SEC review of non‐GAAP comment letters in family firms

• Published date: 01 October 2022
• Author: Samer Khalil,Denise O'Shaughnessy,Ian Twardus
• Date: 01 October 2022
• DOI: http://doi.org/10.1002/jcaf.22575

Received:  April  Accepted:  May 

DOI: ./jcaf.

RESEARCH ARTICLE

SEC review of non-GAAP comment letters in family firms

Samer Khalil Denise O’Shaughnessy Ian Twardus

Murray State University, Murray, USA

Correspondence

Ian Twardus, MurrayState University,

Murray,KY, USA.

Email: itwardus@murraystate.edu

Abstract

In this paper, we investigate whether the Securities and Exchange Commission

(SEC)’s review of voluntary non-GAAP disclosures in -K reports varies with

firm ownership structure. Relying on the voluntary disclosure literature, we

argue that managers voluntarily disclose financial and non-financial informa-

tion in order to resolve information asymmetries arising from firm ownership

structure. We find, using a sample of firms over the period –, that fam-

ily ownership reduces the likelihood of receiving a comment letter related to

non-GAAP disclosures. We also show that family firms take a longer period

and exchange a larger number of correspondence letters with the SEC before

the latter closes the case. These findings contribute to the family firm literature

and expand the literature investigating the SEC review of voluntary non-GAAP

disclosures.

KEYWORDS

family firms, non-GAAP earnings, SEC comment letters

1 INTRODUCTION

The Securities and Exchange Commission (SEC), and as

per Section  of the Sarbanes-Oxley Act (SOX) of ,

is entrusted with reviewing the periodic disclosures of

reporting companies at least once every  years (Cassell

et al., ). During the review process, the SEC identifies

firms having deficient disclosures and request additional

information, revisions of current filings, or amendments

to future filings via a comment letter (Gunny & Her-

mis, ). After one or more correspondence with the

concerned entities, the SEC generally closes the case by

sending a notice of “no further comment.”

Prior research investigates various aspects of the SEC

review process (Johnston & Petacchi, ; Kubick et al.,

).Scant research, however, investigates SEC’s review

of voluntary non-GAAP disclosures. This is intriguing for

three reasons. First, firms increasingly use non-GAAP dis-

closures where % of S&P  firms used non-GAAP

financial measures in earnings releases (Audit Analyt-

ics ). Second, investors, directors, and managers view

non-GAAP earnings as useful measures of operating per-

formance (Bradshaw et al., ; Christensen et al., ).

Third, SEC officials note that non-GAAP earnings require

“close attention” and maybe “a source of confusion” given

the “extent and nature of the adjustments” (Schnurr,;

White, ).

The voluntary disclosure literature suggests that man-

agers voluntarily disclose financial and non-financial

information in order to resolve the information asymme-

tries that arise from firm ownership structure (Diamond

& Verrecchia, ; Kim & Verrecchia, ). Hence, in

this paper, we examine whether SEC’s review of volun-

tary Non-GAAP disclosures in -K filings varies with

ownership structure. We focus on a unique form of own-

ership, family ownership, for the following reasons. To

start with, family firms are common place. They consti-

tute % (%) of the Standard and Poor’s  ()index

firms. Next, family members hold undiversified equity

stakes for extended period of time and are intimately

involved in the management and governance of the fam-

ily firm. This reduces (increases) information asymmetries

J Corp Account Finance. ;:–. © Wiley Periodicals LLC. 173wileyonlinelibrary.com/journal/jcaf

174 KHALIL  .

between family block holders and managers (minority

shareholders) and ultimately affect voluntary disclosure

practices. Finally, while extant research investigates the

likelihood of voluntary disclosures in family firms, it does

not explore the quality of these disclosures (Ali et al., ;

Chen et al., ).

We first posit that family firms provide superior vol-

untary non-GAAP disclosures, and hence are less likely

to receive non-GAAP related comment letters, than non-

family firms. Families, and by virtue of their long-term and

undiversified equity holdings, are keen on providing high-

quality non-GAAP metrics to investors. By doing so, they

can boost the family’s reputation, reduce the cost of capital,

increase analyst following and stock liquidity. They also

avoid the costs associated with handling SEC comment

letters and preempt litigation against the family firm.

