreview.htm (accessed 9/24/2015).
2
The SECs 2006 Audit Report #401 states that the Division of Corporate Finance has 515 staff,
of which 80 percent are assigned to review filings. The costs of operations for the Division are
$125 million, out of $888 million total costs.
3
Various parties had been filing Freedom of Information requests with the SEC for the comment
letters and had in turn been selling the information. Increasingly, SEC reviews are getting more
exposure. Groupons accounting deficiencies is a recent example that received press coverage
(WSJ Nov. 2, 2012).

2
of capital (e.g., Welker 1995; Leuz and Verrecchia 2000; Brown et al. 2004). Given issuer and

auditor incentive problems (Imhoff 2003), as well as enhancements to the SEC following the

Sarbanes-Oxley Act of 2002 (SOX), the comment letter process could significantly enhance

corporate accounting and disclosure.4 However, mandatory accounting and disclosure standards in

the U.S. are extensive, and public companies are subject to an audit requirement, intended to

ensure compliance with those standards; therefore the incremental effect of comment letters on the

information environment could be small. The second potential consequence of an SEC review is

that it may change investors perception of the firms earnings quality. Although accounting or

disclosure enhancements could improve the firms earnings quality or the perception of its earning

quality, the market may still ascribe less credibility to the firms financial reports due to the

revelation of the reporting changes or the comment letters. Thus, it is an empirical question

whether an SEC review changes the markets assessment of the reporting quality of the firm under

review.

To examine these questions, we collect all comment letters from the SECs website for

20042006 and retain those related to annual and quarterly reports (10Ks and 10Qs). Our final

sample contains 6,057 letters from 2,374 cases for 2,256 firms. A case focuses on a particular year

or quarter and at a minimum involves one comment letter and one response but may involve more

of both. A case ends upon satisfactory resolution of the SECs concerns.

Content analysis of a sub-sample of letters reveals that a significant portion of the SEC

comments address accounting, financial reporting, and disclosure issues. To explore the reporting

changes arising from comment letters, we examine the cases that resulted in amended filings to

resolve the SEC review. Seventeen percent of our sample (402 cases) amend one or more filings.

Approximately 40 percent of these amendments address what we consider to be editorial or legal

4
For example, Bens and Johnston (2009) provide evidence of the SECs oversight role in limiting
earnings management through restructuring charges.

3
technicalities; for example, wording of internal control reports, missing date or office location of

audit reports. The remaining amendments are more substantial; for example, financial statements

and/or footnotes are revised in more than half the cases. Providing some evidence of their relative

importance, we find abnormal stock returns around the amended filings, but only for the

substantial revisions. In addition to the amendments, we find companies commit to a significant

number of additional changes in future filings.5

To evaluate the impact of the comment letters on the firms information environment

following comment letter resolution, we examine the changes in the adverse selection component

of the bid-ask spread, a proxy for information asymmetry, and Earnings Response Coefficients

(ERCs). To enhance our confidence of causality, we explore the change in the quarter immediately

following resolution. Further, since compliance with existing regulations and standards is likely to

result in changes that persist, we also examine the change over a longer window, the subsequent

eight quarters. If comment letters enhance disclosure and improve reporting quality, we would

expect a lower level of information asymmetry and larger ERCs upon the resolution of the cases.

Alternatively, if comment letters lack substance or signal poor quality reporting, we would expect

no change in information asymmetry and a decline in ERCs.

We find that comment letter resolution is associated with reduced information asymmetry

and higher ERCs. Our results are robust to a comparison with a sample of propensity score

matched control firms that do not receive a comment letter, but have similar propensity of

receiving a comment letter as the sample firms. Our evidence suggests that an SEC review

enhances the reviewed firms information environment and the perception of their earnings

quality. We find little evidence that comment letters signal poor quality reporting, leading to a loss

of reporting credibility. Although we find negative abnormal returns around the filings of

5
The future filing changes are outlined in the company response documents to the SEC.

4
comment letter caused amendments, we find no market reaction around the release of the letters

and no decline in ERCs subsequent to the letters. Overall the evidence suggests that if there is a

loss of credibility effect, it is limited. Finally, we find no evidence that comment letter firms

increase the quantity or change the type of voluntary disclosure subsequent to the letters, thereby

eliminating a possible competing explanation for the information environment improvement.

Our study contributes to three streams of research. The first investigates the economic

consequences of companies that voluntarily commit to higher levels of disclosure (e.g., Leuz and

Verrecchia 2000). Our paper complements these studies by examining the consequences of

improved reporting and enhanced disclosure that arise from a regulators direct monitoring of

corporate reporting compliance. Unlike voluntary disclosures which are discretionary, comment

letter changes are likely to persist since they are required to meet accounting or reporting

standards.

The second research area explores private and public enforcement of securities laws. La

Porta et al. (2006) and Djankov et al. (2008) conclude that public enforcement of securities laws

has limited value. Jackson and Roe (2009), however, find that these papers underestimate the

extent to which public enforcement is associated with capital market development. Christensen et

al. (2013) show enhanced enforcement plays a critical role in the beneficial market effects of IFRS

adoption. These international studies construct their enforcement measures indirectly through

lawyer surveys (La Porta et al. 2006; Djankov et al. 2008) or resources devoted to regulators

(Jackson and Roe 2009). In contrast, our study examines actual oversight activities undertaken in

the U.S. by the SEC. Unlike LaPorta et al. (2006) and Djankov et al. (2008), but similar to Jackson

and Roe (2009) and Christensen et al. (2013), our results suggest that there are positive benefits of

public enforcement.

The third research stream examines the SEC Accounting and Auditing Enforcement

Releases (AAER) (see for example, Feroz et al. 1991; Dechow et al. 1996; Beatty et al. 1998;

5
Beneish 1999; Farber 2005).6 These papers explore the impact of enforcement actions on

corporate governance, managers, auditors, underwriters, and market participants. AAERs are in

general more involved, take longer to resolve, and are far more infrequent than comment letters.

Comment letters are often the precursor to AAERs. Studying comment letters adds another

dimension to the research that assesses the impact of the SEC.

This paper documents a beneficial effect of the oversight role played by the SEC in

enhancing and maintaining the reporting quality of U.S. listed firms. Enforcement evidence is

important, because practitioners and academics often focus on the SECs role in terms of creating

regulations.7 Our results could be of interest to policymakers and to the SEC itself, particularly

because the Commission has devoted significant resources in conducting these reviews. Moreover,

the results could be instructive for regulators in other countries that wish to evaluate the benefits of

enforcement or the implications of publically releasing the results of regulator reviews. Finally,

comment letters could create other potential benefits. For example, the resulting higher quality

disclosure could create a spillover or positive externality effect on other firms. Or the mere

existence of the SEC review process could affect issuer and auditor behavior, which enhances ex-

ante reporting quality. We leave these questions to future research.

The paper is organized as follows. Section 2 provides institutional details about the

SECs comment letter process and develops our hypotheses. The research design outline is in

Section 3. Section 4 describes the sample as well as an exploratory analysis of comment letter

content and resolutions. Empirical analyses are presented in Section 5. Section 6 concludes.

6
One could view the third stream as a sub-set of the second. We distinguish the AAER literature
here because of its historic presence in the accounting literature.
7 For example, the 1992 revision of executive compensation disclosure rules (Lo 2003), the 1997
SFAS 131 revisions of segment reporting (Wysocki 1998), and the 2000 Regulation Fair
Disclosure (Bailey et al. 2003; Heflin et al. 2003).

6
2. SEC Comment Letters: Institutional Background and Hypothesis Development

Institutional background

Public companies file quarterly (10Q) and annual financial reports (10K) with the SEC. The

Sarbanes-Oxley Act of 2002 requires the SEC review a companys filings at least once every three

years, but they may review companies more frequently.8 The SEC states it:

concentrates its resources on critical disclosures that appear to conflict with

Commission rules or applicable accounting standards and on disclosure that
appears to be materially deficient in explanation or clarity.

Feroz et al. (1991) cite an SEC official who claimed that half of all SEC enforcement leads come

from these reviews.9

The SEC does not reveal when a firm will be subject to review, so only if a firm receives

a comment letter does it become aware of the review. Many reviews are completed without issuing

any comments. When a comment letter is issued, the company has ten business days to respond.

The company can either submit a response letter or amend the filing under review. Follow-up

comment letters and responses occur until all issues are resolved, at which point the SEC advises

the filer that the review is complete.

Prior to 2005, public access to SEC comment letters and the related responses were only

available through a Freedom of Information Act request. In 2005, the SEC began to publicly

release, on their website, comment letters and responses relating to filings made after August 1,

2004, but no earlier than 45 days after completion of the review. In most cases the public learns of

the existence and content of the letters only upon SEC release.10

8
Prior to SOX, the SEC reviewed approximately 20 percent of the filings each year.
9
In a speech on July 19, 2000, the Chief Accountant of the Division of Corporate Finance of the
SEC, Robert A Bayless, made the following remark: the review and comment process in the
Division of Corporation Finance unearths a surprising number of accounting errors, disclosure
deficiencies, and tortured interpretations of GAAP in filings with the Commission.
10
Beginning on December 1, 2005, accelerated and large accelerated filers were required to
disclose in their 10K, whether they have any unresolved SEC staff comments. In our sample, we

7
Hypothesis development

We hypothesize four possible effects of comment letters. There may be no economic consequence

if the SEC raises non-substantive issues or only inconsequential information results. Increased or

improved disclosures could reduce information asymmetry. Changes in accounting or disclosure

could improve the firms earnings quality or the perception of its earning quality. Finally, the

market may ascribe less credibility to the firms financial reports upon the revelation of the

reporting changes or the comment letters. We discuss each of these alternatives below.

Given that public companies financial statements are audited, it seems reasonable to

question whether any significant benefit could arise from an SEC review. Unlike an audit, a

review begins simply with the SEC staff reading the corporate filings. A long-standing economic

question is the justification of regulating corporate disclosures (Healy and Palepu 2001). Schulte

(1988) argues that information is similar in nature to public goods, without regulation, it is under-

produced. The tendency in regulation, however, is to oversupply it, because users always overstate

their demand. SEC reviewers may act similarly, simply asking for more detail, which may be of

little incremental value. If comment letters merely create excess disclosure or an oversupply, then

there would be little subsequent improvement in the firms information environment.

Comment letters may also lack substance due to regulatory capture, a theory that suggests

regulated firms manipulate the agency regulating them (see Dal Bo 2006 for a review). If the SEC

is subject to filer influence, then comment letters may avoid substantive issues, thus creating no

economic benefits. Ertimur and Nondorf (2006) examine the effect of comment letters on firms

information environment for a sample of 95 IPO firms, and their lack of results may be evidence

that the letters lack substance. Related anecdotal evidence exists in the SECs 2005 and 2006

annual reports in which they report various metrics to track and report on SEC effectiveness. For

find only 34 cases of such disclosure. Other voluntary disclosures about the reviews were also rare
in our sample.

8
comment letters, the reports in summary state that the SEC is unable to quantify significant

improvements or actions related to the letters. 11 La Porta et al. (2006) and Djankov et al. (2008)

suggest that a regulators role is best in setting rules as opposed to enforcing them.

