Market Reaction to Control Deficiency Disclosures Under the Sarbanes-Oxley Act: The Early Evidence
International Journal of Disclosure and Governance, Vol. 4, No. 1, 2007
21 Pages Posted: 15 Feb 2008 Last revised: 4 Mar 2008
Abstract
Sections 302 and 404 of the landmark Sarbanes-Oxley Act require firms to periodically assess and report control deficiencies to the audit committee as well as to the SEC. Section 302 specifically directs company management to identify and report control deficiencies while Section 404 provides the discipline that forces companies to take the control assessment and reporting task seriously. Importantly, external auditors are required to opine separately on the effectiveness of their client's system of internal control over financial reporting and issue an adverse opinion on internal control in the presence of even a single material weakness. Prior to being mandated by the Sarbanes-Oxley Act, management was not required to assess and report on the state of internal controls in their company. Statement on Auditing Standards (SAS) #60, which provided guidance to the external auditors on these matters, afforded them a great deal of flexibility and judgment not only in determining what constituted a reportable condition but also limited their disclosure only to the audit committee of the board. In a recent speech, Donald T. Nicolaisen, the SEC's Chief Accountant, remarks that these new requirements are not only a major financial but also a significant cultural endeavor for registrants in the U.S. and abroad. Consequently, these new requirements have drawn uproar and concern from companies of all sizes and market capitalization. Given the outcry from companies and regulatory assertions that these disclosures are the best thing that has ever happened to the capital markets, we examine whether such control deficiency disclosures convey valuation-relevant information to the market. This issue is important because increasing disclosure requirements without any attendant effect on valuation would impose unnecessary deadweight costs. The disclosures employed in our study were not mandatory under Section 404 at the time our sample firms made them. While there may be many reasons why our sample firms report these deficiencies early, these disclosures may portend the effect to be faced by other firms when the Section 404 rule becomes binding. Consistent with the regulatory assertions, we find that such disclosures are associated with a negative stock price reaction, on average, indicating that such disclosures do indeed convey valuation-relevant information. This reaction is mitigated to some extent, but not fully, if management also discloses that remediation steps have been taken to correct the weaknesses identified in the disclosures. Additionally, the price reaction is less negative for firms employing a Big Four auditing firm. Conversely, the reaction is more negative for firms with larger current liabilities relative to total assets, which suggests that control weaknesses may have implications for increased default risk.
Keywords: Sarbanes-Oxley, Internal Control Deficiencies, Section 404, valuation
JEL Classification: G12, G14, G30, M41
Suggested Citation: Suggested Citation
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