Securities Fraud Litigation and the Disclosure of Internal Control Material Weakness

• In Event: Internal Control Issues in Fraud

Abstract

We examine the association between the disclosure of internal control material weakness (MW) and securities fraud litigation. Based on our study of 10,106 pooled firm-year observations from 2004 to 2008, we find a significant positive association between MW disclosures and the likelihood of financial reporting lawsuits. In addition, entity-level MW appears to have a greater impact on securities fraud litigation than account-level MW.

We also provide evidence that Sarbanes-Oxley (SOX) section 404 opinions enhance firms’ financial reporting quality by providing investors with a warning signal of potential financial frauds. In market reaction tests, we find that declines in stock price on litigation announcement dates are significantly more severe for MW firms involved in litigation. Our findings suggest that poor internal controls exacerbate investors’ negative perceptions of securities fraud litigation.

Authors

• Yun-Chia Yan, University of Texas-Brownsville

• David Manry, University of New Orleans

• Hua-Wei Huang, National Cheng Kung University

• Wei Jiang, Cal State University - Fullerton