Concerns of limited economic effect of SEC reviews may in part be offset by several

factors. Opportunistic managerial behavior in financial reporting has been written about

extensively (see Dechow and Schrand 2004 for a review). An independent audit is one mechanism

to control such behavior. However, auditing is inherently imperfect, and auditor incentive

problems may magnify the problem (Antle 1982; Imhoff 2003). Other than class action lawsuits,

the SEC is institutionally the last line of defense in policing reporting quality, and has the potential

to compensate for both managerial misbehavior and audit weaknesses. Post-SOX, the SEC

received greater financial support from Congress, allowing them to devote more resources to the

review process and perhaps enhance the quality of their staff. Also, the political environment

changed to be more favorable toward regulator action, conceivably allowing the SEC to be more

aggressive than they had been previously. Therefore the impact of these reviews on the reporting

practices of the chosen firms could be substantial.

If comment letters expand or enhance disclosures with economic substance, they would

create an improved information environment for the firm reviewed. A large body of research

supports such a relation. For example, Welker (1995) shows that a well-regarded disclosure policy

reduces information asymmetry and increases liquidity in equity markets. Leuz and Verrecchia

(2000) examine German firms that commit to higher disclosure levels by adopting International or

U.S. Accounting Standards and find these firms experience a decline in bid-ask spreads. Unlike

11
Divisions of Corporation Finance and Investment Management continued to work toward
establishing a means for accurately tracking data on comments that result in significant
enhancements in financial and other disclosures or other significant actions to protect
shareholders. The divisions will provide data for this indicator once such tracking methods are in
place. See Exhibit 2.23 in the 2006 SEC annual report available at www.sec.gov.

9
voluntary disclosures however, changes resulting from comment letters are more likely to persist.

Since the SECs interest is in assuring compliance with regulations and standards, firms are

expected to maintain any reporting improvements resulting from the comment letter process. The

recurring nature of SEC reviews further supports this expectation, as firms would likely not want

to be found lacking on the same issue in a subsequent review.

Accounting changes and/or additional or enhanced disclosures could also impact

investors perception of earnings quality. Prior studies commonly use the extent to which new

earnings information is capitalized into the stock price as a measure for investors perception of

earnings quality. Holthausen and Verrecchia (1988) show theoretically that the price reaction

around an earnings announcement is a function of the expected quality of the accounting data.

Prior empirical studies further show that firms with higher levels of disclosure and better earnings

quality tend to have greater price responses to earnings (Gelb and Zarowin 2002; Dechow, Ge, and

Schrand 2010). Therefore, if the comment letter process enhances disclosure and/or earnings

quality, we would expect greater price responses to earnings (ERCs) after the letters.

Finally, all firms filing with the SEC are subject to review however, not all firms receive

comment letters. The issuance of a letter suggests, at a minimum, a lack of clarity in a filing as a

knowledgeable reader has an enquiry. Comments may also address completeness or

appropriateness of either disclosure or accounting application hence raising doubt about either the

ability or integrity of the firms management. Comment letters can also lead to amendments or

restatements of filings. As a result, firms receiving letters may be perceived by investors to be

lower quality reporters since their filings have been determined to be deficient or suspect in some

way. Thus, upon the reporting change or the revelation of the letters the market may ascribe less

credibility to the financial reports of these firms. A recent study by Wilson (2008) finds a loss of

reporting credibility for firms restating their earnings, as evidenced by reduced ERCs. However,

10
she finds the decline is only temporary, as the ERCs return to the pre-restatement level within four

quarters.

3. Research design

We examine the change in the information environment following the resolution of the comment

letter case. We define the pre period as the eight quarters prior to the first comment letter issued by

the SEC and the post period as the eight quarters following the revelation of the additional or

enhanced disclosure or reporting changes to the market. Such revelations occur in one of three

ways: an amended filing resulting from the comment letter, a quarterly or annual filing following

case resolution which reflects agreed upon changes in accounting or disclosure if any, or the

release of the comment and company response letters by the SEC. Therefore, our post period

begins with the first quarter after the earliest of these three events (See Figure 1 for the timeline

with a hypothetical example centered on 10K filing). We use eight post quarters to capture the

longer-term effects of improved accounting and disclosure arising from the resolution of the

comment letters.12

Insert Figure 1 here

To capture any comment letter effect on the information environment, we apply the

following regression model:

Variable of Interestit = t + i + 1POSTit + Controlsit + it (1)

where i indexes firms, t indexes time, and t and i are year and firm fixed effects that control for

any market-wide changes in information environment and unobserved heterogeneity across firms.

POST is a dummy variable representing the quarters following case resolution. Controls are

12
We also examine one quarter, pre and post, to enhance our confidence about causality.

11
defined based on the relevant existing literature related to each specific variable of interest and are

detailed in the corresponding results sections. In all our regression analyses, we cluster standard

errors by firm to correct for possible correlations across observations of a given firm (Rogers

1993; Petersen 2009).

The first dependent variable is the adverse selection component of the bid ask spread

(GHLAMBDA). The literature on market microstructure breaks the bid ask spread into three

components: the order processing cost, the inventory holding cost, and the adverse selection cost.

Prior studies (e.g., Glosten and Milgrom 1985; Glosten and Harris 1988) suggest that the order

processing and inventory holding costs are transitory in nature because they are not related to the

underlying value of the securities. By contrast, the adverse selection cost of the spread arising

from order flows is correlated with future price changes. In the presence of information

asymmetry, rational market makers widen the spread to protect themselves from trading against

informed traders and this increase in the spread is the adverse selection component.

We follow the methodology in Glosten and Harris (1988) and adopted in Brennan and

Subrahmanyam (1996), summarized below, to estimate the adverse selection component of the

spread.

= + [ 1 ] + (2)

where p is the transaction price; D is the sign of the order (equal to 1 for buy orders and -1 for sell

orders) classified based on the Lee and Ready (1991) algorithm; q is signed order flow that equals

D multiplied by the number of shares traded; and y is the unobservable error term. represents the

fixed cost of trading (non-information related); the variable portion of the price change, , is the

adverse selection component of the spread. Glosten and Harris (1988) test several different model

specifications and show that the above specification is the most parsimonious model that captures

the essence of the asymmetric information spread theory (p.134). We estimate equation (2) for

each stock-month using intraday transaction data. We require the estimated to be significant at

12
least at a 10 percent level to reduce measurement error, if not we drop that months observation.

We then scale by multiplying by 1,000 for presentation purpose. GHLAMBDA is the quarterly

average of .

Our second variable of interest is ERCs. We adopt the same structure as (Equation 1) for

our ERC analysis with CAR as the dependent variable. CAR is the three day cumulative abnormal

return surrounding each firms quarterly earnings announcement, where abnormal returns are

CRSP firm specific returns less CRSP value-weighted market returns. We add SUE as an

independent variable and interact POST and SUE to capture the change in the ERC following

comment letter resolution. SUE is unexpected earnings for each respective firm quarter, based on

the median of analyst forecasts issued within 90 days of the quarters earnings announcement

deflated by share price at the end of the quarter. Analyst forecasts and actual earnings are taken

from IBES.13

Difference-in-Differences with a propensity score matched control sample

After SOX, all firms are subject to review by the SEC at least once every three years. However,

the SEC also applies a risk-based model to choose the firms for review each year; for example,

Section 408 of the SOX identifies various firm characteristics for consideration by the SEC staff.

The Commission may pay particular attention to certain types of companies, and these companies

will be reviewed more often than others; therefore, they are more likely to receive a letter. This

non-random assignment suggests that there may be systematic differences between firms that

receive an SEC letter and firms that do not. Hence, to ensure the robustness of our results, we

construct a propensity score matched control sample and employ a difference-in-differences

design.

13
ERCs can be estimated based on a short-window event study design or a long window design
such as over an entire quarter or year. Both designs are frequently used in the literature. We
implement the short-window design to be consistent with recent research on the effect of financial
reporting changes on ERCs (e.g., Wilson 2008; Chakravarthy et al. 2014).

13
 A firms propensity score is the probability of receiving an SEC comment letter

conditional on the firms observable characteristics. We estimate each firms propensity score

based on a determinant model, which we detail in Appendix 1. We then select a control firm that

has the closest propensity score to each comment letter firm without replacement. We exclude

comment letter cases where there is not a sufficiently close propensity score match; hence the

number of cases declines slightly compared to our comment-letter only tests.14 Each control firm

has a hypothetical comment letter period based on the matching comment letter firm. The

difference-in-differences design captures the change in the information environment of the

comment letter firms relative to that of the matched control firms. This approach controls for

changes that occur for reasons outside our scope of interest, and thus, provides a better measure of

the treatment effect of comment letters.

The difference-in-differences model takes the form:

Variable of Interestit = t + i + 1POSTit + 2CLi POSTit + Controlsit + it (3)

The difference between equations (3) and (1) is the addition of an interaction term CLi POSTit.

CL is a dummy variable, which equals one if the firm receives an SEC comment letter. Because

the specification includes firm fixed effects, it is not necessary to include the non-interacted CL

dummy.15 The coefficient of interest is 2, which represents the differential change between the

comment letter firms and the matched controls. For the ERC analysis, the triple interaction term

CL*POST*SUE captures the differential change in ERCs between the comment letter firms and

control firms.

An important assumption of the difference-in-differences methodology is that shocks

contemporaneous with the comment letters affect the treatment and control groups similarly. This

14
A match is considered not sufficiently close if the difference in the propensity score between the
comment letter firm and the match is greater than 0.1.
15
See similar specifications in Bertrand and Mullainathan (1999, 2003) and Low (2009).

14
assumption can be problematic if the treatment and control groups have dissimilar characteristics.

However, we select the control firms based on propensity scores, thereby creating a quasi-

randomized experiment (DAgostino 1998). Since the comment letter firm and the control firm

have similar propensity scores, it is as if similar firms were randomly assigned to different groups.

In Appendix 1, we verify that after matching, all the attributes that distinguish comment letter

firms from the non-comment letter firms disappear. This mitigates the above concern. However,

we acknowledge that propensity score matching is subject to the limitation that it can only remove

selection biases based on observable firm characteristics.

4. Sample and comment letter content and resolutions

Sample

We search EDGAR, the SEC database of public company filings, for comment letters and retain

those relating to 10Qs and 10Ks. For the period 2004 to 2006, we obtain 9,206 letters relating to

4,134 cases for 3,815 firms. After requiring non-missing GVKEYs and PERMNOs, the selection

process results in a final sample of 6,057 letters representing 2,374 cases for 2,256 firms.16 Table

1, panel A summarizes the sample selection process. For sample cases that are unresolved by the

end of 2006, we follow them through to completion.

The SEC began publicly disclosing comment letters in 2005 and only released letters

relating to filings made after August 1, 2004. As a result, Table 1, panel B shows that almost all

the sample cases are in 2005 and 2006. Panel C reveals that out of 2,256 firms most of the sample

firms are the subject of one case, 116 firms are the subject of two cases and one firm is the subject

of three cases. In panel D, we see that on average, a case lasts approximately 87 days and has two

16
Further exploration suggests that most of these firms missing GVKEYs are partnerships. A case
is identified from the subject line of the SEC letters. For example, letters are related to the same
case if they have the same subject line for the firm of interest, for example, 2005 10K.

15
to three comment letters. The letters are released, on average, approximately six months after the

case is resolved.17 In panel E, we report the industry distribution of both comment letter firms and

the Compustat universe in the sample period. The industry classification follows Fama and French

(1997). Given our short time series this comparison is purely descriptive, but letter representation

appears to be reasonably proportional, with some industries slightly under or over represented.

Insert Table 1 here

Comment letter content

To explore the nature and frequency of comments in the letters, we read and manually code 157 of

the early letters released by the SEC in 2005. We classify the letter comments into 79 types.