Second, we test whether family firms resolve the issues

raised by SEC comment letters as promptly as non-family

firms. On the one hand, family firms may be swifter in

resolving non-GAAP comment letters since they are more

attentive to external stakeholders’ expectations (Cennamo

et al., ). Family firms also strive to avoid the potential

reputational costs arising from SEC comment letters and

their long-term effects on the family business and wealth

(Engel et al., ). Finally, they are more likely to timely

resolve issues that distract the firm’s management and its

directors from their duties and functions (Cassell et al.,

).

On the other hand, family firms may not be able to

resolve non-GAAP comment letters as swiftly as non-

family firms in cases where the SEC perceives significant

agency problems between controlling family members and

minority shareholders. Following the initial non-GAAP

comment letter, the SECmay conduct a more detailed and

in depth review that uncovers more substantive account-

ing irregularities and disclosure deficiencies (Feroz et al.,

; Johnston & Petacchi, ). This is especially true in

family firms where family block holders seek private ben-

efits of control and conceal these practices through lower

quality or misleading disclosures (Ali et al., ; Chen

et al., ).

We present results obtained using a sample of firms

that received a non-GAAP comment letter ( firm year

observations), and a control sample including firms that

did not receive any comment letters (, firm year

observations) over the period –. In support of the

first hypothesis, results show that family firms are less

likely to receive non-GAAP comment letters than non-

family firms. Findings also show that the incidence of SEC

comment letter is positively associated with financial and

non-financial attributes such as financial distress, mergers

and acquisitions activity, financial losses, age, as well as

the duality of the CEO and the Chair of the board. In con-

trast, comment letters are less likely to occur in firms that

witness high sales growth and firms that resort to external

financing.

To test the second hypothesis, we focus on the sub-

sample of firms that received comment letters related to

non-GAAP disclosures. We test the swift resolution of SEC

comment letters using two proxies:the number of days that

lapsed from the receipt of the first comment letter until the

receipt of “no further comment” notice; and the number

of correspondence between the SEC and the firm over the

same period. Findings show that the SEC review period in

days and the number of correspondence between the SEC

and the registrant are larger in family firms. They are also

larger in firms whose departing auditor expressed a going

concern opinion, firms that had higher sales growth firms

that operate in a litigious industry, as well as those where

the current CEO occupies the Chair of the board position.

The review period is also larger in firms whose depart-

ing auditor had a disagreement with management, firms

that witnessed financial losses, and firms that are larger. In

contrast, the number of correspondence is lower in firms

auditedbyaBigauditfirm.

This paper contributes to the literature in the follow-

ing ways. First, this paper adds to the literature inves-

tigating the SEC review process related to non-GAAP

disclosures. Shedding more light on non-GAAP disclo-

sures is warranted since they are more commonplace,

arecommonlyusedbyinvestors,andaresubjectto

increased SEC scrutiny. Bentley et al. () find that

from  to , managers’ (analysts’) non-GAAP report-

ing frequency increased from % (%) to % (%) of

firm-quarters. Non-GAAP disclosures are also increasingly

scrutinized by the SEC since they can be used opportunis-

tically when results are not favorableor to outright mislead

investors (Bharati et al., ; Bhattacharya et al., ;

Bradshaw et al., ).According to Audit Analytics, the

percentage of comment letters issued to unique companies

addressing non-GAAP reporting issues increased from %

in  to % in , and then spiked to % in  and

% in .

Second, this paper extends current research by exam-

ining the SEC review process of non- GAAP disclosures

in -K reports. As such, it complements prior research

that examined SEC comment letters related tof ilings other

than the -K such as IPO filings (Ertimur & Nondorf,

), -K filings (Ettredge et al., ), as well as proxy

statement filings (Robinson et al., ). The -K report is

important since investors rely on information in -K fil-

ings to make investmentdecisions. In addition, -K filings

‘‘often contain highly significant information about com-

pany performance and financial position not provided by

other means such as earnings announcements and related

communications’’ (Griffin, ).