Material Weakness in Internal Control and Stock Price Crash Risk: Evidence from SOX Section 404 Disclosure

• In Event: Financial Accounting & Reporting III - Corporate Governance and Corporate Social Responsibility (100 mins)

Abstract

This study investigates the hitherto unexplored questions of whether and how the presence of undisclosed internal control weaknesses (ICWs) and their initial disclosure differentially influence the likelihood that extreme negative outliers occur in firm-specific return distributions, which we refer to as stock price crash risk. We predict and find that firms with ICW problems are more crash-prone than firms with effective internal controls. We also find that stock price crash risk is greater for fraud-related ICWs. We provide strong evidence that the positive association between ICWs and crash risk is observed at least two years prior to the initial disclosure of the ICW. More importantly, we find that the positive association gradually decreases over the two-year period following the disclosure and essentially disappears after publicly disclosed ICW problems are remediated. The above results hold after controlling for various firm-specific determinants of crash risk and ICWs. Overall, our results suggest that the presence of undisclosed ICWs tends to exacerbate managers’ bad news hoarding until the ICW problems are disclosed to the public, which increases crash risk. On the other hand, public disclosure of ICWs constrains managerial incentive and ability to withhold bad news from outside investors, thereby mitigating crash risk.

Author

• Jie Zhou, National University of Singapore