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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

Abstract

We examine the stock price reaction to management’s disclosure of internal control weaknesses under §302 of the Sarbanes Oxley Act and to the characteristics of these weaknesses, controlling for other material announcements in the event window. We find that some characteristics of the weaknesses—their severity, management’s conclusion regarding the effectiveness of the controls, their auditability, and the vagueness of the disclosures—are informative. We also find that the information content of internal control weakness disclosures depends on the severity of the internal control weakness. Moreover, in a sub-sample uncontaminated by other announcements in the event window, we find negative price reactions to the disclosure of internal control weaknesses and material weaknesses.

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Notes

  1. 1.

    302 became effective on August 29, 2002, for all filers and §404 became effective for accelerated filers for fiscal years ending after November 15, 2004. Accelerated filers are companies with worldwide market values of at least $75 million that have filed at least one annual report under Section 13(a) or 15(d) of the Exchange Act and that are not eligible to file quarterly or annual reports on Forms 10-QSB or 10-KSB. Note that on December 15, 2006, the SEC postponed the requirement to comply with §404 for nonaccelerated filers until fiscal years ending after December 15, 2007 for management assessment and to fiscal years ending after December 31, 2008, for audit attestation.

  2. 2.

    We define these categories in Sect. 3.

  3. 3.

    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).

  4. 4.

    A control deficiency “exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis” (PCAOB 2004, Appendix ¶8). A significant deficiency is “a control deficiency, or combination of control deficiencies, that adversely affects the company’s ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company’s annual or interim financial statements that is more than inconsequential will not be prevented or detected” (PCAOB 2004, Appendix ¶9). A material weakness is “a significant deficiency, or combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected” (PCAOB 2004, Appendix ¶10).

  5. 5.

    Similarly, in untabulated analyses, we find that mean cumulative size-adjusted returns of −1.18% in the 3-day window surrounding the disclosure of internal control weaknesses for the 98 observations in our sample with no other material news announced in this returns window.

  6. 6.

    Similarly, in untabulated analyses, we find that mean cumulative size-adjusted returns of −2.54% in the 3 day window surrounding the disclosure of internal control weaknesses for the 41 observations in our sample reporting material weaknesses and with no other material news announced in this returns window.

  7. 7.

    These announcements were made by 555 unique firms.

  8. 8.

    De Franco et al. (2005); Doyle et al. (2007a, b); Ge and McVay (2005); Hogan and Wilkins (2006); and Ashbaugh-Skaife et al. (2007) also start with the Compliance Week list when identifying their samples.

  9. 9.

    For example, Compliance Week identified J&J Snack Foods as disclosing an internal control weakness on January 20, 2005, on Form 10-Q. We searched EDGAR to verify the content of this disclosure and then searched prior filings and found that the first disclosure of this weakness occurred on the company’s Form 10-K filed on December 8, 2004, so December 8, 2004 (rather than January 20, 2005) serves as the event date in our analyses. Because we are interested in market reactions to the disclosure of internal control weaknesses and we expect these reactions to be strongest when the weaknesses are initially announced, identifying the first disclosure is important.

  10. 10.

    Interestingly, we found that the first disclosure of an internal control weakness came on the filing identified by Compliance Week for only 52.4% of observations—that is, we found that the first disclosure came on a prior filing for 47.6% of observations.

  11. 11.

    Specifically, sample firms disclosed their internal control weakness on the following forms: 10K (121 observations), 10K/A (25), 10KSB (4), 10KSB/A (2), 10KT (1), 10Q (119), 10Q/A (11), 10QSB (3), 10QSB/A (2), 424B3 (1), 8K (63), 8K/A (1), DEF 14A, (1), S1 (1), S3/A (1), S4 (1), and S4/A (1).

  12. 12.

    While we acknowledge that the use of prior earnings per share can be viewed as a crude expectations model, we use this as the benchmark to avoid losing observations. Thus, a limitation of our study is that our earnings surprise variable is measured with error.

  13. 13.

    The 64 8Ks and 8K/As announcing the internal control weakness simultaneously reported the following additional news items: 34 auditor changes, 13 restatements, six earnings announcements, six delayed filings, and nine other items.

  14. 14.

    Specifically, they examine event studies using short window metrics, published in The Accounting Review during 1992 through 2001. Of the 35 studies examined, 16 (46%) contain at least one analysis using fewer than 50 observations.

  15. 15.

