The U.S. Securities and Exchange Commission's increased focus on tracing state-financed terrorism might detract from its ability to catch other important financial reporting errors, according to a new analysis.

In a paper published April 22 in the Journal of Accounting & Economics, researchers used SEC comment letters inquiries to examine whether efforts to prioritize the review of state sponsors of terrorism could negatively affect the quality of the regulator's oversight of companies' financial reporting. Comment letters are typically dispatched by the SEC following a review of a firm's annual or quarterly financial disclosures, either to obtain more information or notify a firm that its filings contain inaccuracies or errors. 

The researchers analyzed more than 17,800 comment letters sent between 2005 and 2016. In 2005, only 2.2% of the 825 comment letters included a reference to state sponsors of terrorism; 11 years later, that percentage had risen to 8.4%.

"Interest in SST disclosures has increased steadily over time," said William Mayew, co-author of the study and professor of accounting at Duke University. "By 2018, the SEC asking questions to companies about SST occurs at about the same frequency as questions pertaining to revenue recognition and taxes."

And as greater attention is paid to the strict sanctions imposed on members of the state sponsors of terrorism list, other issues regarding company finances may be overshadowed. The researchers found that when SEC comment letters included references to terrorism, the letters were less likely to identify the firm's financial reporting errors. For restatements containing severe mistakes, the SEC's average error-detection rate was 31.1%, but the mention of terrorism caused the error-detection rate to drop to just 10.6%. Such a decline in the discovery of severe financial errors could prove detrimental to investors, according to Mayew, who also rely on the SEC to provide insight on corporate accounting and performance.

To identify why the SEC quadrupled the proportion of comment letters that mention state sponsors of terrorism between 2005 and 2016, Mayew and his fellow researchers submitted a freedom of information act request to obtain detailed information on the staff of the SEC's Division of Corporate Finance. The researchers discovered a change in the composition of SEC review staff over time that coincided with an increase in terrorism references — whereas 51% of employees in the division were from an accounting background in 2005, compared to 36% from a legal background, the proportion had changed to 44% and 43%, respectively, by 2016.

"We cannot say that the shift in the labor mix toward more lawyers than accountants was necessarily in response to terrorism, although it may have been," Mayew said. "Research has established that accountants facilitate error detection more than lawyers. So, the shift toward more lawyers may have naturally [led] to less financial reporting error detection, regardless of the reason for the increase in the proportion of lawyers."

Moving forward, while hiring a greater proportion of accountants than lawyers might seem at first glance to be a viable solution, Mayew warns that the SEC's obligations to investors are complex. There might be instances where an increased number of lawyers on staff is helpful or even crucial. 

"We are considering in our paper oversight within the context of periodic financial filings like [annual] 10-Ks and [quarterly] 10-Qs only," Mayew said. "Therefore, we cannot draw overall conclusions regarding whether the shift in the labor mix at the DCF over time has helped or not."

What the researchers can say, he added, is that the focus on state sponsors of terrorism "has hurt one aspect of what the DCF does with respect to financial reporting oversight. Perhaps no change is necessary in the labor mix so long as there are sufficient benefits to outweigh the financial reporting oversight costs we document."

The study, "State sponsors of terrorism disclosure and SEC financial reporting oversight," published April 22 in the Journal of Accounting & Economics, was authored by Robert Hills, Pennsylvania State University; Matthew Kubic, University of Texas at Austin; and William J. Mayew, Duke University.