Internal control reporting and market liquidity

We investigate the impact of the Sarbanes-Oxley Act of 2002 (SOX) on information asymmetry by analyzing the relation between SOX Sections 302 and 404 control reports and market liquidity using bid-ask spreads. Lower market liquidity indicates higher levels of information asymmetry implying that market participants perceive financial statement misstatement risk is higher. If SOX disclosures contain relevant information, then one would expect firms reporting internal control material weaknesses to have lower market liquidity. Accordingly, we find that market liquidity is lower (i.e., bid-ask spreads are higher) for firms reporting ineffective control compared to firms reporting effective control using either annual SOX 404 internal control reports or quarterly SOX 302 disclosure control reports, which suggests that SOX 302 and 404 reports provide useful information for identifying firms with a higher risk of financial statement misstatement. However, we do not find consistent results using two alternative liquidity measures: trading volume and market quality indices. We then examine whether changes in control reports are associated with changes in market liquidity. We generally do not find that firms with improved (deteriorated) control reports experience a larger decrease (increase) in bid-ask spreads or larger increases (decreases) in trading volume and market quality indices compared to other firms, suggesting that market participants do not discern a change in information asymmetry when the effectiveness of internal controls over financial reporting changes.     

Do Control Effectiveness Disclosures Require SOX 404(b) Internal Control Audits? A Natural Experiment with Small U.S. Public Companies

We use incremental and joint implementation of multiple SOX‐based control effectiveness disclosure and audit mandates to assess relative performance of alternatives for small U.S. public companies. Using data from several low‐ and high‐effort management disclosure and audit regimes implemented from 2003 to 2008, we find substantial and statistically significant increases in material weakness disclosure rates for small firms undergoing initial SOX 404(b) internal control audits, but find quantitatively and statistically similar increases for initial management reports of small firms exempt from such audits. As to audit cost, fees more than double for initial 404(b) audits in 2004 and remain high, while 404(b)‐exempt firms’ fees grow about 10% annually. Our results support the view that, for small firms, management internal control reports and traditional financial audits may be a cost effective disclosure alternative to full application of SOX 404(b). Also, our results suggest that, even without management reports on internal control, analysis of the cause of known accounting mistakes may yield substantial material weakness disclosures.     

How Effective Is Internal Control Reporting under SOX 404? Determinants of the (Non‐)Disclosure of Existing Material Weaknesses

We study determinants of internal control reporting decisions under Section 404 of the Sarbanes‐Oxley Act (SOX 404) using a sample of restating firms whose original misstatements are linked to underlying control weaknesses. We find that only a minority of these firms acknowledge their existing control weaknesses during their misstatement periods, and that this proportion has declined over time. Further, the probability of reporting existing weaknesses is negatively associated with external capital needs, firm size, non‐audit fees, and the presence of a large audit firm; it is positively associated with financial distress, auditor effort, previously reported control weaknesses and restatements, and recent auditor and management changes. These results provide evidence that detection and disclosure incentives play a role in whether existing material weaknesses are reported, which has implications for the effectiveness of SOX 404 in providing investors with advance warning of potential accounting problems.     

The implications of ineffective internal control and SOX 404 reporting for financial analysts

The mandatory reporting of firms’ internal control effectiveness continues to be debated by equity market participants, U.S. regulatory agencies and oversight committees. We investigate the implications of material weaknesses in internal control and SOX 404 required reporting of such for financial analysts because analysts are important intermediaries in the U.S. capital market and it is not known whether analysts’ forecasts or coverage decisions are affected by firms’ internal control problems or reporting, respectively. Results of our empirical tests indicate that analysts provide less accurate forecasts and there is greater forecast dispersion for firms with ineffective internal control. We also find that firms that disclose internal control problems have less analyst coverage and that analyst following declines after the material weakness in internal control is disclosed. The results are robust to controlling for potential self-selection bias and management earnings guidance. Our study documents the consequences of ineffective internal control for an important class of financial statement users and suggests the required reporting on the effectiveness of internal control is beneficial to understanding the properties of analysts’ forecasts.     

Firm Characteristics and Stock Price

This study examines the stock price reaction to the internal control reporting required under Section 404 of the Sarbanes‐Oxley Act of 2002 for three distinct groups of firms. After controlling for general stock price movements, we find that stock returns are most negative for firms that delay filing of their internal control reports, continue to be negative for firms with ineffective internal controls, and are positive for firms with effective internal controls. The decrease in stock prices of the first two groups is more pronounced for those with a lower return on assets, higher growth rate in sales, and no prior disclosure of their internal controls weaknesses. Our results indicate that market participants value the reliability of financial information ensuing from Section 404 compliance, irrespective of firm size and debt proportion. Thus, regulators and policymakers worldwide should consider mandating comparable SOX 404 compliance for all publicly held companies to improve the accuracy and reliability of financial reports.     

