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The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity

61 Pages Posted: 20 Apr 2006 Last revised: 7 Nov 2008

Hollis Ashbaugh Skaife

Graduate School of Management, UC-Davis

Daniel W. Collins

University of Iowa - Department of Accounting

William R. Kinney, Jr.

University of Texas at Austin - Department of Accounting

Ryan LaFond

Algert Global, LLC

Date Written: June 10, 2008

Abstract

The Sarbanes-Oxley Act (SOX) mandates management evaluation and independent audits of internal control effectiveness. The mandate is costly to firms but may yield benefits through lower information risk that translates into lower cost of equity. We use unaudited pre-SOX 404 disclosures and SOX 404 audit opinions to assess how changes in internal control quality affect firm risk and cost of equity. After controlling for other risk factors, we find that firms with internal control deficiencies have significantly higher idiosyncratic risk, systematic risk, and cost of equity. Our change analyses document that auditor-confirmed changes in internal control effectiveness (including remediation of previously disclosed internal control deficiencies) are followed by significant changes in the cost of equity that range from 50 to 150 basis points. Overall, our cross-sectional and inter-temporal change test results are consistent with internal control reports affecting investors' risk assessments and firms' cost of equity.

Keywords: Sarbanes-Oxley Act, Firm risk, Cost of Equity

JEL Classification: G12, G18, G34, G38, M41, M45, M49

Suggested Citation

Skaife, Hollis Ashbaugh and Collins, Daniel W. and Kinney, Jr., William R. and LaFond, Ryan, The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity (June 10, 2008). Journal of Accounting Research, Forthcoming 2008. Available at SSRN: https://ssrn.com/abstract=896760

Hollis Ashbaugh Skaife

Graduate School of Management, UC-Davis ( email )

Graduate School of Management
1 Shields Ave
Davis, CA 95616
United States

Daniel W. Collins (Contact Author)

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
319-335-0912 (Phone)
319-335-1956 (Fax)

William Kinney

University of Texas at Austin - Department of Accounting ( email )

Austin, TX 78712
United States
512-471-3632 (Phone)
512-471-3904 (Fax)

Ryan LaFond

Algert Global, LLC ( email )

One Maritime Plaza
Suite 1525
San Francisco, CA 94111
United States

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