Material Weakness in Internal Control and Stock Price Crash Risk: Evidence from SOX Section 404 Disclosure

Abstract

This study investigates the hitherto unexplored questions of whether and how a material weakness in internal control over financial reporting (ICW) and its disclosure influence the occurrence of extreme negative outliers in stock return distributions, which we refer to as stock price crash risk. We predict and find that firms with ICW problems are more crash-prone than firms with effective internal controls. We also find that stock price crash risk is even greater for fraud-related ICWs and revenue/cost of goods sold-related ICWs. The positive impact of ICW on crash risk is observed at least two years prior to the initial disclosure of the adverse opinion on internal control quality, but gradually decreases over the two-year period after the initial disclosure and essentially disappears subsequent to the remediation of publicly disclosed ICW problems. The above results hold even after controlling for various firm-specific characteristics that are known to influence crash risk and ICWs. Overall, our results suggest that the presence of ICWs tends to facilitate managers’ bad news hoarding, which eventually increases stock price crash risk. On the other hand, public disclosure of ICWs constrains managerial incentive and ability to withhold bad news from outside investors, thereby mitigating stock price crash risk.

Keywords: internal weakness, crash risk, Sarbanes-Oxley Act (SOA)

JEL Classification: G12, M41, K22