Investor Reactions to Disclosures of Material Internal Control Weaknesses

Abstract

This paper examines 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. The sample consists of 342 firms with initial SOX 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 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.