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Can Short Sellers Detect Internal Control Material Weaknesses? Evidence from Section 404 of the Sarbanes-Oxley Act

55 Pages Posted: 27 Sep 2012 Last revised: 3 Feb 2017

Zvi Singer

HEC Montreal

Yan Wang

McMaster University

Jing Zhang

University of Alabama in Huntsville

Date Written: January 1, 2017

Abstract

We examine whether short sellers are interested in, and capable of, identifying firms with an upcoming revelation of Internal Control Material Weaknesses (ICMW). We show that short sellers accumulate positions in firms that are about to disclose ICMW under Section 404 of the Sarbanes-Oxley Act for the first time when internal control problems are severe. We find that the short interest build-up is mainly due to the use of private rather than public information, which suggests that their trades contain incremental prediction power of the upcoming internal controls failure. Furthermore, the ability of short sellers to predict ICMW is more pronounced in firms operating in poor information environments. Finally, we find no evidence that trades by short sellers prior to the ICMW disclosure creates a cascade of selling that leads to an overreaction of ICMW. Overall, we present evidence that corporate governance information in the form of ICMW is part of the short sellers’ information set, and we establish a path through which ICMW impacts equity investors.

Keywords: short selling; internal control material weaknesses; severe internal control problems; Section 404 of the Sarbanes-Oxley Act; triggering events

JEL Classification: G32, M41, M42, D82, K22

Suggested Citation

Singer, Zvi and Wang, Yan and Zhang, Jing, Can Short Sellers Detect Internal Control Material Weaknesses? Evidence from Section 404 of the Sarbanes-Oxley Act (January 1, 2017). Journal of Accounting, Auditing and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2153082 or http://dx.doi.org/10.2139/ssrn.2153082

Zvi Singer (Contact Author)

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada
514-340-1847 (Phone)

Yan Wang

McMaster University ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada

Jing Zhang

University of Alabama in Huntsville ( email )

Huntsville, AL 35899
United States
2568246617 (Phone)

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