Appendix 2 details the 79 comment types as well as the tabulation of our coding. 18

The comment types are grouped into four categories. The first, Accounting Issues,

includes big-picture problems. Comments relate to issues such as adherence to GAAP, materiality,

and auditor issues. The second group, Accounting/Financial Reporting/Disclosure Topics,

comprises comments specific to accounting balances or transactions, such as revenue recognition,

inventory, and related party transactions. The third group, Business Issues, represent more generic

business issues, such as liquidity, competitive environment, and risk factors. The fourth group,

Tone and Level of Disclosure, is editorial in nature; the comments address presentation issues.

The 157 letters contain 1,499 comments, slightly less than ten per letter, on average.

Forty-five percent of the comments fall into the second group, Accounting/Financial Reporting/

Disclosure Topics. Within that group, questions about claims, commitments, and contingencies are

the most frequent, followed by revenue recognition and then expenses. The other three groups are

17
We collect the public release dates of the cases by reading the private-to-public date in each
letters header.
18
Ertimur and Nondorf (2006) is the source of our 79 comment types. We found that their
descriptions and categories accurately depict the content of the letters. Since Ertimur and Nondorf
(2006) focus on S filings and we focus on 10Ks and 10Qs, we exclude three items that do not
apply to our setting.

16
approximately equal in terms of the percentage of comments. In the first group, Accounting Issues,

the most common comment is a request for a cite from authoritative literature to support an

accounting treatment. Other frequent comments include: a request to clarify an accounting policy,

reasons to explain why the company is not following GAAP, and a request to disclose certain

material information. In the third group, Business Issues, both MD&A disclosure and liquidity

issues receive substantial attention. In the editorial group, Tone and Level of Disclosure Issues, the

most common comments are a request for something to be clarified or to quantify an amount

related to a disclosure.

Comment letter resolutionsamended filings

To document reporting changes, we examine amended filings caused by comment letters.

Amending a filing provides prima facie evidence of the importance of the issues raised in the

comment letters. We obtain all amended filings from the SECs EDGAR database. We select

comment letter firms amended filings that occur after the comment letter case starting date but no

later than one year after the case ending date. Of the 2,374 cases, 880 have such amendments. We

manually check whether the comment letters cause the amended filings. We do so by reviewing

the comment letter issues and the response letters from the companies. The response letters detail

what the companies propose to amend. We cross-check these proposed changes to the actual

amendments. 402 cases, 17 percent of our sample, result in an amended filing caused by a

comment letter.

We code the revisions into five categories: MD&A, Financial Statements, Footnotes,

Other, and Future Filings.19 MD&A represents changes to the Management Discussion & Analysis

19
Future Filings represents changes that occur after the initial amendment. We identify them here
by matching the comment letters and firm response letters and the initial amendment. This sample
of future filings may not be representative as it relates only to firms which also amended. These
items are obtained from the company response letters. Many letters may be resolved with future
filing changes but no immediate amendment.

17
section of the filing. Financial Statements captures presentation, classification, and numeric

changes to any of the four financial statements (Income Statement, Balance Sheet, Cash Flow

Statement, and Statement of Shareholders Equity) in the amended filing. Footnotes represents

revisions of the notes to the Financial Statements. Other quantifies revisions to any other part of

the filing. Generally these other revisions represent what we consider technical corrections; for

example, internal control report wording and/or audit report issues, such as a missing signature,

date, or office location.20 Future Filings represents issues that the company does not address in the

amendment, but commits to correct in a later filing. We provide an example of each type of

revision in Appendix 3.

Table 2, panel A presents the tabulated results, for the 402 amendments there are 2,628

total revisions, or 6.5 per case, on average. Since all revisions relate to amended filings, the

minimum resolution is one, but the maximum is 55. Future Filings represents the largest single

category total with 1,070, slightly more than 40 percent of the all revisions. Hence, 1,558 actual

revisions occur in the amended filings, approximately four per case. Other is the next largest

category with 579 revisions, slightly more than a third of the 1,558 immediate revisions. Changes

to financial statements and footnotes are about equally common, with 334 and 369 revisions

respectively. MD&A is the smallest with 276 revisions.

Of the 402 amendments, 157 have revisions only in the Other category. For the

remaining 245 cases, we recalculate the mean and median resolution per category. For MD&A,

Financial Statements, and Footnotes, the average revisions per case increase. MD&A increases

from 0.7 to 1.1, Financial Statements increases from 0.8 to 1.4, and Footnotes increases from 0.9

to 1.5. The median of one for both Financial Statement and Footnotes shows that more than half

20
Clearly, the audit firm signature is an important component of the report, but absent an attempt
at fraud by the firm, correcting its absence is a relatively minor correction. The office location is
even more minor. But the review process is to ensure compliance, so these types of issues appear.

18
of these cases result in changes to the financial statements or the footnotes. These 245

amendments are likely to be more economically important than the other 157 cases.

To assess whether market participants consider these revisions economically important,

we examine the 3-day cumulative abnormal returns (CAR) around the amended filing date. Of the

402 cases, we are able to find non-missing filing date returns for 388. Of the 388, 151 have only

technical revisions (Other). Since the daily stock return departures from normality substantially

(Fama 1976), we compute the median values of the abnormal returns. Table 2, panel B presents

the results. We find negative market reactions to the amended filings for the 388 comment letter

cases. The median 3-day CAR over (1, +1) is approximately 0.5 percent. Moreover, the

negative market reactions are driven by the cases that are more than just revisions in the Other

category. The 3-day CAR for the 151 amendments that only contain technical revisions (Other) is

statistically insignificant. In contrast, the remaining 237 amendments show a negative 3-day CAR

of 0.67 percent. Negative returns are the norm in previous studies of restatements. As a

benchmark, Hennes et al. (2008) examine restatements in the 2002 to 2006 period, a slighter

longer period than our sample, but overlapping. Using a longer, 15 day window around non-fraud

related restatements they find a median CAR of -0.9 percent.

Insert Table 2 here

Although we find negative returns around the amendments, it does not necessarily

indicate a loss in reporting credibility. In untabulated analysis, we examine the market reaction

around the revelation of the comment letters to the public for the amended filing sample and find

no statistically significant reaction.21 The negative returns around the amendment suggest the

accounting or disclosure changes that are revealed are, on average, bad news to the market or there

is a loss in credibility. However, the enhanced accounting or disclosure resulting from the SEC

21
We also perform the analysis for the remainder of the sample that did not file an amendment and
again, find no statistically significant market reaction to the revelation of comment letters.

19
review can improve the information environment of the firms under review.22 We explore these

informational effects in greater detail in the next section.

5. Informational changes

Adverse selection component of the bid-ask spread

If SEC comment letters improve reporting and disclosure and thus enhance firms information

environment, we expect information asymmetry to decline. We proxy for the level of information

asymmetry with the adverse selection component of the bid-ask spread (GHLAMBDA). For this

analysis, we have complete data for 1,890 cases and Table 3, panel A provides the related

descriptive information. The 1,890 cases result in 11,977 quarterly observations available in the

pre-letter period and 10,443 quarterly observations in the post-letter period. The univariate

comparisons show a decrease in GHLAMBDA both in mean and median following resolution of

the comment letters. This provides preliminary evidence that the SEC comment letters result in a

lower level of information asymmetry by improving companies disclosure.

Following earlier studies, we consider control variables that may affect information risk.

Van Ness et al. (2001) investigate the relation between adverse selection cost and several

corporate governance variables. They find that volume and volatility are the only variables

persistently associated with the adverse selection component of the spread estimated under

different model specifications. VOLUME is the average daily share turnover during the quarter,

and VOLATILITY is the standard deviation of the daily stock return during the quarter. El-Gazzar

(1998) and Jiambalvo et al. (2002) find that institutions influence a firms information

environment and price informativeness. ONeill and Swisher (2003) further show that firms with

22
An example might be an enhanced segment note. By revealing additional segments, the market
reassesses the firms prospects and the stock price adjusts. However, the markets understanding
of the firms business is enhanced, hence information asymmetry is lowered. The change may also
reduce investor trust in management.

20
higher institutional ownership tend to have a lower degree of informed trading. INSTOWN is the

proportion of the firms shares held by institutions in the end of the quarter. Brennan and

Subrahmanyam (1995) and Easley et al. (1998) find that the level of information asymmetry is

lower for firms with higher analyst following. FOLLOWING is the number of analysts making

earnings forecasts during the quarter. Finally we include size and market to book to control for the

general information environment of the firm. SIZE is the natural logarithm of the market value of

equity at the end of the quarter. MTB is the ratio of market value of equity to the book value of

equity at the end of the quarter.

Insert Table 3 here

Table 3, panel B contains the regression results. We present the comment letter only

sample result in column [1] and the propensity score matched sample result in column [2] to allow

the reader to assess the consistency of the results. Regardless of the specification, we find that

comment letters lead to a decline in the adverse selection component of the spread. In column [1]

the coefficient on POST is negative and statistically significant (0.0003, t-statistic of 2.759). In

column [2] the coefficient on POST is insignificant, which suggests that the control firms on

average do not experience any change in the level of information asymmetry. However, the

negative and significant coefficient on the interaction term POST CL (0.0002, t-statistic of

1.730) suggests that relative to the control firms, treatment firms on average experience a

reduction in the level of information asymmetry. Given the average GHLAMBDA of 0.0035 in the

pre-letter period, comment letter firms, on average, undergo a 5.7 percent reduction in the level of

information asymmetry relative to the control firms. As discussed earlier, the information

environment for these firms is already rich given mandatory reporting requirements, so a modest

comment letter effect is perhaps not surprising. The number of cases for the matched sample is

slightly smaller due to dropped observations because an appropriate match is unavailable, but the

number of quarterly observations increases due to the addition of control firms.

21
 To enhance our confidence about the causality of the above change, we re-do the analysis

focusing on one quarter immediately before and after the letters. The comment letter only sample

results for this analysis are presented in column [3] and the propensity score matched sample

results in column [4]. The results are consistent with those presented in columns [1] and [2], with

the matched sample results being slightly stronger both statistically and in magnitude.

Overall, the evidence that the adverse selection component of the bid-ask spread

decreases over a sustained period following the resolution of comment letters is consistent with

the interpretation that SEC comment letters achieve their goal of enhancing corporate reporting

and disclosure. Consistent results in the first post quarter provide additional assurance that the

reduction in information asymmetry is due to the comment letters.

Earnings response coefficient analysis (ERCs)

To explore whether SEC comment letters change the market perception of earnings quality, we

examine the change in ERCs following the resolution of an SEC review. We include a set of

standard control variables based on an extensive ERC literature. NONLINEAR is defined as SUE

|SUE| and is a control for the nonlinearity in the price-earnings relation (Freeman and Tse 1989).

PERSIST is the slope coefficient from a regression of current quarter earnings per share on same

quarter last year earnings per share over the past 10 years, and PREDICT is the square root of the

error variance from the regression. Prior studies find a positive relation between ERCs and the

degree of persistence in earnings and the predictability of earnings (Kormendi and Lipe 1987; Lipe

1990).23 MTB is the market-to-book ratio at the end of the quarter, and BETA is the market model

regression coefficient estimated over the year prior to the earnings announcement. Collins and

Kothari (1989) document that MTB and risk (as proxied by BETA) are associated with ERCs.

LOSS and Q4 are indicator variables equal to one if the firm reports negative earnings in the

23
Note that we expect a negative coefficient on SUE x PREDICT, because PREDICT captures
earnings predictability inversely (the larger the variable, the lower the earnings predictability).

