An Empirical Analysis of Value-relevance of Disclosure of Material Weaknesses Under Section 404
C.S. Agnes Cheng
Louisiana State University
Joanna L.Y. Ho
University of California, Irvine - Accounting Area
University of Hong Kong - School of Business
January 9, 2006
Section 404 of the Sarbanes-Oxley Act (SOX) requires publicly traded companies to include in their annual reports an assessment of the effectiveness of their internal control over financial reporting (ICOFR). Due to its reportedly high implementation costs, Section 404 is one of the most controversial parts of SOX. In this study, we examine if the disclosure under Section 404 is value-relevant to investors. We first use the event study approach to examine if the market reacts to the initial announcement of material weakness in ICOFR. We find that on average firms announcing material weaknesses suffer significant losses (i.e., negative cumulative abnormal returns) over a short period surrounding the announcement day. In particular, the market reacts more negatively when managers indicate the material weaknesses cannot be fixed by fiscal year-end or when firms simultaneously announce a restatement. However, the negative market reaction is mitigated for firms with complex business structures, reflecting that the market has a prior expectation of weaker internal controls for such firms. We further use long window portfolio tests to examine if the foreknowledge of ICOFR adds value to investors. We employ a material weakness expectation model to construct a set of matched firms for both effective and ineffective ICOFR. Our results show a roughly 10 percent of risk-free return for the hedge portfolio (i.e., long the effective ICOFR firms and short the ineffective ICOFR firms). Our study contributes to the current debate of the importance of internal control effectiveness to firm value.
Keywords: Sarbanes-Oxley Act Section 404, earnings surprise, hedge portfolio, management assessment, material weaknesses in internal controls, restatement, value relevance
JEL Classification: M41working papers series
Date posted: January 20, 2006
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo6 in 0.500 seconds