IT internal control weaknesses and firm performance: An organizational liability lens

The information systems literature and the public press have called for organizations to more closely scrutinize their information technology (IT) controls; however, little more than anecdotal evidence exists on the business value of quality IT internal control, beyond regulatory compliance. In this paper, we (a) advance an organizational liability perspective to the question of IT internal control value; and (b) use the unique setting provided by the enactment of the Sarbanes–Oxley Act of 2002 (SOX) to investigate the relationship between IT internal control weaknesses (ICWs) and both accounting earnings (a contemporaneous measure of firm performance) and market value (a forward looking, risk-adjusted measure of firm performance). Using a data set that provides audited annual assessments of the effectiveness of both IT and non-IT internal controls for a cross-section of companies as mandated by SOX, we find that firms that report an IT ICW have lower accounting earnings compared to firms with strong IT internal controls. We also find that IT ICW moderates the association between accounting earnings and market valuation, with firms reporting weak IT internal controls having a lower earnings multiple. These results are sustained even after controlling for non-IT ICWs and firm-specific factors that are known determinants of ICWs, and are reinforced using an inter-temporal changes analysis in which we use each firm as its own control at a different point in time. Overall, our results provide empirical evidence which suggests that IT internal controls are a strategic necessity and that information systems risk is priced by the capital markets. The implications of these findings for theory and practice are discussed.     

Corporate derivatives use and the cost of equity

We investigate the relation between derivatives use and corporations’ cost of equity capital. Using a large sample of non-financial firms, we compute and analyze (i) the relative cost of equity of firms that use derivatives and those that do not; and (ii) the change in cost of equity experienced by firms initiating derivatives programs. We find that the cost of equity of derivatives users is lower than non-users by 24-78 basis points. Our results are robust to specifications that account for potential endogeneity related to a firm’s derivatives use and capital structure decisions. We further find that the reduction in the cost of equity is attributable to both lower market beta and SMB beta, suggesting that firms use derivatives to reduce their financial distress risk and that this distress risk has a systematic component that is priced in the market. Finally, the observed reductions in the cost of equity tend to be largest for smaller firms and for firms utilizing currency and interest rate derivatives.     

Stock price crash risk and internal control weakness: presence vs. disclosure effect

This study examines the stock price crash risk for a sample of firms that disclosed internal control weaknesses (ICW) under Section 404 of the Sarbanes‐Oxley Act (SOX). We find that in the year prior to the initial disclosures, ICW firms are more crash‐prone than firms with effective internal controls. This positive relation is more pronounced when weakness problems are associated with a firm's financial reporting process. More importantly, we find that stock price crash risk reduces significantly after the disclosures of ICWs, despite the disclosure itself signalling bad news. The above results hold after controlling for various firm‐specific determinants of crash risk and ICWs. Using an ICW disclosure as a natural experiment, our study attempts to isolate the presence effect of undisclosed ICWs from the initial disclosure effect of internal control weakness on stock price crash risk. In so doing, we provide more direct evidence on the causal relation between the quality of financial reporting and stock price crash risk.     

Internal control weaknesses and evidence of real activities manipulation

We examine whether US public firms that file internal control weakness (ICW) disclosure reports with the Securities and Exchange Commission, as part of the reporting requirements under Section 404 of the Sarbanes–Oxley (SOX) Act, exhibit higher levels of real activities manipulation (RM), compared to firms that do not file such reports. Using firm-level data for the post-SOX period, 2004–2010, we find a positive relationship between firms reporting internal control weaknesses and real activities manipulation. Further, those ICW-firms that use RM to beat earnings benchmarks have lower performance in the subsequent year. Our results also show that firms do not use discretionary accruals as a substitute for RM when they report internal control weaknesses. Overall, our findings suggest that ICW-firms are prone to using real activities manipulation as a form of earnings management. Our findings also have implications for audit quality as auditors need to gain a better understanding of how real activities manipulation influences the operations of the firm.     

Increased Disclosure Requirements and Corporate Governance Decisions: Evidence from Chief Financial Officers in the Pre‐ and Post–Sarbanes‐Oxley Periods

I study how increased internal control disclosure requirements mandated by the Sarbanes‐Oxley Act (SOX) affect annual corporate governance decisions regarding CFOs. Using non‐CEO, non‐COO executive officers as a control group, I find that CFOs of firms with weak internal controls receive lower compensation and experience higher forced turnover rates after the passage of SOX. In contrast, CFOs of firms with strong internal controls receive higher compensation and do not experience significant changes in forced turnover rates. These results are consistent with the “disclosure of type” hypothesis, which suggests that the mandatory internal control disclosures under SOX are a credible mechanism that effectively distinguishes good CFOs from bad ones by revealing the firm's internal control quality. The empirical evidence thus supports the notion that mandated increases in disclosure reduce information asymmetry in the executive labor market.     

