Characteristics of Firms with Material Weaknesses in Internal Control: An Assessment of Section 404 of Sarbanes Oxley

32 Pages Posted: 4 Apr 2005

See all articles by Stephen H. Bryan

Stephen H. Bryan

Wake Forest University

Steven B. Lilien

City University of New York (CUNY) - Stan Ross Department of Accountancy

Date Written: March 2005

Abstract

The legislation known as Sarbanes Oxley (SOX) requires firms to assess their internal controls over financial reporting and to report material weaknesses, as defined by the Public Accounting Oversight Board. Based upon early evidence, we find that firms with material weaknesses are, on average, both smaller and worse performers than their matched industry counterparts. We also find that firms with material weaknesses, on average, have higher betas, suggesting a higher discount by the market for these firms. From a macro-economic view, the total market value of firms with reported material weaknesses is only 1.28% of the market value of the S&P 500 firms. Finally, although we document negative stock returns on the date of the announcement of the material weakness, over a narrow interval, the returns are insignificant.

Identifying small firms that collectively constitute a minor portion of the economy at a very high cost to all public firms seems out of balance. Whether SOX will yield benefits to corporations through better operations, reduced cost of capital, or other means remains to be seen. Moreover, if these benefits materialize, whether they should, in effect, be legislated is a matter of debate. Although some maintain that SOX will reduce earnings management, firms continue to manage earnings through pro forma earnings. Furthermore, although the SEC's Reg G, also enacted as part of SOX legislation, makes the "managed disclosure system" through pro forma earnings more transparent, it fails to exercise control over the reconciliation process that firms use both to set and to meet analyst earnings estimates.

Keywords: Sarbanes Oxley, Section 404, Internal Control

JEL Classification: M41, M43, M49, G12, G34, G38

Suggested Citation

Bryan, Stephen H. and Lilien, Steven B., Characteristics of Firms with Material Weaknesses in Internal Control: An Assessment of Section 404 of Sarbanes Oxley (March 2005). Available at SSRN: https://ssrn.com/abstract=682363 or http://dx.doi.org/10.2139/ssrn.682363

Stephen H. Bryan

Wake Forest University ( email )

7659 Reynolda Station
Winston-Salem, NC 27106
United States
336-758-3671 (Phone)

Steven B. Lilien (Contact Author)

City University of New York (CUNY) - Stan Ross Department of Accountancy ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States
646-312-3163 (Phone)
646-312-3161 (Fax)

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