    Specifically, Kothari and Warner (2007) report that a sample size of 21 allows statistical power of 90% when abnormal returns are 1% for low returns volatility firms, and a sample size of 60 is required for statistical power of 90% when abnormal returns are 5% and firms have high returns volatility.

  16. 16.

    We describe this technique in the multiple regression section.

  17. 17.

    Because we find no evidence that some of the characteristics of the internal control weaknesses are associated with market reactions, we also checked the variance inflation factors (VIFs). No VIFs exceed 9.4, suggesting that multicollinearity is not a concern. Furthermore, no significant correlations between the characteristics exceed 0.32 in absolute value.

  18. 18.

    For example, Allied Holdings, Inc.’s disclosure includes the following evaluation: “…the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective…”

  19. 19.

    The partners and senior manager had an average of 18 years of auditing experience and had participated in an average of 2.6 internal control audits.

  20. 20.

    See Table 3 for a list of the 57 weakness types identified.

  21. 21.

    Recall that each internal control disclosure describes between 1 and 13 individual control weaknesses.

  22. 22.

    For example, Aclara Biosciences, Inc.’s 10Q filed November 9, 2004 contained the following description of its weaknesses: “[o]ur documentation and testing to date have identified certain deficiencies in the documentation, design and effectiveness of internal controls over financial reporting that we are in the process of remediating.” We coded this disclosure as vague because we could not determine the accounting cycle or account to which the weaknesses relate, their severity, the underlying cause, or the implications for future financial statement reporting due to their presence. In contrast, Activcard, Corp.’s 8K filed September 9, 2004 contained the following description of its weakness: “…the financial closing and reporting process in the second quarter represents a significant deficiency in internal control. Specifically, the significant deficiency related to the Company not following a systematic closing and review process, the process associated with the transition of the finance function from Canada to Fremont, California, and the timing of the financial closing for the quarter ended June 30, 2004.” We coded this disclosure as not vague because we could determine the process to which the weakness relates, the source of the problem, and the implications for future financial statement reporting.

  23. 23.

    For example, Big Eight auditors are sued less often than non-Big Eight auditors (Palmrose 1988), Big Eight clients have larger management forecasting errors (Davidson and Neu 1993), firms that switch auditors following disagreements are more likely to have previously engaged Big Eight auditors (DeFond and Jiambalvo 1993), the earnings response coefficients of Big Eight clients are higher (Teoh and Wong 1993), Big Eight auditors command higher audit fees (Craswell et al. 1995), and Big Six auditors are more likely to issue modified audit reports when income-increasing accruals are high (Francis and Krishnan 1999).

  24. 24.

    For example, clients of Big N audit firms record fewer income-increasing discretionary accruals (Becker et al. 1998; Francis et al. 1999) and lower discretionary and current accruals (Myers et al. 2003).

  25. 25.

    Berkman and Truong (2006) note that almost all of the price reaction to earnings news occurs by the end of a correctly specified day 0.

  26. 26.

    An alternative method would be to compare the t-statistics from the observed data to the distribution of t-statistics generated via randomization, but according to Noreen (1989, p. 30), “[w]hen the matrix of explanatory variables is fixed, it doesn’t make any difference whether the estimated coefficients or their t-statistics are used as the test statistics in an approximate randomization tests. This is because the t-statistics are directly proportional to the coefficients when the covariance matrix is fixed.”

  27. 27.

    This is likely because the nature of the news is not uniform. See Table 2.

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Acknowledgements

We thank Anwer Ahmed, Steve Baginski, Linda Bamber, Michael Bamber, Joe Carcello, Jenny Gaver, Kathryn Kadous, Russell Lundholm, Maureen McNichols (editor), James Myers, Tom Omer, Isabel Wang, Mike Wilkins, Dave Ziebart, two anonymous reviewers, and workshop participants at the Deloitte/University of Kansas Audit Symposium, the Southeast Summer Accounting Research Conference, and Texas A&M University for their helpful suggestions. We are also grateful to Jaime Schmidt and Chad Simon for their able research assistance. Linda Myers gratefully acknowledges the financial support of the PricewaterhouseCoopers Foundation. All data used in this study are publicly available.

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Correspondence to Linda A. Myers.

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Hammersley, J.S., Myers, L.A. & Shakespeare, C. 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. Rev Acc Stud 13, 141–165 (2008). https://doi.org/10.1007/s11142-007-9046-z

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Keywords

  • Internal control weakness
  • Material weakness
  • Market reactions
  • Event study
  • Sarbanes Oxley Act of 2002

JEL Classifications

  • G14
  • M41
  • M42