The Impact of Internal Control Weaknesses on Equity Market Investors: Evidence from Short Sellers

• In Event: Corporate Control Systems and Financial Misreporting

Abstract

The empirical findings on the equity market effect of internal control weaknesses (ICW) disclosure remain mixed (Kim et al., 2011). In this study we focus on one mechanism through which ICW might influence equity market - the trading activities of short sellers. We examine whether short sellers accumulate positions in firms that are about to disclose ICW under Sarbanes-Oxley, Section 404 for the first time. We find negative abnormal returns, around severe ICW revelation events, and correspondingly, a short interest build-up prior to the events. We show that the short interest build-up cannot be explained by parameters associated with ICW. Further, short sellers’ ICW prediction power is more pronounced in firms with poor information environment, and cannot be attributed to leakage of information through insiders. Overall, we present evidence on short sellers’ ability to predict and trade on ICW disclosures, and establish a path through which ICW impacts equity investors.

Authors

• Zvi Singer, McGill University

• Yan Wang, McGill University

• Jing Zhang, McGill University