Market Reactions to the Disclosure of Internal Control Weaknesses and to the Characteristics of Those Weaknesses Under Section 302 of the Sarbanes Oxley Act of 2002

Abstract

Under Section 302 of the Sarbanes Oxley Act, officers must evaluate the effectiveness of internal controls quarterly. We examine the stock price reaction to management's disclosure of internal control weaknesses and to their characteristics, controlling for other material announcements are made during the event window. We find evidence suggesting that some characteristics of the internal control weaknesses - their severity, management's conclusion regarding the effectiveness of the controls, their auditability, and how vague the disclosures are - are informative. In subsequent analyses, we find that the relation between returns and auditability holds for significant deficiencies and control deficiencies as well as for material weaknesses. However, the relation between returns and how vague the disclosure is is driven by the observations with material weaknesses. This suggests that the information content of internal control weakness disclosures depends on the severity of the internal control weakness.

Keywords: Internal control weakness, material weakness, market reactions, event study, Sarbanes Oxley Act of 2002

JEL Classification: G14, M41, M42