The robustness of the Sarbanes Oxley effect on the U.S. capital market

We examine the incidence of new listings and delistings on U.S. stock exchanges and firms’ propensity to delist, as a function of general market conditions, firm fundamentals, and the costs of compliance with the Sarbanes Oxley Act (SOX). We find that both general market conditions and firm fundamentals explain the delisting incidence and firms’ delisting decisions; while SOX variables are positively associated with firms’ delisting likelihood only when general market conditions are not included in the analyses. Further analyses on the population partitioned into size quintiles suggest that the passage of SOX was not associated with an increase in the likelihood of delisting for any size quintile of firms and that the implementation of SOX section 404 is positively associated with the delisting likelihood for midsized and larger firms. Our empirical evidence is useful to regulators as they consider changes in the imposition and implementation of SOX section 404.     

The effect of external audits of internal control over financial reporting on financial reporting for clients of Big 4, Second-tier,and small audit firms

The external audit of internal control over financial reporting (ICFR) is a very expensive and contentious aspect of the Sarbanes–Oxley Act (SOX). Larger public firms were first required to file a management report on and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the audit requirement. Whereas most related prior research investigates the combined effect of management and auditor reports on financial reporting, this study examines the distinct effect of auditor reports on reporting quality. For companies audited by small auditors, we find evidence that financial reporting quality improves with an auditor report on ICFR. We find no evidence that auditor ICFR reports improve reporting quality for clients of Big 4 or Second-tier audit firms. Our study adds to the debate on the applicability of SOX Section 404 to smaller firms.     

Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation: Evidence from the Sarbanes‐Oxley Act

This paper provides evidence about the unintended consequences arising when small companies are exempted from costly regulations—these firms have incentives to stay small. Between 2003 and 2008, the SEC postponed compliance with Section 404 of the Sarbanes‐Oxley Act of 2002 (SOX) for “non‐accelerated filers” (firms with public float less than $75 million). We hypothesize and find that some of these firms had an incentive to remain below this bright line threshold. Moreover, we document that these firms remained small by undertaking less investment, making more cash payouts to shareholders, reducing the number of shares held by non‐affiliates, making more bad news disclosures, and reporting lower earnings than control firms. Finally, there is no evidence that firms remaining small are doing so to maintain insiders' private control benefits. These findings have implications beyond SOX because numerous federal and state regulations exempt small firms via bright line size thresholds.     

Effects of SOX 404(b) implementation on audit fees by SEC filer size category

This study provides novel information about the consequences of the Sarbanes-Oxley Act (SOX) by documenting differential audit fee shocks accompanying implementation of SOX 404(b) internal control tests and reports for clients in three size categories: large accelerated filers (LAFs), small accelerated filers (SAFs), and non-accelerated filers (NAFs). First, we find that although both LAFs and SAFs experience audit fee shocks attributable to 404(b), SAFs on average experience relatively greater fee shocks than LAFs (107.8% versus 84.6%; Table 6). Second, even though NAFs are not subject to 404(b) procedures, we document a 42.7% fee shock for NAFs. Our interpretation is that 404(b) generated an immediate increase in demand for audit services with no corresponding sudden increase in supply of experienced audit personnel, enabling audit firms to charge higher prices for all filers including NAFs. We find that audit fee shocks attributable to 404(b) are positively associated with audit offices’ bargaining power relative to clients, and that the effect of offices’ bargaining power is strongest for SAFs and weakest for NAFs. Although higher audit fees (with client characteristics held constant) are often considered an indicator of better audit quality, we find virtually no evidence that the massive fee increases in 2004 are accompanied by improvements in same-year or next-year audit quality, measured as decreases in discretionary accruals and a lower likelihood of subsequent restatements of audited financial reports.     