22
quarter and if the earnings announcement is for the fourth quarter. Prior studies show that negative

earnings and fourth-quarter earnings have lower information content (Hayn 1995; Mendenhall and

Nichols 1988). MEETBEAT is an indicator variable equal to one if the earnings surprise was zero

or positive, and 0 otherwise. Prior studies find that ERCs are higher for firms that meet or beat

current analysts earnings forecasts (Bartov et al. 2002; Rees and Thomas 2010). Finally, we

control for firm size by including the natural log of the market value of equity. 24

Table 4 reports the ERC results. In column [1], we report a baseline model including only

SUE as the regressor. We find that the variable is positively associated with three day CAR with a

magnitude comparable to prior research.25 In column [2], we present the full model result of the

comment letter only sample. We find that the coefficient on the POST SUE is 0.46 (t-statistic of

2.9), suggesting that the ERCs in the eight quarters after a comment letter increase. The results of

the propensity matched sample are in column [3], and the magnitude of the coefficient on CL

POST SUE is also 0.46, but statistically weaker. In untabulated analyses we find the increase in

ERCs is greatest in the early quarters, so we do not observe the U pattern found in Wilson (2008).

Overall, the stable or larger ERCs are not consistent with the reduced credibility

hypothesis. Rather, the larger ERCs are suggestive of improved earnings quality, thus providing

additional evidence of the beneficial effect of comment letters.

Insert Table 4 here

24
The revelation of the SEC correspondence could affect some of the control variables (such as
MTB and LOSS if the comment letters change how the company measures earnings). We thank a
referee for pointing this out.
25
In his review article, Kothari (2001) suggests that prior empirical estimates of ERC magnitudes
range from one to three.

23
Changes in voluntary disclosure

Although collectively our results suggest that comment letters improve compliance with disclosure

regulations and accounting standards thus enhancing firms information environment, an

alternative explanation is that management makes more or higher quality voluntary disclosures

after receiving an SEC comment letter. More frequent or better quality voluntary disclosures could

potentially explain the decrease in information asymmetry and higher ERCs. Although a higher

level of voluntary disclosure may also be caused by comment letters, we differentiate the two

explanations, as we believe accounting and disclosure changes would persist whereas voluntary

disclosures are more discretionary and may be short lived. We investigate using management

earnings forecasts as a proxy for voluntary disclosures.

We obtain management forecast data from First Calls Corporate Issued Guidance

database for our matched sample. The data contain managers estimates or discussions of current

periods and future periods earnings, where periods are both quarters and years. For each fiscal

quarter, we calculate the number of management forecasts from the day after the previous

quarters earnings announcement to the day of the current quarters earnings announcement. We

also decompose the forecasts into point estimates, range estimates, and other qualitative

descriptions. We find that neither the change in the total number of management forecasts nor the

change in the composition of the forecasts differ between comment letter firms and control firms

(untabulated). Therefore, a change in voluntary disclosure as an explanation for our enhanced

information environment results seems unlikely.

6. Conclusion

The SEC issues comment letters when they identify potential shortcomings in company

filings. We explore the content and resolution of 10-K and 10-Q related SEC comment letters and

then examine the informational effects of letter resolution. Our sample includes 2,256 firms that

24
receive comment letters in the 20042006 period. The content analysis shows that nearly half of

the comments involve accounting application, financial reporting, and disclosure issues. Seventeen

percent of our sample cases result in immediate amended filings to resolve comment letters. These

amendments often involve revisions to financial statements and/or footnotes.

Our results show a decline in information asymmetry in the period after comment letter

resolution. Further, ERCs increase in the post comment letter period. We find no evidence of a

change in voluntary disclosure behavior by comment letter firms. We conclude that the SEC

comment letter process is beneficial in enhancing the firms information environment.

To our knowledge, our paper provides the first large-sample evidence on the financial

reporting oversight role of the SEC. We find that regulators can improve firms information

environment by monitoring corporate reporting. These results contrast with recent papers that

question the role of public enforcement (La Porta et al. 2006; Djankov et al. 2008). Our findings

could be of interest to policy makers, both domestic and foreign, who wish to evaluate the

effectiveness of this regulatory effort.

We note that our paper is not without its limitations. Our sample of SEC comment letters

is clustered in a short time frame and hence the generalizability of our results may be a concern. In

addition, the SEC comment-letter process may create other effects that we do not explore.

Whether comment letters create costs that exceed the benefits remains an open question.

25
Appendix 1: Determinants of Receiving an SEC Comment Letter

Whether a firm receives an SEC comment letter in a particular year depends on whether the firm is
selected for review in that year and its reporting quality. We develop our determinant model based
on these two factors. Although the SEC does not publicly disclose its selection criteria for
scheduling reviews, Section 408(b) of SOX has listed several factors for consideration by the SEC
staff.26 Following these factors, we conjecture that firms are more likely to be reviewed if they
have a restatement history, volatile stock prices, or a large market capitalization. Emerging
companies with a disparate PE ratio and industry leaders are also more likely to be reviewed.
A firms restatement and amendment history is representative of its historic reporting
quality, which may impact the likelihood of review and receiving a letter. We further distinguish
whether the restatements and amendments happen recently. RESTATE_1YR and AMEND_1YR are
dummy variables that equal 1 if the firm restates or amends respectively in the year prior to
receiving the letter, and 0 otherwise. RESTATE_B4 and AMEND_B4 are dummy variables that
equal 1 if the firm has a restatement or amendment previously, excluding the prior year, and 0
otherwise. We measure a firms price volatility as its idiosyncratic volatility in the stock market
1-R2
where IDIOSYNCRATIC_VOL = ln( 2 ), and R2 is the R-square from the market model
R
estimated one year prior to receiving the comment letter (Durnev et al. 2004; Ferreira and Laux
2007). SIZE is the natural log of the firms market capitalization at the fiscal year-end prior to
receiving a comment letter. To measure whether a firm is an emerging company with a disparate
PE ratio, we include a firms age and its earnings per share to share price ratio (E/P). AGE is the
quartile ranking of the number of years the firm appears on CRSP. EP is the quartile ranking of
the E/P ratio, calculated at the fiscal year-end prior to the comment letter.27 To measure the impact
of a firms operation on the industry, we calculate each companys proportion of their respective
industry revenue at the fiscal year-end prior to the comment letter and denote the variable as
REVENUE_PROP.
In addition to the SOX review criteria, we include four additional factors that relate to a
firms reporting quality. First, firms with high uncertainty in their operating environment are likely
to use greater estimation and more approximations in their financial reports, hence potentially
more subject to reporting errors. We use the volatility of a firms operating cash flow as our proxy
for operating uncertainty. CFO_VOL is the standard deviation of cash flows from operation (CFO)
over the five years prior to receiving the comment letter. We scale CFO by total assets. Second,
dominant audit suppliers are likely to provide higher quality audits because they have more
resources and wish to protect their reputational capital. We expect companies audited by these
large audit firms to have higher reporting quality, and hence to be less likely to receive a comment
letter. The dominant audit suppliers in our sample period are the so-called Big 4 public
accounting firms: Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers. BIG4
equals 1 if the firm is audited by one of these audit firms, and 0 otherwise. Third, prior research

26
Section 408(b) of SOX requires the Commission to consider the following factors in scheduling
reviews: (1) issuers that issued a material restatement of financial results; (2) issuers that
experience significant volatility in their share price as compared to other issuers; (3) issuers with
the largest market capitalization; (4) emerging companies with disparities in price-to-earnings
ratios; (5) issuers whose operations significantly affect any material sector of the economy; and (6)
any other factors that the Commission may consider relevant.
27
We use the E/P ratio rather than a P/E ratio because some of the sample firms have zero
earnings.

26
(e.g., Teoh et al. 1998) shows that firms may manage earnings around initial public offerings
(IPOs).28 We include a dummy variable IPO that equals 1 if the firm went public within four years
prior to receiving the letter, and 0 otherwise. Finally, we consider firms registering to issue
securities. The SEC may have greater concern for the quality of disclosure for firms issuing new
securities. SFILE_1YR is a dummy variable that equals 1 if the firm files an S filing in the year
prior to receiving the comment letter, and 0 otherwise.
Of the 2,374 comment letter cases, 2,308 have complete data for the determinant test.
There are 9,720 non-comment letter firm-years in Compustat, during the sample period, that have
similarly complete data. For comment letter firms, we measure all variables prior to the date of the
first letter. For non-comment letter firms, we measure all variables at the prior years fiscal year-
end date.
Table 5, Panel A provides descriptive statistics and the results on univariate tests. We
find that comment letter firms differ from non-comment letter firms on most dimensions. We run
our determinant model using a logit regression where the dependent variable equals one if the firm
receives a comment letter. Table 5, Panel B presents the results. The model yields a Wald 2 of
268.4, which is significant at the one percent level or better, thereby rejecting the null hypothesis
that all the coefficients equal 0. We find that firms that have amended and restated filings in the
past have the largest marginal effect on the probability of receiving an SEC comment letter. We
also find that the SEC is more likely to review firms that wish to issue securities. Consistent with
the SOX guideline, we find that larger firms and firms with higher stock price volatility face a
higher probability of getting a letter. Inconsistent with the SOX criteria, however, we find that
older firms are more likely to receive a letter. We find no evidence of the firms share of industry
revenue or its E/P ratio being related to getting a letter. Firms with a more uncertain operating
environment and not audited by Big 4 auditors face a higher probability of receiving a letter.
In Table 5 Panel C, we present the Hosmer-Lemeshow statistic to evaluate the logit
models goodness-of-fit. We create ten ordered groups based on the fitted probabilities and then
compare the actual number in the each group (observed) to the number predicted by the logit
model (expected). Across our ten groups, the frequency observed is very close to the number
expected, both for the comment letter firms and for the non-comment letter firms. The Hosmer-
Lemeshow test statistic further confirms that the model prediction does not significantly differ
from the observed (p-value = 0.325). Therefore, our logit model fits the data well.
We estimate each firms propensity score based on the determinant model outlined
above. We then select a control firm that has the closest propensity score to each comment letter
firm without replacement. Table 5, Panel D presents the descriptive statistics between the
comment letter firms and the matched control firms. We can find matches for 2,269 comment
letter firms. We find that comment letter firms and the matched control firms exhibit similar
characteristics. All the factors that determine whether a firm receives a comment letter have
similar values between the comment letter firms and the control firms. This result suggests that
our matching procedure works fairly well.

Insert Table 5 here

28
A private conversation with a former SEC staff member also suggests that the Commission may
monitor more frequently companies that just became public.

