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

41 Pages Posted: 23 Nov 2014 Last revised: 9 Dec 2014

See all articles by Yingqi Li

Yingqi Li

Shanghai Lixin University of Commerce

Ruiqing Shao

Shanghai Lixin University of Commerce

Junli Yu

Shanghai Jiao Tong University (SJTU) - School of International and Public Affairs

Zhou Zhang

University of Regina

Steven Xiaofan Zheng

University of Manitoba - Asper School of Business

Date Written: November 5, 2014

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

Suggested Citation

Li, Yingqi and Shao, Ruiqing and Yu, Junli and Zhang, Zhou and Zheng, Steven Xiaofan, The Effect of Internal Control Weakness on Firm Valuation: Evidence from SOX Section 404 Disclosures (November 5, 2014). 2015 Canadian Academic Accounting Association (CAAA) Annual Conference. Available at SSRN: https://ssrn.com/abstract=2529273 or http://dx.doi.org/10.2139/ssrn.2529273

Yingqi Li

Shanghai Lixin University of Commerce ( email )

2800 Wenxiang Road
Shanghai
China

Ruiqing Shao

Shanghai Lixin University of Commerce ( email )

2800 Wenxiang Road
Shanghai
China

Junli Yu

Shanghai Jiao Tong University (SJTU) - School of International and Public Affairs ( email )

Shanghai, 200030
China

Zhou Zhang (Contact Author)

University of Regina ( email )

3737 Wascana Parkway
Regina, Saskatchewan S4S OA2 S4S0A2
Canada
306-337-3197 (Phone)

Steven Xiaofan Zheng

University of Manitoba - Asper School of Business ( email )

Department of Accounting and Finance
Winnipeg, Manitoba R3T 5V4
Canada
204-474-7933 (Phone)

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