The effect of internal control and risk management regulation on earnings quality: Evidence from Germany

We investigate the impact of mandatory internal control and risk management (ICRM) reform on earnings-based attributes of accounting quality in Germany. Although prior studies examine changes in accounting quality under SOX Sections 302 and 404, there is scant evidence of the accounting quality effects of ICRM reform in foreign jurisdictions. Such evidence is warranted given the ongoing global policy debate of ICRM reform in the post-SOX era. We extend existing research by examining changes in earnings quality following the 1998 German legislation on control and transparency (KTG). The KTG regime provides a unique setting in which the regulatory scope extends beyond internal control over financial reporting (ICFR) to include broad business and enterprise risk control. Using both a differences and difference-in-differences research design, we find that German firms experience an increase in timely loss recognition and a decrease in earnings smoothing after KTG. We also find some evidence of a decrease in loss avoidance behavior. Additional analyses show that the sensitivity of capital investment efficiency to earnings quality increases in the German market after KTG, suggesting that earnings quality effects of mandatory ICRM reform has positive consequences for capital resource allocation. Together, our results are consistent with the achievement of one of the intended outcomes of ICRM regulation—increased accounting quality through effective ICRM systems.     

Multiple large shareholders, control contests, and implied cost of equity

In this paper, we examine whether the presence of multiple large shareholders alleviates a firm's agency costs and information asymmetry manifested in the cost of equity financing. Using data for 1165 corporations from 8 East Asian and 13 Western European countries, we find evidence that the implied cost of equity decreases with the presence, number, and voting size of large shareholders beyond the controlling owner. We also find that the identity of the second largest shareholder is important in determining the risk of corporate expropriation in family-controlled firms. Our regional analysis reveals that, mainly in East Asian firms, multiple large shareholders structures exert an internal governance role in curbing private benefits and reducing information asymmetry, perhaps to sidestep deficiencies in the external institutional environment.     

The role of strategic enterprise risk management and organizational flexibility in easing new regulatory compliance

The impact of new regulatory requirements for internal control reporting on an organization's ability to maintain strategic flexibility has been debated in the popular press extensively. This paper tests theory from strategic management to examine the relationship between an organizations' pre-regulatory strength of strategic enterprise risk management (ERM) processes and their ability to react to new regulatory mandates. In the context of companies' adoption of SOX Section 404 internal control reporting requirements, we examine organizations' pre-SOX ERM processes, ERM supporting technologies, and organizational flexibility in order to better understand the antecedents to the difficulty encountered in meeting SOX 404 requirements. Using responses from 113 Chief Audit Executives (CAEs), we find that organizations with stronger strategic ERM processes and flexible organizational structures already in place incurred little difficulty in implementing SOX 404 mandates. On the other hand, organizations using weaker ERM processes, which focused on control compliance, experienced more difficulty. These findings provide key insights into the importance of strategic ERM in effectively complying with new regulatory controls in volatile environments.     

Do investors perceive a change in audit quality following the rotation of the engagement partner?

Though Section 203 of the Sarbanes-Oxley Act (SOX) calls for the rotation of the audit partner every five years, we do not know whether investors value audit partner rotation. This is an important issue since many in the auditing profession believe that mandatory rotation of the audit partner is unnecessary and may in fact impair audit quality. We identify a sample of firms that disclosed changes in the engagement partner in the proxy statement and examine whether equity investors perceive a change in audit quality following the partner rotation. We find a significant increase in earnings informativeness following audit partner rotation. We also find that short sellers regard earnings in the post-rotation to be of higher quality than earnings prior to the rotation. Finally, cost of equity capital is lower following partner rotation. Our findings have important implications for the regulators, auditors, and investors.     

Does the value of cash holdings deteriorate or improve with material weaknesses in internal control over financial reporting?

We find that cash holdings are more valuable for firms disclosing material weaknesses in the Sarbanes–Oxley (SOX) 404 internal control assessments. We estimate that the value spread for firms with weak controls vs. effective controls is about $0.25 for an extra dollar of cash. Our results are not driven by account-level weaknesses but by more severe, company-level weaknesses in internal control over financial reporting (ICFR). Further, the economic consequences of cash resources significantly decrease with the remediation of previously reported material weaknesses. These results suggest that the favorable (precautionary) impact induced by weak ICFR appears to more than offset the adverse (agency) effect entailed by ineffective ICFR. Overall, our results survive alternative variable specifications, sample splits, matched sample analyses, and a variety of controls.     

Dynamic internal control performance over financial reporting and external financing

In this paper, we present a theoretical model and empirical evidence on the effects of dynamic internal control performance on external financing choices of a company. Using both within-sample and difference-in-difference analysis, we find that after issuing internal control weakness (i.e. ICW) reports under SOX 404, the ICW companies rely more on debt financing and less on equity financing than in previous periods. This effect is more pronounced for the companies with low ex ante probability of internal control weakness. In addition, we show that after correcting the previously reported ICWs, these ICW companies rely more on equity as opposed to debt financing. This result is more pronounced for smaller companies. Our findings suggest that increased (decreased) information asymmetry induced by ineffective (effective) internal control over financial reporting leads a company to follow specific external financing choices to meet its financial deficits.