An Analysis of Small Firms’ Internal Control Disclosures

• In Event: Internal Controls

Abstract

We investigate Section 404(a) disclosures of internal control effectiveness by non-accelerated filers. We find that these disclosures are value-relevant, documenting negative price reactions of up to 3.28 percent in the three days around the disclosure of ineffective controls. We also provide an assessment of the accuracy of these disclosures, finding that non-accelerated filers often fail to disclose ineffective controls. We estimate that, among non-accelerated filers, the actual number of firms maintaining ineffective internal controls is 53 percent higher than the number currently reported. This is notably higher than our estimate of misreporting among small accelerated filers that are subject to 404(b) of 39 percent, indicating that 404(b) would curb a substantial amount of this misreporting. Further, we document systematically lower earnings quality among potential misreporters than firms that also report effective internal controls but are not suspected of misreporting, suggesting that investors would benefit from knowing which firms maintain ineffective internal controls. Our findings suggest that Section 404(b) provides a significant incremental benefit over Section 404(a) by improving the accuracy of internal control disclosures.

Authors

• Allison Koester, Georgetown University

• Weili Ge, University of Washington-Seattle

• Sarah E McVay, University of Washington-Seattle