Internal Control Weaknesses and Information Uncertainty

Abstract

We analyze a sample of 330 firms making unaudited disclosures required by Section 302 and 383 firms making audited disclosures required by Section 404 of the Sarbanes-Oxley Act. We find that Section 302 disclosures are associated with negative announcement abnormal returns of −1.8 percent, and that firms experience an abnormal increase in equity cost of capital of 68 basis points. We conclude that Section 302 disclosures are informative and point to lower credibility of disclosing firms' financial reporting. In contrast, we find that Section 404 disclosures have no noticeable impact on stock prices or firms' cost of capital. Further, we find that auditor quality attenuates the negative response to Section 302 disclosures and that accelerated filers—larger firms required to file under Section 404—have significantly less negative returns (−1.10 percent) than non-accelerated filers (−4.22 percent). The findings have implications for the debate about whether to implement a scaled securities regulation system for smaller public companies: material weakness disclosures are more informative for smaller firms that likely have higher pre-disclosure information uncertainty.

Market reactions to the disclosure of internal control weaknesses and to the characteristics of those weaknesses under section 302 of the Sarbanes Oxley Act of 2002

“…Additionally, their tests related to trading volume suggest that trading by small investors is driving these negative returns. Second, Beneish et al (2006) investigate whether the effect of material weaknesses on the cost of capital and on stock prices is associated with audit quality (proxied for by auditor type and by industry specialization). They find cumulative size-adjusted returns of À1.8% in the 3-day window surrounding the disclosure for their sample of 330 firms making material weakness disclosures under §302.…”

“…Other potential benefits include a lower cost of capital(Beneish et al 2006) and reduced financial reporting failures and investor losses due to internal control reporting, but the latter benefits are difficult to measure(Nicolaisen 2004).…”

Effects of CEO Turnover and Board Composition Reform on Improvements in the Internal Control Quality

“…According to this definition, it is clear that ICFR quality affects the credibility of financial statements because SDs in ICFR increase the risk of material misstatements in financial statements. In fact, many previous studies indicate that SD disclosures damage a company's image in equity markets (Beneish, Billings, & Hodder, 2008;Hammersley, Myers, & Shakespeare, 2008), trigger negative market reactions (De Franco, Guan, & Lu, 2005;Hammersley, Myers, & Shakespeare, 2008), raise the cost of capital (Ashbaugh-Skaife, Collins, Kinney Jr., & Lafond, 2009;Ogneva, Subramanyam, & Raghunandan, 2007) and control risk assessments by external auditors (Hoitash, Hoitash, & Bedard, 2008;Krishnan, Rama, & Zhang, 2008;Raghunandan & Rama, 2006) (Note 8). In addition, SDs indicate upper management's failure in its responsibility to design and operate effective ICFR, which in turn impacts the credibility of a firm's financial statements after Global Economic Crisis.…”

“…Disclosing SDs in ICFR entails serious consequences; for example, SDs inspire less confidence in equity markets (Beneish, Billings, & Hodder, 2008;Hammersley, Myers, & Shakespeare, 2008). To mitigate these consequences, firms must remediate their SDs immediately, perhaps through drastic steps, such as replacing the CEO and changing the composition of the board of directors (e.g., Desai, Hogan, & Wilkins, 2006;Hennes, Leone, & Miller, 2008;Agrawal & Cooper, 2014).…”

External reputational penalties for CEOs and CFOs following information technology material weaknesses

“…6 Thus, the quality of internal controls appears to have improved under SOX. Second, firms disclosing material weaknesses are punished by the marketplace and experience significant stock price declines (e.g., Beneish et al, 2008), indicating that the market does attach value to effective internal controls as they "support the governance of the organization" (COSO, 2013, p.1). Finally, firms punish internal members of its governance structure for the reporting of ineffective controls.…”