Doi 10.1111 - Jbfa.12015

Journal of Business Finance & Accounting
Journal of Business Finance & Accounting, 40(3) & (4), 318–349, April/May 2013, 0306-686X
doi: 10.1111/jbfa.12015
Financial Reporting Quality, Structural

Problems and the Informativeness of
Mandated Disclosures on Internal
Controls
ALOKE (AL) GHOSH AND YONG GYU LEE*
Abstract: Even before firms report internal control weaknesses under the Sarbanes–Oxley Act
(SOX), they are characterized by structural problems, are prone to internal control weaknesses,
and have low financial reporting quality. If the stock market incorporates much of this
information during the pre-disclosure years, investors are less surprised when firms subsequently
report internal control weaknesses under SOX. We find that for the pre-disclosure period,
firms reporting internal control weaknesses under SOX, (1) had structural problems, (2) were
prone to internal control problems, and (3) had low financial reporting quality. Further, we
provide direct evidence that stock prices during pre-disclosure years incorporate much of the
information about structural problems, the likelihood of internal control weaknesses, and low
reporting quality. Finally, we find that many of these value-relevant factors are not related
to announcement period returns when firms eventually disclose such problems under SOX
and that limited new information about structural problems is generated around this date.
Our results provide a compelling explanation for the muted stock price reaction around the
mandatory disclosure date.
Keywords: Sarbanes–Oxley Act of 2002, internal control weakness, market reactions, financial
reporting quality
1. INTRODUCTION
Understanding the determinants of financial reporting quality is one of the fundamen-
tal issues in accounting research (Costello and Wittenberg-Moerman, 2011). Factors
∗ The authors are from the Stan Ross Department of Accountancy, Zicklin School of Business, Baruch
College, City University of New York. An earlier version of this paper was circulated under the title
“Timeliness and mandated disclosures on internal controls under Section 404.” We acknowledge helpful
comments from Sara Berman, Peter Joos, Ryan Lafond, Martien Lubberink, Shamin Mashruwala, Hugo
Nurnberg, John O’Hanlon, Ken Peasnell, Stephen Penman, Gil Sadka, Jan Sweeney, Bob Tucker, Yuan
Zhang, Jerry Zimmerman, participants at the Katholieke Universiteit Leuven accounting research workshop
and participants at the American Accounting Association Meetings. (Paper received August, 2011, revised
version accepted December, 2012).
Address for correspondence: Aloke (Al) Ghosh, Stan Ross Department of Accountancy, Zicklin School of
Business, Baruch College, City University of New York, 55 Lexington Avenue, New York, NY 10010, USA.
e-mail: Aloke.Ghosh@baruch.cuny.edu