27
Appendix 2: Classification of Comment Types

I. Accounting Issues
These items represent issues or questions that the SEC posed relating to how specific accounting
items were represented in the financial statements and disclosures.
1. Accounting Cite: A request for a specific citation from accounting literature as a basis for the
treatment that the firm used to account for a particular transaction.
2. Accounting Change: A request for further information regarding a change in accounting
principle or change in accounting estimate that was either inadequately disclosed or not disclosed
at all.
3. Audit Issue: A request for additional information regarding the firms relationship with its
audit firm, including issues with auditor changes, issues with matters disclosed (or that should
have been disclosed) in the audit report, and issues with the auditors consent letter for the
offering.
4. Clarify Accounting Policy: A general request to clarify or provide more information about the
firms accounting treatment regarding a particular transaction or series of transactions. This
request is more about how a firm applies a given standard, not what accounting standard was used
(see Accounting Cite).
5. Critical Accounting Policies and Estimates: Questions or issues about the firms critical
accounting policy disclosures (or lack of disclosures) and disclosures about the firms bases for
accounting estimates.
6. Financial Statement Formatting: Comments about the general formatting of the financial
statements and tables in the footnote disclosures.
8. Internal Controls: Questions about the firms internal control systems and the testing, if any,
of controls.
9. Materiality Issues: Comments or questions about the firms obligation to disclose material
information in the filing, including the reiteration of the definition of materiality.
10. New Accounting Pronouncements: Comments regarding a firms disclosures of the effects of
newly issued accounting pronouncements, particularly the firms consideration of any material
impact that the pronouncements may have on the firms financial results.
11. Not Following GAAP: An indication by the reviewer that the firm does not appear to be
following the tenets of GAAP in recording a particular type of transaction or series of transactions.
12. Pro Forma Disclosures: Questions or critiques about either the firms pro forma disclosures
(effects of changes in the firms capital structure based on the offering or effects of a merger
transaction) or non-GAAP financial disclosures (EBITDA or another non-GAAP measure).
13. Quality of Earnings or Cash Flows: Explicit comments or questions regarding the quality of
the firms earnings or cash flows as the firm has presented its results, usually accompanied by
comments to balance the tone of the disclosure or make risks/negative results a more prominent
part of the disclosure.
14. Reportable Conditions: Request for additional information and disclosure related to a
reportable condition or other irregularity that was identified by management related to the firms
internal controls.

II. Accounting/Financial Reporting/Disclosure Topics

These items represent questions or issues posed by the SEC related to the accounting, financial
reporting, or disclosure of specific transactions or classes of transactions.
16. Acquisitions: Questions or comments about the accounting treatment and disclosures of
business combination transactions, including purchase price allocations.
17. Capital Expenditures: Questions or issues about the firms investment in property, plant and
equipment, particularly its accounting treatment related to capitalization of these items.

28
18. Claims, Commitments, and Contingencies: Issues or comments raised about the firms
accounting for and disclosure of its obligations and long-term commitments, including legal
matters.
19. Contra Asset Accounts: A request for information about contra asset-type accounts, such as
the allowance for doubtful accounts or loan losses for loan receivables.
20. Depreciation/Amortization: Questions or issues related to the firms depreciation and
amortization policies.
21. Derivatives: Questions related to the accounting treatment for the firms derivative and
hedging programs, including the application of hedge accounting models and hedge effectiveness
assessments.
22. Environmental Reserves: Questions or comments related to the firms environmental
remediation obligations.
23. Earnings per Share: Questions related to the computation of earnings per share disclosures.
24. Employee Stock Options and Fair Value: Questions or comments related to the application
of SFAS 123(R), Share-Based Payments, particularly regarding the valuation methods used,
including assumptions such as expected volatility and expected term.
25. Expenses and Cost Allocations: Requests for information about expense items and cost
allocations.
26. Goodwill and Impairment: Questions or comments related to the firms goodwill balance
and impairment testing, including the definition of reporting units and valuation issues.
27. Intangibles: Questions or comments regarding the firms accounting treatment for intangible
assets, including how they were valued and/or whether they should have an indefinite life.
28. Intercompany Accounts: Requests for information about a firms accounting and disclosures
for intercompany transactions.
29. Inventories: Questions or comments about a firms inventory and related accounting policies.
30. Investments: Questions or comments about a firms investment balances, including the
accounting treatment based on ownership percentages and fair value determinations.
31. Leases: Questions or comments about the accounting for leasing transactions, including terms
of leases, the treatment of rental escalations, and the treatment of leasehold improvements.
32. Minority Interests: Questions or comments regarding the accounting for minority interests.
33. Off-Balance Sheet Arrangements: Questions or comments relating to the understanding of
off-balance sheet arrangements, including special purpose entities, and their material effects.
34. Other Fair Value Assessments: Questions or comments regarding valuation assessments for
all balance sheet items, excluding acquisition-related and stock option-related fair value
determinations.
35. Pensions and Other Employee Benefits: Questions or issues about the assumptions and
estimates, including the assumed discount rate, and funding obligations related to a firms benefit
obligations.
36. Preferred Stock: Questions or comments regarding the firms preferred stock.
37. Related-Party Transactions: Requests for additional clarification or details surrounding the
accounting for the firms transactions with related parties, including management, board members,
and other insiders.
38. Reserve Accounts: Questions or comments regarding the accounting and disclosure for
reserve liabilities such as warranties and other accrued liabilities.
39. Restructuring Reserves: Questions or comments specifically related to restructuring reserve
liabilities, including severance costs.
40. Revenue Recognition: Questions or comments related to a firms method of accounting for
revenues and material considerations in evaluating the quality and uncertainties surrounding their
revenue-generating activity.

29
41. Segment Reporting: Questions about the identification of operating segments, aggregation of
operating segments, and information about geographic areas in which the firm operates.
42. Shareholders Equity: Questions regarding the accounting treatment of items included as part
of shareholders equity, including other comprehensive income and retained earnings
(accumulated deficits).
43. Statement of Cash Flow Classification: Questions or comments about the classification and
presentation of the statement of cash flows. Emphasis is made on ensuring an accurate
presentation of the firms actual cash receipts and cash payments based on activity (operating,
investing, or financing).
44. Subsequent Events: Requests for additional information and/or disclosure related to events
occurring after the date the financial statements were prepared.
45. Tax Accounting: Questions or comments regarding the firms income tax disclosures,
particularly items disclosed in their income tax footnotes such as the allowance on deferred tax
assets.

III. Business Issues

These items represent questions or comments about the firms operating, financing, or investing
matters.
46. Backlog: Questions about the firms disclosures of its order backlog.
47. Competitive Environment: Comments or questions about the firms competitive environment
and its strategies in addressing competitive forces.
48. Components of Revenue: Requests for information about disclosure and reporting about the
firms various sources of revenue, including the separation of product and service revenues.
49. Customer Profiles: Requests for information about the firms key customers, including any
customer concentration.
50. Debt Covenants: Questions or issues surrounding the companys contractual covenants
related to its outstanding debt, including disclosure about the firms compliance with these
covenants.
51. Dividends: Requests for more information regarding the firms dividend policy, including
recent past dividend declarations and/or payouts, and support for statements regarding the firms
intention to pay future dividends.
52. Going Concern: Questions or comments regarding the firms ability to continue as a going
concern.
53. Intellectual Property: Questions or comments about the firms disclosure of the terms of its
intellectual property and any claims against its intellectual property.
54. Key Performance Indicators: Requests for additional information about disclosures of the
key performance metrics in a firms industry.
55. Liquidity: Questions or comments regarding the firms liquidity disclosures, including how
the statement of cash flows translates into operating cash inflows and outflows, and sensitivity
analysis related to future cash flow needs.
56. Material Contracts: Comments regarding material contracts and their terms that are disclosed
or should be disclosed and included as exhibits in the firms registration document.
57. Management Discussion and Analysis: Questions or comments about the type of information
disclosed or that should have been disclosed as part of the filing.
58. Properties and Facilities: Questions or comments surrounding the description of the locations
in which the firm operates.
60. Risk Factors: Questions or comments regarding the identification and disclosure of the firms
material risk factors, including the potential impact of the factors on the firms operations and cash
flows.

30
61. Research and Development Projects: Comments regarding the identification and disclosure
of the firms material R&D projects.
62. Terms of Debt/Credit Arrangements: Questions or comments about the disclosures of the
material terms of the firms debt and credit arrangements.
63. Trends: A request to provide additional information regarding the material trends underlying
the firms reported operations and cash flows, as well as any forward-looking information about
the effects of trends on future operations and cash flows.

IV. Tone and Level of Disclosure Issues

These items represent requests for additional information or questions about the manner in which
the firm presented its disclosures and the level of disclosure that the firm presented.
64. Balanced Discussion: A request for management to balance the overly positive tone of their
disclosures with more discussion of the risks and downside of their business and operating
environment.
65. Clarify Subject: General requests to provide more specific information regarding a disclosure
issue.
66. Confidentiality Request: Represents the SECs acknowledgement of the firms request for
confidential treatment of various components of the firms responses to the SEC comment letters.
67. Confusing Format: A notation by the SEC that a particular disclosure or presentation is in a
difficult-to-follow format. It is often accompanied by a suggestion from the SEC for improved
presentation.
68. Disaggregation: A request to provide a finer level of detail related to disclosures or questions
about line-item classification.
69. Forward-Looking Information: Comments or questions about the firms disclosure of
forward-looking information.
70. General Formatting: Comments or questions regarding the overall, non-financial statement
formatting of the offering document.
71. Inaccuracies: An observation that there are inaccuracies in the filing document, including
misstatements of fact or numbers that do not reconcile within the document.
72. Incomplete: An annotation that the document is incomplete.
73. Inconsistencies: A comment regarding disclosures that conflict with each other.
74. Independent Support: A request for independent, third-party support for statements included
in the filing document; often, these requests relate to disclosures about fair value disclosures or the
firms market position.
75. Make Prominent: A request to alter the format of the filing to highlight or improve the
visibility of a particular disclosure.
76. Plain English: Requests to modify the language used in the disclosures to eliminate
obfuscating language, industry-specific terminology, or excessive use of acronyms.
77. Quantify Amounts: Request to quantify amounts in disclosures where an issue is discussed in
qualitative terms.
78. Repetitive Disclosures: A comment that management has unnecessarily repeated information
or disclosures throughout sections of the filing without providing additional substance.
79. Specific to Firm: A request to make the firms disclosures less generic and boilerplate, and to
add content that applies the disclosures to the particular circumstances of the firm.
80. Supplemental Information: Requests for supplemental information that would support
assertions in the firms disclosures; this information may or may not be further incorporated in the
disclosures, but may just be information that the SEC wanted to review (e.g., reviewing a drug
effectiveness study that supports certain disclosures made by the firm in its filing).
81. Supporting Calculations: A request to provide detailed support for the calculations that result
in the numbers or figures disclosed in the document.

31
82. Too Detailed: Comments that certain portions of the filing documents, such as the summary
sections, contained too much detail and information that would be more appropriately included in
later sections of the filing.

Note: Items 7, 15, and 59 were removedthey related specifically to IPO firms only.

