Internal Control Weakness and Cost of Equity: Evidence from Sox Section 404 Disclosures

Abstract

Section 404 of the Sarbanes-Oxley Act (SOX) requires every company to report on the effectiveness of internal controls over financial reporting. Section 404 has arguably been the most controversial provision of SOX, with many registrants complaining that the high cost of compliance outweighs its benefits. In contrast, the SEC and others have argued that the Section 404 provisions are beneficial to the capital markets and will eventually reduce the cost of capital. In this paper, we examine the association between implied cost of equity and internal control effectiveness for firms that filed Section 404 reports with the SEC. We find marginally higher cost of equity for firms disclosing material weakness in internal controls than for a sample of firms disclosing no material weaknesses. The differences in cost of equity disappear after controlling for firm characteristics associated with firms disclosing material weaknesses. Overall, our results are consistent with internal control weakness identified under Section 404 not being directly associated, on average, with higher implied cost of equity.

JEL Classification: G12, G34, G38