C 2013 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA. 318

INFORMATIVENESS OF INTERNAL CONTROL DISCLOSURES 319
that govern financial reporting quality include internal and external monitoring
mechanisms. While there is extensive research on the linkages between disparate
monitoring mechanisms and reporting quality, the literature on internal control over
financial reporting and internal monitoring mechanisms (Goh and Li, 2011; and
Johnstone et al., 2011) has grown considerably over the last decade largely as a
consequence of regulatory intervention in the US (see Schneider et al., 2009 for
a review). The disclosures under the Sarbanes–Oxley Act of 2002 (SOX) provide
valuable data for researchers to use exploring areas that were previously limited
because internal control data were not easily available.1
The academic literature on internal control over financial reporting can be
broadly classified into two categories.2 One branch focuses on the causes of internal
control problems and the key attributes associated with weak internal-control firms
(Ashbaugh-Skaife et al., 2007; Doyle et al., 2007a; Ogneva et al., 2007; Naiker and
Sharma, 2009; and Hoitash et al., 2009). Another branch examines the consequences
of internal control disclosures including stock market reactions (Beneish et al., 2008;
and Hammersley et al., 2008), earnings quality (Doyle et al., 2007a; Ogneva et al.,
2007; Ghosh et al., 2010; and Goh and Li, 2011), and the cost of capital (Ashbaugh-
Skaife et al., 2007; Ogneva et al., 2007; and Beneish et al., 2008). In particular, prior
market-based studies find a muted stock market reaction to the announcement of
weaknesses in internal controls (e.g., Beneish et al., 2008; and Hammersley et al.,
2008). In this study, we investigate explanations of why the stock market reaction
to internal control disclosures is muted by drawing on the literature on the causes
of internal controls. Because structural problems lead to internal control problems,
and many of the structural problems are priced by investors prior to firms reporting
such problems, internal control disclosures provide limited new information. Thus,
we contribute to the internal control literature by providing a direct linkage between
the studies that examine the causes of internal controls and those that focus on the
consequences of internal controls.
The disclosures on the effectiveness of internal controls over financial reporting,
required under Sections 302 and 404 (§302 and §404, respectively, hereafter) of
SOX are expected to provide new information about the reliability of financial
statements (SEC, 2003).3 Contrary to these claims, stock market reaction around the
time of the mandated disclosures on internal controls is generally weak. For instance,
Hammersley et al. (2008) and Beneish et al. (2008) find that the mean abnormal
stock returns for firms reporting material weaknesses in internal controls under §302
1 The US Congress passed the Sarbanes–Oxley Act which mandated the evaluation and disclosures of the
effectiveness of internal controls by public firms and an external audit of the management’s representation
of the effectiveness of internal control (Kinney and Shepardson, 2011).
2 Internal control over financial reporting is a process which provides reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements. Because firms with internal
control problems have more than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected, financial statements are less reliable when firms have
weak internal controls (PCAOB, 2004).
3 Because weak internal controls lead to low financial reporting quality, disclosures of internal control
weaknesses under SOX might provide new information about the firms’ financial reporting quality.
Similarly, since weak internal controls are associated with persistent structural problems, internal control
weaknesses under SOX might indicate that these firms have fundamental problems which were previously
unknown to the market.

C 2013 Blackwell Publishing Ltd
320 GHOSH AND LEE
are economically small (between 0.5 and 2%), but statistically significant.4 Beneish
et al. (2008) find no evidence to suggest that the stock market reacts negatively to
material weaknesses in internal controls under §404. In contrast, Ashbaugh-Skaife
et al. (2009) find a statistically significant stock market reaction, but the magnitude
is less than 1%. The median numbers are generally insignificant or not reported in
these studies. Finally, while a few studies find a relationship between stock market
reaction and the severity of the internal control problems (Hammersley et al., 2008),
others find no such evidence (Beneish et al., 2008).
We provide several inter-related explanations for the muted stock market reac-
tion to the announcement of internal control problems under SOX. First, firms
with weak internal controls are associated with structural problems ranging from
changes in the organizational structure, complexity/scope of operations, intricate
business transactions, and operating in diverse markets (Ashbaugh-Skaife et al., 2007).
Because firms tend to develop structural problems over time, and remediation of
these problems can be prolonged, some of the structural problems associated with
firms having weak internal controls might have pre-dated the mandated disclosure
period. Therefore, investors might be able to assess whether firms have structural
problems from observable attributes including changes in organizational structure,
firm performance, financial health, and complexity of business transactions.
Second, it is possible for investors to discriminate, at least partially, between firms
with weak and strong internal controls even in the absence of mandated disclosures.
Prior studies find that firms with material weaknesses in internal controls are smaller,
less profitable, growing rapidly, more complex, take large restructuring charges, and
have frequent auditor changes (Doyle et al., 2007a; and Krishnan, 2005). Therefore,
investors can rationally assess which firms are more likely to encounter internal control
problems based on observable firm attributes over the pre-disclosure period.
Third, firms with weak internal controls have low financial reporting quality because
of errors in the estimation of accruals and management injected biases (Ashbaugh-
Skaife et al., 2007; and Doyle et al., 2007b). The low financial reporting quality
is also likely to have pre-dated the mandated disclosure period. If firms reporting
internal control weaknesses under SOX were also prone to such problems prior to the
disclosure period, earnings quality is also expected to be low for this period. Further,
some of the structural problems that are key reasons for firms developing internal
control problems are also factors that erode earnings quality.
Our fundamental hypothesis is that most of the information about structural
problems, latent internal control problems, and low financial reporting quality is
expected to be incorporated in the stock price during the pre-mandated disclosure
years. Therefore, market participants are less surprised when firms subsequently report
internal control weaknesses under SOX. Figure 1 provides a chart presenting the
linkages among firm-specific attributes, the likelihood of having internal control
problems, and financial reporting quality, and their effects on the stock price for the
pre- and post-disclosure periods.
4 Using the median (mean) market value of equity reported for the sample of firms with material
weaknesses in internal controls in Beneish et al. (2008) as a benchmark, mean abnormal returns of around
2% over a three-day window translate into a loss of US$ 55,522 (US$ 5,428) for shareholders, which appears
to be economically small.