Number of
Accounting Issues Percentage
Comments
1. Accounting Cite 53 3.5%
2. Accounting Change 1 0.1%
3. Audit Issue 18 1.2%
4. Clarify Accounting Policy 49 3.3%
5. Critical Accounting Policies and Estimates 27 1.8%
6. Financial Statement Formatting 7 0.5%
8. Internal Controls 30 2.0%
9. Materiality Issues 48 3.2%
10. New Accounting Pronouncements 12 0.8%
11. Not Following GAAP 39 2.6%
12. Pro Forma Disclosures 20 1.3%
13. Quality of Earnings or Cash Flows 1 0.1%
14. Reportable Conditions 3 0.2%
308 20.6%
Accounting/Financial Reporting/Disclosure
Topics
16. Acquisitions 15 1.0%
17. Capital Expenditures 10 0.7%
18. Claims, Commitments, and Contingencies 66 4.4%
19. Contra Asset Accounts 20 1.3%
20. Depreciation/Amortization 14 0.9%
21. Derivatives 2 0.1%
22. Environmental Reserves 3 0.2%
23. Earnings per Share 16 1.1%
24. Employee Stock Options and Fair Value 30 2.0%
25. Expenses and Cost Allocations 46 3.1%
26. Goodwill and Impairment 32 2.1%
27. Intangibles 16 1.1%
28. Intercompany Accounts 23 1.5%
29. Inventories 39 2.6%
30. Investments 22 1.5%
31. Leases 15 1.0%
32. Minority Interests 8 0.5%
33. Off-Balance Sheet Arrangements 9 0.6%
34. Other Fair Value Assessments 45 3.0%
35. Pensions and Other Employee Benefits 13 0.9%
36. Preferred Stock 0 0.0%
37. Related-Party Transactions 9 0.6%
38. Reserve Accounts 18 1.2%
39. Restructuring Reserves 16 1.1%

32
40. Revenue Recognition 56 3.7%
41. Segment Reporting 40 2.7%
42. Shareholders Equity 34 2.3%
43. Statement of Cash Flow Classification 23 1.5%
44. Subsequent Events 9 0.6%
45. Tax Accounting 30 2.0%
679 45.3%
Business Issues
46. Backlog 2 0.1%
47. Competitive Environment 0 0.0%
48. Components of Revenue 18 1.2%
49. Customer Profiles 6 0.4%
50. Debt Covenants 6 0.4%
51. Dividends 4 0.3%
52. Going Concern 5 0.3%
53. Intellectual Property 2 0.1%
54. Key Performance Indicators 4 0.3%
55. Liquidity 37 2.5%
56. Material Contracts 8 0.5%
57. Management Discussion and Analysis 91 6.1%
58. Properties and Facilities 4 0.3%
60. Risk Factors 19 1.3%
61. Research and Development Projects 8 0.5%
62. Terms of Debt/Credit Arrangements 14 0.9%
63. Trends 16 1.1%
244 16.3%
Tone and Level of Disclosure Issues
64. Balanced Discussion 0 0.0%
65. Clarify Subject 100 6.7%
66. Confidentiality Request 0 0.0%
67. Confusing Format 2 0.1%
68. Disaggregation 19 1.3%
69. Forward-Looking Information 1 0.1%
70. General Formatting 27 1.8%
71. Inaccuracies 3 0.2%
72. Incomplete 11 0.7%
73. Inconsistencies 24 1.6%
74. Independent Support 2 0.1%
75. Make Prominent 3 0.2%
76. Plain English 2 0.1%
77. Quantify Amounts 41 2.7%
78. Repetitive Disclosures 2 0.1%
79. Specific to Firm 3 0.2%
80. Supplemental Information 10 0.7%
81. Supporting Calculations 18 1.2%
82. Too Detailed 0 0.0%
268 17.8%

33
Total 1,499 100%

34
Appendix 3: Revision Examples

AMR Corp: MD&A change

Comment:
Based on your responses to our previous comments 4 and 5 regarding your basis for changing the
estimated useful life of three aircraft types from 25 years to 30 years, we believe that your MD&A
section should be revised with robust disclosure that completely addresses this highly material
change in estimate, including a clear and in-depth discussion of managements reasons for the
significant change in estimate and the impact on current and future earnings. We note from your
response that the focus in MD&A has been your difficult liquidity situation and the revenue
environment, as well as the impact of rising fuel prices, and we agree that those issues warrant a
thorough discussion. However, we believe that this significant change in estimate should be
emphasized as well, as it had a material impact on the current period and will continue to impact
future financial results. We do not believe that your current level of disclosure complies with the
guidelines set forth in FR-72, which states that if a change in an estimate has a material favorable
impact on earnings, the change and the underlying reasons should be disclosed so that readers do
not incorrectly attribute the effect to operational improvements. As such, in the amended Form
10-K please revise your MD&A discussion of this change in estimate to clearly and concisely
address the following items, at a minimum:

The change in events and circumstances that warranted the change in depreciable lives of
certain aircraft but not other aircraft types.
The economic factors, industry trends, and financial condition of the company which
contributed to managements decision to extend the expected useful life of these
aircraft types.
The characteristics of the aircraft that support your assertion that a 30- year useful life is
reasonable and expected.
The manner in which this change in estimate supports managements fleet plan in the
foreseeable future.
Why the change in depreciable lives of your aircraft based on their economic lives is
unique to your facts and circumstances, while other airlines with similar financial
conditions and reduced capital spending plans have not extended the life of their
aircraft; and
The risks and impact of maintaining aircraft longer in the fleet. Among the items that
should be discussed are: (i) anticipated increase in maintenance expenditures; (ii) the
potential savings in fuel efficiency by replacing aircraft; (iii) customer safety and
satisfaction in utilizing older aircraft; (iv) matters that may cause changes in current
plans; (v) new technology in the marketplace, including your expectation of the
current or anticipated technological advances beyond these aircraft capabilities; (vi)
supply and demand economics within the industry.

Response:
In order to more fully describe the change in depreciable lives for certain aircraft types, the
Company proposes amending the first sentence under Results of Operations on page 33 of the
Companys 2005 Form 10-K to
read as follows:

The Company incurred an $861 million net loss in 2005 compared to a net loss of $761
million in 2004. The Companys 2005 results were impacted by the continuing increase

35
 in fuel prices and certain other costs, offset by an improvement in revenues; a $108
million decrease in depreciation expense related to a change in the depreciable lives of
certain aircraft types described further below, in Critical Accounting Policies in this Item
7, and in Note 1 to the consolidated financial statements; and productivity improvements
and other cost reductions resulting from progress under the Turnaround Plan.

In addition, the Company proposes adding the following paragraph to the end of the Results of
Operations discussion on page 33 of the 2005 Form 10-K:

Although the Company is currently receiving a depreciation expense benefit from the
change in estimate of depreciable lives discussed above, the Companys operating
expenses excluding depreciation will likely be higher than operating new aircraft during
the extended life of the MD-80 aircraft. For example, based on current estimates, the
Companys MD-80 aircraft consume more fuel and incur higher maintenance expense
than a new aircraft that requires minimal maintenance during the first several years of
operation.

Finally, the Company proposes adding the following three paragraphs to the Critical Accounting
Policies and Estimates discussion related to Long-lived assets on page 40 of the Companys 2005
Form 10-K:

On November 17, 2004, American deferred the delivery date of 54 Boeing aircraft by
approximately seven years which, in combination with numerous other factors, led
American to re-evaluate the expected useful lives of its aircraft. As a result of this
evaluation, American changed its estimate of the depreciable lives of its Boeing 737-800,
Boeing 757-200, and McDonnell Douglas MD-80 aircraft from 25 to 30 years effective
January 1, 2005. The primary factors that supported changing the estimated useful life of
these aircraft were (i) the absence of scheduled narrow body deliveries until 2013 (even
these 47 narrow body deliveries would only replace less than ten percent of the
Companys existing narrow body fleet of 547 aircraft. assuming the deliveries are not
used to grow the Companys capacity at that time); (ii) the financial condition of the
Company, which significantly limits its flexibility to purchase new aircraft; and (iii) the
absence of technology step change for narrow body aircraft, such as technology that
would allow the Company to fly its aircraft substantially more efficiently (as was the case
with replacements for previous-generation aircraft such as the B-727, which had three
engines versus two on the replacement aircraft), that would clearly economically compel
the Company to replace the fleet. In addition, there are currently no government
regulations, such as noise reduction requirements, that would require aircraft
replacement.

Subsequent to the change in depreciable lives on January 1, 2005, all of Americans fleet
types are depreciated over 30 years except for the Airbus A300 and the Boeing 767,
which did not generally meet the above conditions to support extending their lives.

It is possible that the ultimate lives of the Companys aircraft will be significantly
different than the current estimate due to unforeseen events in the future that impact the
Companys fleet plan, including positive or negative developments in the areas described
above. For example, operating the aircraft for a longer period will result in higher
maintenance, fuel, and other operating costs than if the Company replaced the aircraft. At

36
 some point in the future, higher operating costs could change the Companys analysis of
the economic impact of retaining aircraft versus replacing them with new aircraft.

Brinker International: Financial Statement Change

Comment:
With respect to the $4.4 million of reacquired development rights, it is unclear whether this
involved the acquisition of a business. In this regard, the reacquisition of developer rights does
not appear to be the acquisition of a business because no incremental revenues will result from
such transactions. We believe these types of transactions may be more appropriately characterized
as the termination of a previous contractual arrangement and that, in such situations, any related
termination fees should not be capitalized. These transactions appear analogous to the termination
of a management contract intended to eliminate future management fees. These types of "one-
time" termination fees are generally charged to expense. Further, when a management contract is
terminated, the related management services are no longer provided. Similarly, when you
reacquire developer rights, the contract previously granting those rights is, in effect, terminated
and the development efforts previously provided by the area developer are discontinued.
Supplementally explain to us the nature of the transaction that generated this intangible asset and
your basis in the accounting literature for capitalizing the cost of reacquiring development rights
or if after reconsidering your position, you deem it appropriate not to capitalize such amounts,
please revise your financial statements to write-off the amounts, accordingly. If management
believes and can support an assertion that such amounts are not material to results of operations
and financial condition, we would not object to a write-off in the next quarterly reporting period.

Response:
The purpose of this letter is to confirm our understanding of the resolution to your questions set
forth in your letter dated November 30, 2004, and further discussed with you on our conference
call on December 17, 2004.
We confirm that we believe it would have been more appropriate to expense the purchase price of
the intangible franchise rights acquired in fiscal 1998. As such, the $4.4 million intangible asset
will be recorded as an adjustment to retained earnings in an amended Form 10-K for the year
ended June 30, 2004, and an amended Form 10-Q for the period ended September 29, 2004.

Brookfield Homes: Footnote Change

Comment:
We note that you have operating segments based on geographical housing and land regions, which
you have stated are economically similar. Based on the selected operating data and your
disclosures within MD&A, it is unclear how you arrived at this conclusion. It appears that there is
a disparity in the number of home closings and the average selling prices between the four regions
presented. Further, you state on page 19 of your 2005 Form 10-K that housing margins are higher
in the San Diego and Washington, D.C. regions. As such, please provide us with copies of all the
different types of reports reviewed by your CODM on a regular basis (e.g., daily, weekly,
monthly, quarterly, annually, etc.). Please also provide us with your analysis of paragraph 17 of
SFAS 131 for aggregating your operating segments into one reportable segment. For the similar
economic characteristics criteria, please provide us with net sales, gross profit, gross profit
margins, operating profit, and operating profit margins, along with any other information you
believe would be useful, for each of your operating segments for each of the five years ended
December 31, 2005, and the six-month periods ended June 30, 2006 and 2005, to help us
understand how the aggregated operating segments are economically similar. Specifically address

37
any differences in the trends these financial indicators depict (e.g., if gross profit margin is
decreasing for one operating segment and increasing for another).

Response:
The Company has historically believed, and continues to believe, that its economic data support a
conclusion that each of its operating segments have similar economic characteristics given the key
measures used by the Chief Operating Decision Maker to make segment capital allocation
decisions and to assess segment performance. However, in considering the Companys response to
the Comment Letter, the Company has concluded that based on recent interpretations it believes
have been applied by the Staff, the Company, in reviewing the current variances in margins in the
Companys segments, will amend the applicable segment disclosure in its SEC filings.
Consequently, in future filings, the Company will disclose the information required by paragraph
25 through 33 of SFAS 131 for each of its four reportable segments. Furthermore, the Company
intends to re-file its Annual Report on Form 10-K for the year ended December 31, 2005, and its
subsequent Quarterly Reports on Form 10-Q for 2006, and proposes to provide in such filings
restated segment information in the following format:

Segment Information (as restated)

As defined in SFAS 131, Disclosures about Segments of an Enterprise and Related Information,
we have five operating segments. Historically, the Company has aggregated its operating
segments into one reportable segment. Subsequent to the issuance of our consolidated financial
statements for the quarter ended September 30, 2006, we have concluded that we should revise our
segment disclosure for all periods presented by providing disclosure for each of our four
reportable segments: Northern California, Southland/Los Angeles, San Diego/Riverside, and the
Washington D.C. area. The Companys fifth operating segment does not meet the quantitative
thresholds for separate disclosure. The Company has restated the accompanying consolidated
financial statements to revise its segment disclosures for all periods presented.

