Financial watchdogs may wield more bark than bite.
But their bark alone can be a pretty effective deterrent against fraud, according to new research by Terrence Blackburne, an assistant professor of accounting at the University of Washington Foster School of Business.
Blackburne’s analysis of regulatory oversight by the Securities and Exchange Commission (SEC) over the past six decades reveals that an increase in capacity to review the financial disclosures of public firms discourages accounting malfeasance by management.
“There’s a lot of debate as to whether this review process really matters. We don’t have any evidence that it uncovers fraud,” Blackburne says. “But my analysis suggests that the process of review affects behavior in the first place. Firms that know they’re being watched are less likely to initiate a fraud.”
Since its creation in 1934, the SEC has been charged with the task of regulating the nation’s securities industry and enforcing federal securities laws in order to protect investors against accounting fraud. This enforcement role mandates periodic review of the financial reports that publicly traded companies are required to submit on a quarterly and annual basis.
The Sarbanes-Oxley Act of 2002 established that the SEC must review at least one financial disclosure from every public firm every three years. This, as it might appear, is not terribly frequent. And limited regulatory budgets don’t always allow more than the minimum review required.
Moreover, SEC reviews rarely approach the level of an audit, according to Blackburne, who worked as a regulator in the White House Office of Management and Budget before becoming an academic. Unless there is cause for suspicion, a routine review is simply a face-value inspection of the report—or a section of the report—from an investor perspective. That is to say, do the numbers make sense?
So perhaps it’s not surprising that the SEC review process is not what typically catches fraudulent accounting.
Considering this reality, Blackburne set out to determine whether the oversight function of the SEC offers any value in protecting investors.
To find out, he examined the relationship between the resources allocated to review financial reporting and the incidence of accounting fraud during the period between 1960 and 2013.
Rather than examine the SEC’s oversight budgets alone, he focused on capacity—that is, budget relative to workload.
By controlling for macroeconomic factors—GDP growth, unemployment rate, whether it was an election year—that would affect the overall SEC budget, Blackburne achieved a clearer picture of oversight capacity versus the incidence of fraud.
Plotting these data on a graph, a range of sawtooth trend lines appears, illustrating the rise and fall of resources that the SEC has at its disposal for disclosure review. And fluctuations in the rate of fraudulent financial reporting correspond with these fluctuations in oversight capacity.
“When you control for macroeconomic factors,” Blackburne says, “an increase in fraud appears to follow a decrease in SEC oversight resources as opposed to the budget increasing in response to fraud.”
In other words, when examination intensity increases, managers are less likely to engage in earnings management and issue fewer financial restatements.
In an additional analysis of the years 2003 to 2012, Blackburne dissected the oversight capacities of the SEC’s 11 financial review offices (now 12), organized by industry: healthcare; consumer products; information technology; natural resources; transportation; manufacturing and construction; real estate; beverages, apparel and mining; electronics; telecommunications; and financial services.
This enabled him to disentangle the effects of each office’s budget from regulatory changes that might also affect financial reporting quality.
This clean look at the regulatory intensity of each SEC office generated 11 distinct resource trend lines illustrating a general spike in capacity of most industry offices in response to the financial crisis of 2008.
But it also reveals a curious outlier. The SEC office charged with monitoring disclosures of the financial industry appears to be the most underfunded and overworked of the dozen oversight offices.
Even though its budget grew after the financial collapse, the number and complexity of industry disclosures needing review grew at a faster pace, leaving it even less equipped than it was before the crisis. Between 2003 and 2012, the SEC’s finance office employed, on average, three dozen regulators to review more than 6,000 filings—the most, by far, in any industry.
“When the financial crisis hits, you would expect the gap in capacity to narrow between the SEC’s finance office and its offices reviewing other industries. But we see that this gap widens rather than narrows,” Blackburne says. “The oversight capacity increases for regulators monitoring every industry except for finance—the one most impacted in the crisis.”
Broken window theory
No regulatory body is omnipresent enough to observe every infraction. Some, like the SEC, actually uncover rather few. So why does an increase in oversight resources dampen fraud?
Blackburne says the deterrent effect of the SEC’s regulatory oversight is a corollary of the “broken windows theory.” According to this theory, proposed by James Wilson and George Kelling in 1982, monitoring and enforcing petty crimes also discourages more serious crimes by sending a signal to would-be perpetrators that they are being watched.
In the case of SEC oversight, Blackburne says that more intensive scrutiny—enabled by greater resources and staffing in the various offices—notifies managers that their actions are being noted.
The cost of enforcement
Could the SEC and other regulatory bodies do more to catch or prevent fraud? Of course. Bigger budgets would enable greater enforcement.
“But the cost of eradicating fraud completely would be incredibly high,” Blackburne says. “Whether a larger oversight budget would decrease fraud is not the question. The real question is whether it’s worth the cost.”
What he has shown is that the act of regulatory review is a deterrent against fraud. And increasing investment in the review of financial disclosures counteracts the incentives that managers might have to cook the books.
“As for the optimal allocation of resources for oversight,” he adds, “I’ll leave that to the policy makers.”
“Regulatory Oversight and Reporting Incentives: Evidence from SEC Budget Allocations” is the work of Terrence Blackburne.