Figure 1
Firms with Internal Control Weaknesses: Linkages between Disclosure and
Pre-Disclosure Periods
Firms reporting internal control weaknesses under SOX
Pre-disclosure period (2002) Disclosure period (2003–2007)
Explanations for weak stock market reaction to disclosures on internal controls
Internal Control Problems

- High probability
Stock Market Pricing

- Some market reaction to
Disclosures on Internal Controls
Structural Problems structural problems, high
- Weak stock market reaction
- Firm attributes probability of internal
control problems, and low
financial reporting quality
Financial Reporting Quality
- Low
We provide insights into the related hypotheses using the following methodology.
First, we examine whether the attributes that are associated with internal control
weaknesses pre-date the disclosures under SOX (“firm attributes test”). Second, we test
whether firms reporting internal control problems under SOX are prone to internal
control problems for the pre-disclosure period compared to other firms without such
problems (“control problems test”).5 Third, we investigate whether firms reporting
internal control weaknesses under SOX had low financial reporting quality for the
pre-disclosure years (“reporting quality test”).
Finally, and more importantly, we examine whether investors incorporated firm
attributes, high likelihood of internal control problems, and low financial reporting
quality into security prices for the pre-disclosure years (“market pricing test”). We
decompose the time period leading up to the announcement of internal control
problems under SOX into three sub-periods: (1) pre-disclosure year, i.e., 2002; (2)
the interim period between 2002 and the year before the announcement date;
and (3) the announcement date. If the stock market incorporated much of the
information before the announcement date, the stock price over the pre-disclosure
and interim years is expected to be associated with pre-existing problems including
structural problems, latent internal control problems, and low financial reporting
quality. Further, these factors are unlikely to be associated with the stock market
reaction to the announcement of internal control weaknesses if such information has
already been incorporated in the stock price.
Our results are based on a sample of 672 distinct firms that reported material
weaknesses under §302 or §404 for fiscal years 2003–2007. Prior studies document
that firms reporting internal control weaknesses under SOX were associated with
complex operations, age of the firm, poor performance, poor financial health,
5 We model the probability of internal control problems based on firm attributes, such as complexity,
performance, financial health, size, growth, auditor characteristics, restatement, and litigious industries,
using data from the mandated disclosure period (2003–2007) and then estimate an ‘implied’ probability
of internal control problems for the pre-disclosure year (2002) using the estimated coefficients and the
firm-specific values for that year. See Section 3 for details.