The Company is a residential homebuilder and land developer. The Company is organized and
manages its business based on the geographical areas in which it operates. Each of the Companys
segments specialize in lot entitlement and development, and the construction of single-family
homes. The Company evaluates performance and allocates capital based primarily on return on
assets, together with a number of other risk factors. Earnings performance is measured using
operating income. The accounting policies of the segments are the same as those described in Note
1, Significant Accounting Policies.

Neiman Marcus: Other change

Comment:
Item 1. Business

Please disclose for each of the last three years the percentage or amounts of revenues contributed
by classes of your products that accounted for 10% or more of revenues in any of the last three
years as required by Item 101(c)(i) of Regulation S-K.

Response:
We will disclose revenues by merchandise category for each of the years presented in future
applicable filings and in our Form 10-K/A; see page 4 for the changes.

38
Comment:
Item 5. Market for the Registrants Common Equity and Related Shareholder Matters

Please include a description of the nature of stock repurchase transactions that were not made
under publicly announced repurchase plans or programs as required by Item 703 of Regulation S-
K.

Response:
All of the stock repurchase transactions were made under publicly announced repurchase plans or
programs. The table included in Item 5 of the Form 10-K mistakenly included our stock
repurchases of 10,450 shares during the period commencing on July 4, 2004, and ending on
July 31, 2004, only in the first column of such table. The 10,450 shares were repurchased as part
of a publicly announced plan and therefore should also have been included in the third column
(Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs) of such
table. The table has been revised as part of the Form 10-K/A; see page 9 for the changes.

Peets Coffee & Tea: Future Filing change

Comment:
We note that you include an operating expenses caption within a broader group of costs that are
also depicted as operating expenses, while differentiating it from costs of sales, general and
administrative costs, and marketing and advertising costs. Since you have utilized the same label
for costs segregated at two different levels, references to operating expenses in your textual
discussions may be left without the requisite degree of specificity. Therefore, we believe that you
should disclose the nature of this cost group, and utilize a more descriptive caption, which
distinguishes it from the larger group.

Response:
In response to the Staffs comment, we propose to make the following improvements in future
filings to disclose the nature of these expenses, and to distinguish them from total costs and
expenses:

Delete the header on the Statements of Income called Operating expenses;

Change the subtotal description on the Statements of Income to Total costs and expenses
from operations;
Add a paragraph to Note 2 after Cost of sales and related occupancy expenses to describe
Operating expenses as expenses to operate our retail stores and other distribution channels,
consisting primarily of employee labor and benefits, as well as training, travel, supplies,
repairs and maintenance, and banking and card processing fees.

39
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45
Figure 1 Comment letter timelinehypothetical example centered on 10K filing

Pre-comment letter period Comment letter period Post-comment letter period

Qt1 through Qt8 omit Qt+1 through Qt+8
(relative to first CL issued)

10K 10K reviewed

Qt8 Qt1 Case resolved Qt+1 Qt+8
filed by the SEC
first CL issued last CL issued

Accounting and disclosure changes first revealed to the

public, earlier of: a comment letter related amendment; a 10Q

or 10K filing following case resolution; or release of the

letters to the public.

46
TABLE 1

Sample description

Panel A: Sample selection process

Number of Number of Number of

letters cases firms
10K & Q comment letters on EDGAR from
9,206 4,134 3,815
2004 to 2006
Less: Firms without COMPUSTAT GVKEY (1,571) (1,084) (898)
Less: Firms without CRSP PERMNO (1,578) (676) (661)
Final sample 6,057 2,374 2,256

Panel B: Frequency of the comment letter cases by year

Comment letter case issue year Number of comment letter cases Percentage
2004 55 2.32
2005 1,061 44.69
2006 1,258 52.99
Total 2,374 100

Panel C: Frequency of the comment letter cases by firm

Cases Number of firms Percentage of firms Total comment letter cases

1 2,139 94.82 2,139
2 116 5.14 232
3 1 0.04 3
Total 2,256 100 2,374

Panel D: Descriptive statistics on comment letter cases

Mean Median Std. Dev.

Case length (days) 87.23 65 84.95
Number of letters 2.55 2 1.14
Days between case end date and public release date 199.28 180 142.12

47
TABLE 1 (Continued)

Panel E: Comment letters by industry (in percentage) relative to Compustat

Industry Comment letter firms Compustat population

Agriculture 0.34 0.27
Aircraft 0.17 0.4
Alcoholic Beverages 0.21 0.32
Apparel 1.26 0.91
Automobiles and Trucks 1.39 1.15
Banking 9.52 9.83
Business Services 10.11 10.87
Business Supplies 0.93 0.83
Candy and Soda 0.21 0.2
Chemicals 1.47 1.62
Coal 0.21 0.26
Computers 4.04 3.32
Construction 1.18 0.82
Construction Materials 1.6 1.32
Consumer Goods 1.14 1.08
Defense 0.25 0.14
Electrical Equipment 1.01 0.73
Electronic Equipment 6.66 5.34
Entertainment 1.18 1.43
Fabricated Products 0.17 0.21
Food Products 1.39 1.25
Healthcare 1.85 1.2
Insurance 5.05 2.69
Machinery 2.78 2.36
Measuring and Control Equip. 2.32 1.63
Medical Equipment 3.62 2.88
Miscellaneous 1.05 1.95
Nonmetallic Mines 0.42 2.68
Personal Services 1.31 0.77
Petroleum and Natural Gas 4 5.48
Pharmaceutical Products 6.12 6.29
Precious Metals 0.25 1.78
Printing and Publishing 0.59 0.72
Real Estate 0.67 1.03
Recreational Products 0.59 0.59
Restaurants, Hotel, Motel 1.32 1.36
Retail 4.3 3.58
Rubber and Plastic Products 0.63 0.68

48
Shipbuilding, Railroad Equip. 0.13 0.15
Shipping Containers 0.29 0.19
Steel Works 1.22 1.12
Telecommunications 2.62 3.43
Textiles 0.29 0.2
Tobacco Products 0.04 0.11
Trading 6.23 5.52
Transportation 2.23 2.53
Utilities 2.78 4.1
Wholesale 2.86 2.68
Total 100 100

Notes:

This table provides information on the sample composition. Panel A reports the sample selection

process. Panel B (C) presents the distribution of the comment letter cases by year (firm).

Table 1, panel D provides information on the case length and the number of letters per

case. Panel E reports the industry distribution, where the industry is defined by Fama and

French (1997).

49
TABLE 2

Comment Letter ResolutionsAmended Filings

Panel A: Revisions in the amended filings caused by comment letters

Revisions

MD&A Financial Footnotes Other Future Total

Statements Filings
Total 276 334 369 579 1,070 2,628
Mean per case 0.7 0.8 0.9 1.4 2.7 6.5
Median per case 0 0 0 1 1 5
Minimum 0 0 0 0 0 1
Maximum 12 22 11 17 27 55
Number of cases 402
Mean per case,
excluding
Other only 1.1 1.4 1.5 1.1 2.8 7.9
Median per case,
excluding
Other only 0 1 1 0 1 6
Number of cases,
excluding
Other only 245

Panel B: Market reactions around the amended filing dates

Median CAR (1, +1) around amendment filing dates

n CAR (1, +1)
All cases 388 0.0049***
Excluding Other only 237 0.0067***
Other category only 151 0.0020
Notes:

This table summarizes the types and frequency of revisions undertaken or committed to undertake

to resolve a comment letter case in the 402 cases where one or more filings were

amended. Panel A reports categories of revisions reported in the amended filings. Panel B

reports median market reactions around amendment filing dates. MD&A captures

changes to the Management Discussion & Analysis of the filing. Financial Statements

represents presentation, classification, and numeric changes to any of the four financial

50
statements in the amended filing. Footnotes represents any revisions to the notes to the

Financial Statements. Other quantifies revisions to any other part of the filing; primarily

these changes represent Internal Control report wording and/or audit report issues, for

example a missing signature, date, or office location. Future Filings represents issues that

the company commits to correct in later filings. CAR is the cumulative abnormal returns

around amendment filing dates. In Panel A, if the resolution involved only Other issues

(157 cases), the mean and medians for the categories are re-calculated in the bottom of

the table excluding those cases. ***, **, and * indicate significance at the 1 percent, 5

percent, and 10 percent levels, respectively (two-tailed).

51
TABLE 3:

Changes in Information Asymmetry

Panel A: Descriptive statistics

Pre-comment letters Post-comment letters Comparison

Variables n Mean Median Std Dev n Mean Median Std Dev Tests of means Tests of medians
GHLAMBDA 11,977 0.0035 0.0011 0.0100 10,443 0.0029 0.0009 0.0083 *** ***
VOLUME 11,977 0.8626 0.6227 0.7964 10,443 1.0594 0.8288 0.8450 *** ***
VOLATILITY 11,977 0.0231 0.0196 0.0129 10,443 0.0239 0.0211 0.0124 *** ***
SIZE 11,977 7.0729 6.9775 1.8352 10,443 7.1622 7.0772 1.8799 *** ***
MTB 11,977 3.2852 2.3737 3.7476 10,443 3.2654 2.3639 3.9797 **
INSTOWN 11,977 0.5242 0.5789 0.3344 10,443 0.5995 0.6832 0.3576 *** ***
FOLLOWING 11,977 5.0900 3 5.5759 10,443 5.2991 4 5.5065 *** ***

52
TABLE 3 (Continued)

Panel B: Regression analysis

Dependent variable = GHLAMBDA

Event window (+/- 8 quarters) Event window (+/- 1 quarter)

Predicted Comment Matched Comment Matched

Sign Letter Firms Sample Letter Firms Sample
[1] [2] [3] [4]
POST -/? -0.0003*** 0.0000 -0.0002** 0.0001
[-2.759] [0.199] [-2.141] [1.431]
POST*CL - -0.0002* -0.0003**
[-1.730] [-2.210]
VOLUME - -0.0005*** -0.0005*** -0.0003* -0.0004***
[-6.007] [-9.148] [-1.771] [-3.006]
VOLATILITY + 0.0248*** 0.0262*** 0.0189 0.0223**
[4.355] [6.299] [1.614] [2.365]
SIZE +/- 0.0007*** 0.0009*** 0.0010*** 0.0009***
[7.301] [10.113] [3.232] [4.941]
MTB +/- 0.0000*** 0.0000*** 0.0000 0.0000
[4.028] [4.089] [1.376] [1.442]
INSTOWN - -0.0013*** -0.0016*** -0.0013** -0.0013***
[-5.357] [-8.981] [-2.259] [-3.032]
FOLLOWING - -0.00001*** -0.0000*** 0.0000 0.0000
[-3.233] [-2.732] [0.816] [1.078]

Firm FE Yes Yes Yes Yes

Year FE Yes Yes Yes Yes
Number of
cases 1,890 1,785 1,463 1,244
Observations 22,420 41,544 2,926 4,976
Adjusted R-
squared 0.876 0.847 0.920 0.904

Notes:

53
a.
This table reports changes in information asymmetry after the SEC comment letters. Panel A

presents summary statistics. Panel B presents regression analysis. GHLAMBDA is the

quarterly average of the adverse selection component of the bid-ask spread estimated

based on Glosten and Harris (1988). VOLUME is the average daily share turnover during

the quarter. VOLATILITY is the standard deviation of the daily stock return during the

quarter. INSTOWN is the proportion of the firms shares held by institutions in the end of

the quarter. FOLLOWING is the number of analysts making earnings forecasts during the

quarter. SIZE is the natural logarithm of the market value of equity at the end of the

quarter. MTB is the ratio of market value of equity to the book value of equity at the end

of the quarter. t-statistics are in brackets and are calculated based on White

heteroskedastic consistent standard errors adjusted for clustering by firm. ***, **, and *

indicate significance at the 1 percent, 5 percent, and 10 percent levels, respectively (two-

tailed).
b.
We predict the coefficient on POST to be negative in columns [1] and [3] and do not have

predictions on this variable in columns [2] and [4].

