Articlegreen2010

Investor reactions to disclosures of material internal control weaknesses

32 citations0/0 files storedManagerial Auditing Journal

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Auditing, Earnings Management, Governance Corporate Finance and Governance Corporate Governance and Financial Management

Abstract

Purpose The purpose of this paper is to examine investor reactions to material internal control weakness disclosures. In particular, the abnormal returns, the change in volatility, and the change in systematic risk are analyzed around auditors' material weakness reports. Design/methodology/approach The sample consists of 342 firms with initial Sarbanes‐Oxley Act, Section 404 weakness disclosures issued between 2005 and 2007. The paper uses three measures for investor reactions: abnormal returns and the change in volatility and systematic risk. The hypotheses of the paper are investigated using univariate analysis. Findings The initial results imply surprisingly that the material weakness disclosure is good news to investors. However, after controlling for the preceding management's internal control disclosure, the results show that the abnormal reaction is positive only when the audit report is consistent with the preceding management report. In addition, the results show a significant change in volatility after the auditor's weakness disclosure. Research limitations/implications These results imply that the investor reactions to auditors' material weakness disclosures depend on the content of the preceding report issued by management: there is a positive reaction if management has identified and reported the existing material weaknesses before the auditor, and a negative reaction when management has failed to identify or report the material weaknesses before the auditor. Originality/value The findings of this paper emphasize that the value of the information contained in the auditors' material internal control weakness disclosures vary significantly depending on management disclosures.

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References

2007Determinants of weaknesses in internal control over financial reporting 2007Accruals Quality and Internal Control over Financial Reporting 2008The Effect of SOX Internal Control Deficiencies and Their Remediation on Accrual Quality 2008The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity 2006Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses 2006The discovery and reporting of internal control deficiencies prior to SOX-mandated audits 2007Market 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 2008Internal Control Weaknesses and Information Uncertainty

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