Revolving Doors Weaken SEC Oversight

New regulators are less likely to flag reporting errors at companies audited by their former accounting firms

Based on the research of Matthew Kubic and Sara Toynbee

Regulators often move in and out of revolving doors between government and the industries they oversee. They can bring valuable expertise. But their ties also can raise questions about whose interests their knowledge ultimately serves.

In one recent case, staffers at the U.S. Treasury Department — who previously worked at Big Four accounting firms — helped draft tax regulations that benefited their former clients. The officials later returned to those firms with promotions and higher pay.

New research from the McCombs School of Business at The University of Texas at Austin finds more subtle revolving door effects at the Securities and Exchange Commission. It suggests a “cooling-off” period might be valuable for newly hired regulators.

Matthew Kubic, assistant professor of accounting, and Sara Toynbee, associate professor of accounting, examined SEC reviews of corporate financial statements. They found regulators were less likely to flag errors when they were reviewing companies audited by their former accounting firms.

“Oversight appears less rigorous when prior employment ties are present,” Kubic says.

Though such conflicts are less obvious, they can harm both investors and confidence in the financial system, he says. “If people believe that oversight is biased due to the revolving door, or other potential conflicts of interest, this could lead to a loss of faith in U.S. capital markets.”

Missing Errors

With doctoral student Rui Silva — now at the University of Washington — the researchers compiled 14 years of employment records for more than 250 staff accountants who reviewed filings for the SEC’s Division of Corporation Finance (DCF).

The data allowed them to identify where reviewers had previously worked. They found 76% who conducted filing reviews were connected to a Big Four firm.

Although they could not identify an official policy, Kubic says the SEC appears aware of potential conflicts in a new employee’s first year. In an examiner’s first year with DCF, they had only a 3% chance of being assigned to review a company their former employer had audited. By an examiner’s second year, however, the likelihood jumped to 25%.

Connected reviewers were less likely than nonconnected peers to detect financial statement errors.

• Teams including a connected reviewer flagged errors only 16% to 19% of the time, depending on the size of the team.
• By contrast, teams with no connected reviewers caught errors 32% of the time.

“These reviewers also asked fewer questions, made lower-quality comments, and pushed back less in terms of asking firms to make amendments,” says Toynbee.

How Long to Cool

Toynbee suspects that response is subconscious and unintentional. The effect is strongest in connected reviewers’ first three to five years at the SEC and then begins to taper off.

The American Accounting Association restricts reviewing work from one’s former institution for five years, Kubic notes. At the SEC, he says, a cooling-off period longer than one year “could increase confidence in regulatory oversight and improve the quality of reviews.”

With limited staff, however, such a “magic cutoff” might be hard to implement at the SEC, Toynbee says. The agency also must weigh the risk of conflicts of interest against the value of industry expertise.

“There’s a key advantage to hiring people from industry,” Toynbee says. “They have practical knowledge and are well equipped to focus on high-risk areas. But they can also be biased.

“It’s up to the SEC to figure out how to balance the trade-off between having more staff available for reviews versus potentially getting lower-quality filing reviews.”

“Conflicted Regulators: Indirect Revolving-Door Connections in SEC Filing Reviews” is published in The Accounting Review.  

Story by Deborah Lynn Blumberg