54
TABLE 4

Changes in ERCs after the Comment Letters

Dependent variable = CAR (-1, +1)

Predicted
Baseline Comment Letter Firms Matched Sample
Sign
[1] [2] [3]
SUE + 1.792*** 3.509*** 4.174***
[17.998] [5.645] [7.999]
POST +/- -0.003 -0.002
[-1.342] [-1.316]
POST x SUE +/? 0.462*** -0.072
[2.915] [-0.354]
CL x SUE +/- -0.198
[-0.916]
CL x POST +/- -0.001
[-0.696]
CL x POST x SUE + 0.462*
[1.779]
NONLINEAR - -43.807*** -42.035***
[-5.707] [-6.649]
PERSIST +/- 0.000 0.001
[0.206] [0.866]
PREDICT +/- -0.002 -0.002
[-1.057] [-1.602]
BETA +/- 0.003 0.002
[1.444] [1.098]
MTB +/- -0.005*** -0.005***
[-3.645] [-3.915]
SIZE +/- -0.016*** -0.017***
[-6.385] [-8.488]
LOSS +/- -0.004* -0.008***
[-1.880] [-4.243]
Q4 +/- 0.003** 0.003***
[1.982] [3.201]
MEETBEAT +/- 0.029*** 0.028***
[16.788] [20.696]

55
SUE x PERSIST + -0.100 -0.034
[-0.490] [-0.206]
SUE x PREDICT - -0.036 -0.130
[-0.299] [-1.125]
SUE x BETA - 0.325** 0.462***
[2.198] [3.931]
SUE x MTB + 0.319*** -0.016
[2.665] [-0.160]
SUE x SIZE +/- -0.145** -0.159***
[-2.474] [-3.230]
SUE x LOSS - -1.230*** -1.360***
[-4.788] [-6.513]
SUE x Q4 - -0.417** -0.487***
[-2.195] [-3.168]
SUE x MEETBEAT + 0.049 0.086
[0.139] [0.311]
Intercept 0.001**
[2.203]

Firm FE No Yes Yes

Year FE No Yes Yes
Number of cases 1,504 1,504 1,379
Observations 19,773 19,773 35,395
Adjusted R-squared 0.047 0.129 0.129

Notes:
a.
This table reports changes in ERCs after the SEC comment letters. CAR is the three-day

cumulative abnormal return surrounding each firms quarterly earnings announcement.

SUE is unexpected earnings based on the median of analyst forecasts issued within 90

days of the quarters earnings announcement deflated by end of the quarter stock price.

NONLINEAR is SUE |SUE|. PERSIST is the slope coefficient from a regression of

current quarter earnings on same quarter last year earnings, and PREDICT is the square

root of the error variance from the regression. MTB is the market-to-book ratio at the end

56
 of the quarter. BETA is the market model regression coefficient estimated over the year

prior to the earnings announcement. SIZE is the natural log of the market value of equity.

LOSS is a dummy variable equal to 1 if earnings are negative, and 0 otherwise. Q4 is a

dummy variable equal to 1 if the earnings announcement is for the fourth quarter, and 0

otherwise. MEETBEAT is an indicator variable equal to 1 if the earnings surprise is 0 or

positive, and 0 otherwise. t-statistics are in brackets and are calculated based on White

heteroskedastic consistent standard errors adjusted for clustering by firm. ***, **, and *

indicate significance at the 1 percent, 5 percent, and 10 percent levels, respectively (two-

tailed).

b. We predict the coefficient on POST x SUE to be positive in column [2] and do not have

predictions on this variable in column [3].

57
TABLE 5

Determinants of Receiving an SEC Comment Letter

Panel A: Descriptive statistics on firm characteristics before matching

Comment letter firm-years Non-comment letter firm-years

Comparison (p-value)
(n = 2,308) (n = 9,720)
Variable Mean Median Std. Dev. Mean Median Std. Dev. Test of Means Test of Medians
RESTATE_B4 0.157 0 0.364 0.119 0 0.324 (<0.001)*** (<0.001)***
RESTATE_1YR 0.075 0 0.263 0.057 0 0.232 (0.001)*** (0.001)***
AMEND_B4 0.466 0 0.499 0.335 0 0.472 (<0.001)*** (<0.001)***
AMEND_1YR 0.261 0 0.439 0.216 0 0.412 (<0.001)*** (<0.001)***
SFILE_1YR 0.532 1 0.499 0.465 0 0.499 (<0.001)*** (<0.001)***
IDIOSYNCRATIC_VOL 2.883 2.148 2.18 3.045 2.406 2.196 (0.001)*** (<0.001)***
SIZE 6.261 6.094 2.115 5.999 5.914 2.026 (<0.001)*** (<0.001)***
REVENUE_PROP 0.01 0.001 0.026 0.008 0.001 0.023 (0.003)*** (<0.001)***
AGE 1.774 2 1.091 1.534 2 1.09 (<0.001)*** (<0.001)***
EP 1.519 2 1.099 1.469 1 1.117 (0.048)** (0.046)**
BIG4 0.753 1 0.431 0.75 1 0.433 (0.749) (0.729)
CFO_VOL 0.164 0.044 1.854 0.107 0.047 0.46 (0.008)*** (0.003)***
IPO 0.144 0 0.351 0.2 0 0.4 (<0.001)*** (<0.001)***

58
Table 5 (Continued)

Panel B: Logit regression of the determinants of receiving a comment letter

Dependent variable = 1 for comment letter firm-

years, and 0 for non-comment letter firm-years
Variable Predicted Sign Coefficient Marginal Effect
Intercept 3.030***
[16.445]
RESTATE_B4 + 0.141* 0.021
[1.780]
RESTATE_1YR + 0.179* 0.027
[1.831]
AMEND_B4 + 0.783*** 0.117
[11.481]
AMEND_1YR + 0.663*** 0.099
[8.798]
SFILE_1YR + 0.146*** 0.022
[2.872]
IDIOSYNCRATIC_VOL + 0.041*** 0.006
[2.642]
SIZE + 0.112*** 0.017
[5.486]
REVENUE_PROP + 0.080 0.012
[0.063]
AGE - 0.165*** 0.025
[4.535]
EP - 0.006 0.001
[0.251]
BIG4 - 0.132* 0.020
[1.925]
CFO_VOL + 0.051** 0.008
[2.397]
IPO + 0.111 0.017
[1.120]

Observations 12,028
Pseudo R2 0.0323
Wald 2 268.4
Prob. > 2 < 0.001

59
TABLE 5 (Continued)

Panel C: Goodness-of-fit test for the logit model

Comment letter firm-years Non-comment letter firm-years

Group Fitted Prob. (comment letter = 1) Observed Obs. Expected Obs. Observed Obs. Expected Obs. Total
1 0.1041 125 113 1,078 1,090 1,203
2 0.1193 138 134.4 1,065 1,068.6 1,203
3 0.1395 157 154.7 1,046 1,048.3 1,203
4 0.1689 170 184.8 1,033 1,018.2 1,203
5 0.193 230 218.7 972 983.3 1,202
6 0.2115 244 243.4 959 959.6 1,203
7 0.2296 264 265.4 939 937.6 1,203
8 0.2506 286 288.2 917 914.8 1,203
9 0.2818 288 318.8 915 884.2 1,203
10 0.8704 406 386.5 796 815.5 1,202

Panel D: Descriptive statistics on firm characteristics after matching

Comment letter firm-years Non-comment letter firm-years

Comparison (p-value)
(n = 2,269) (n = 2,269)
Variable Mean Median Std. Dev. Mean Median Std. Dev. Test of Means Test of Medians
RESTATE_B4 0.157 0 0.364 0.15 0 0.357 (0.51) (0.509)
RESTATE_1YR 0.072 0 0.259 0.076 0 0.265 (0.65) (0.650)
AMEND_B4 0.463 0 0.499 0.471 0 0.499 (0.592) (0.592)
AMEND_1YR 0.259 0 0.438 0.25 0 0.433 (0.496) (0.495)
SFILE_1YR 0.525 1 0.499 0.514 1 0.5 (0.458) (0.457)
IDIOSYNCRATIC_VOL 2.907 2.18 2.188 2.902 2.124 2.271 (0.946) (0.297)
SIZE 6.198 6.053 2.065 6.266 6.228 2.021 (0.258) (0.221)
REVENUE_PROP 0.009 0.001 0.026 0.009 0.001 0.025 (0.88) (0.571)

60
AGE 1.756 2 1.09 1.773 2 1.066 (0.582) (0.679)
EP 1.513 1 1.101 1.507 2 1.107 (0.861) (0.875)
BIG4 0.75 1 0.433 0.759 1 0.428 (0.448) (0.448)
CFO_VOL 0.103 0.044 0.613 0.109 0.043 0.748 (0.769) (0.411)
IPO 0.146 0 0.353 0.139 0 0.346 (0.497) (0.496)

Notes:

This table explores determinants associated with receiving SEC comment letters. Panel A presents summary statistics before matching, Panel B

the logit model estimates, Panel C the goodness-of-fit diagnostic for the logit model, and Panel D summary statistics after matching. For

comment letter firms, we measure all variables prior to the date of the first letter. For non-comment letter firms, we measure all variables at the

prior years fiscal year end date. RESTATE_B4 equals 1 if the firm files a restatement before the prior year, and 0 otherwise. RESTATE_1YR

equals 1 if the firm files a restatement within the prior year, and 0 otherwise. AMEND_B4 equals 1 if the firm files an amendment before the

prior year, and 0 otherwise. AMEND_1YR equals 1 if the firm files an amendment within the prior year, and 0 otherwise. SFILE_1YR equals 1

if the firm files an S filing within the prior year, and 0 otherwise. IDIOSYNCRATIC_VOL is the relative idiosyncratic volatility estimated from

the market model over the prior year. SIZE is the natural log of the market value of equity at the end of the prior year. REVENUE_PROP is the

firms share of industry revenue in the prior year. AGE is the quartile rank of the number of years the firm appears on CRSP. EP is the quartile

rank of the EPS to price ratio at the end of the prior year. BIG4 equals 1 if the firm is audited by the Big 4 audit firms, and 0 otherwise.

CFO_VOL is the standard deviation of cash flows from operation over the prior five years. IPO equals 1 if the firm went public in the prior 4

61
years, and 0 otherwise. t-statistics are in brackets and are calculated based on White heteroskedastic consistent standard errors adjusted for

clustering by firm. ***, **, and * indicate significance at the 1 percent, 5 percent, and 10 percent levels, respectively (two-tailed).

62