Material Weakness in Internal Controls and Stock Price Crash Risk

Journal of Accounting, Auditing, and Finance, Volume 35, Issue 1, pp. 106-138, 2020

42 Pages Posted: 7 Apr 2017 Last revised: 3 Mar 2021

See all articles by Gerald J. Lobo

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

Chong Wang

University of Kentucky

Xiaoou Yu

California State University, Long Beach - College of Business Administration; Xiamen University - Institute for Financial and Accounting Studies

Yuping Zhao

University of Houston

Date Written: April 7, 2017

Abstract

We investigate the association between material weakness in internal controls (MW) disclosed under Section 302 of SOX and future stock price crash risk. We argue that relative to firms with effective internal controls, firms with MW have lower financial reporting precision. The lower reporting precision (1) increases divergence of investor opinion with regard to firm valuation, and (2) facilitates managers’ withholding of negative information, which increases the information asymmetry between managers and outside investors. We hypothesize that both these effects increase the probability of a future stock price crash. We find empirical evidence consistent with our prediction. In additional analyses, we document that the positive association between MW and crash risk is primarily driven by company-level rather than by account-specific weaknesses, increases in the number of material weaknesses, and intensifies during the financial crisis. Additionally, we find that both the existence and the disclosure of MW incrementally affect crash risk and that MW facilitates managers’ withholding of bad news. Finally, we fail to find consistent evidence of a significant relation between MW disclosed under Section 404 of SOX and crash risk.

Keywords: internal controls, material weakness, financial reporting precision, stock price crash risk

JEL Classification: M42

Suggested Citation

Lobo, Gerald J. and Wang, Chong and Yu, Xiaoou and Yu, Xiaoou and Zhao, Yuping, Material Weakness in Internal Controls and Stock Price Crash Risk (April 7, 2017). Journal of Accounting, Auditing, and Finance, Volume 35, Issue 1, pp. 106-138, 2020, Available at SSRN: https://ssrn.com/abstract=2948698

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

Chong Wang

University of Kentucky ( email )

Lexington, KY 40506
United States

Xiaoou Yu

Xiamen University - Institute for Financial and Accounting Studies ( email )

Xiamen, Fujian 361005
China

California State University, Long Beach - College of Business Administration ( email )

1250 Bellflower Blvd.
Long Beach, CA 90840
United States

Yuping Zhao (Contact Author)

University of Houston ( email )

334 Melcher Hall
Houston, TX 77204
United States
713-743-2166 (Phone)
713-743-4828 (Fax)

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