Internal Control Weaknesses and Information Uncertainty

TLDR

The study examines 330 firms’ Section 302 unaudited disclosures and 383 firms’ Section 404 audited disclosures under Sarbanes‑Oxley. Section 302 disclosures are associated with a −1.8 % abnormal return and a 68‑basis‑point rise in cost of capital, signaling lower credibility, while Section 404 disclosures have no significant price or cost‑of‑capital effect; auditor quality mitigates the negative reaction to Section 302, and accelerated filers experience smaller adverse returns, suggesting that material‑weakness disclosures are more informative for smaller firms with higher pre‑disclosure uncertainty.

Abstract

We analyze a sample of 330 firms making unaudited disclosures required by Section 302 and 383 firms making audited disclosures required by Section 404 of the Sarbanes-Oxley Act. We find that Section 302 disclosures are associated with negative announcement abnormal returns of −1.8 percent, and that firms experience an abnormal increase in equity cost of capital of 68 basis points. We conclude that Section 302 disclosures are informative and point to lower credibility of disclosing firms' financial reporting. In contrast, we find that Section 404 disclosures have no noticeable impact on stock prices or firms' cost of capital. Further, we find that auditor quality attenuates the negative response to Section 302 disclosures and that accelerated filers—larger firms required to file under Section 404—have significantly less negative returns (−1.10 percent) than non-accelerated filers (−4.22 percent). The findings have implications for the debate about whether to implement a scaled securities regulation system for smaller public companies: material weakness disclosures are more informative for smaller firms that likely have higher pre-disclosure information uncertainty.