The Effect of Internal Control Weakness on Firm Valuation: Evidence from SOX Section 404 Disclosures

Abstract

We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes-Oxley Act have 13% lower valuation than non-ICW firms based on Tobin’s q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. Those ICW firms that remedy the internal control weakness in the year after disclosure have much better stock performance compared to those ICW firms who fail to remedy ICW during the same period. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has reflected the negative information associated with SOX 404 ICW reports before the actual disclosures are made. Additional analysis suggests that the market cannot independently reflect the ICW information. More likely, the activities related to the preparation of ICW disclosure generate new information that is reflected in the stock prices.

Keywords: Sarbanes-Oxley Act, Internal Control Material Weakness, Firm Valuation, SOX 404, SOX 302, Benchmark Adjusted Returns

JEL Classification: G14, G18, G30