322 GHOSH AND LEE
firm size, rapid growth, frequent auditor changes, high audit fees, Big 6 auditors,
more restatements, industries with frequent lawsuits, external financing needs, and
institutional ownership. Consistent with the attributes test, we find that the factors
that distinguish between firms reporting internal control weaknesses under SOX and
those without such problems generally discriminate the two sets of firms also for the
pre-disclosure year. Also consistent with the control problems test, we find that firms
reporting weaknesses in internal control under SOX had significantly higher implied
internal control probabilities for the pre-disclosure year compared to firms without
such weaknesses. Further, we show that the pre-disclosure financial reporting quality is
lower for firms reporting internal control weaknesses under SOX, compared to those
without such problems.
More importantly, our market pricing test indicates that information regarding
firm attributes, internal control issues, and financial reporting quality have been
incorporated in stock prices prior to the mandated disclosure period. We find that
the likelihood of internal control problems and structural problems is negatively
associated with abnormal returns for the pre-disclosure year (2002). We also find
evidence indicating that the likelihood of internal control problems is associated
with abnormal returns during the interim period. In contrast, these value-relevant
factors are not related to three-day abnormal returns around the disclosures of
material weaknesses. Therefore, our results suggest that most of the value-relevant
information associated with internal control problems is observed, or anticipated,
and incorporated in the stock price over the pre-disclosure period. Controlling
for the prior period information, limited new information is revealed around the
announcement of internal control problems which explains the relatively weak market
reaction.
Finally, we also examine a sub-sample of foreign firms cross listed in the US. Because
foreign cross-listed firms (e.g., ADR firms) are also subject to the internal control
disclosures under SOX, even though such disclosures may not be required in their
home countries, ADR firms provide a powerful setting to examine the information
content of the mandated disclosures on internal controls. Similar to the full sample
results, we find that stock prices incorporate information about structural problems
even before ADR firms report internal control problems under SOX.
Our study augments the literature in several ways. First, although internal control is
widely accepted as a key determinant of financial reporting quality (e.g., Peasnell et al.,
2005), much of the research is limited to the US because of data limitations. However,
insights from US studies, including ours, can potentially inform other countries on the
relative benefits of regulating internal controls. Second, research studies on internal
controls tend to provide unique insights analyzing data from the post-SOX period (i.e.,
the mandated period). In contrast, we emphasize the pre-SOX period (i.e., the pre-
mandated period) to better understand the disclosure consequences in the post-SOX
period. Third, the literature on the internal controls focuses on either the causes or
consequences of weak internal controls without acknowledging a causal link between
the two streams of literature. We bridge this gap. Finally, a key implication of our
study is that earnings quality/structural problems and internal control weaknesses are
endogenous. However, prior studies fail to account for this endogeneity, which limits
our ability to draw unambiguous conclusions from such studies.
The rest of the paper is organized as follows: Section 2 provides the background
on the issue of internal control over financial reporting and presents our hypotheses.

Section 3 describes our research design. Section 4 explains our data selection proce-
dure. Section 5 reports the empirical results. Section 6 summarizes and concludes.
2. INTERNAL CONTROL OVER FINANCIAL REPORTING
(i) Background
Internal control over financial reporting is broadly defined as a process carried out by
a company’s board of directors, management, and other personnel that is designed
to provide reasonable assurance regarding (1) the effectiveness and efficiency of a
firm’s operations, (2) the reliability of financial reporting, and (3) compliance with
applicable laws and regulations. Internal control deficiencies arise from design flaws
or operating problems. A “significant deficiency” is an internal control deficiency that
could adversely affect a firm’s ability to initiate, record, process, and report financial
data. A “material weakness” exists when a significant deficiency in one or more of
the internal control components precludes the firm from detecting and preventing a
material misstatement in its financial statements on a timely basis.
The debate surrounding internal control over financial reporting is not new
(Kinney et al., 1990). In 1978, the Cohen Commission recommended that manage-
ment provide a report of their assessment of the firm’s internal controls (The Cohen
Commission, 1978). The Treadway Commission of 1987 (The Treadway Commission,
1987) and the Committee of Sponsoring Organizations of the Treadway Commission
(COSO, 1992) also made similar recommendations. All three reports (Cohen, Tread-
way and COSO) recognized the value of management reports on internal controls
(Hermanson, 2000).
In 1991, the US House of Representatives passed a bill requiring management to
provide a report on internal controls, accompanied by the auditor’s assessment of the
management report, but the bill did not pass the Senate. Prior to the Sarbanes–Oxley
Act of 2002, the FDIC Improvement Act of 1991 required that management of large
banks report on internal control and that auditors attest to management’s assessment.
Based on a survey of nine different financial user groups (bankers, brokers,
directors, executives, analysts, institutional investors, individual investors, CPAs and
internal auditors), Hermanson (2000) concludes that respondents agree about the
value of voluntary management reports on internal controls, but are neutral about the
role of mandatory management reports on internal controls in enhancing decision-
making.
More recently, the SEC approved rules implementing §404 requiring management
and independent auditors of public companies to evaluate and report on the effective-
ness of a firm’s internal control over financial reporting.6 The Securities and Exchange
Commission (SEC) claims that “an effective internal control over financial reporting
is necessary to produce reliable financial statements used by investors” (SEC, 2003).
In 2004, the Public Company Accounting Oversight Board (PCAOB, 2004) issued
Auditing Standard No. 2 that described the related auditor attestation requirements.
In addition, §302 requires that management evaluate the effectiveness of disclosure
6 In the original proposal, firms were required to comply with §404 for fiscal years ending on or after
September 15, 2003 (SEC, 2003). However, the compliance date was extended for accelerated (non-
accelerated) filers to the fiscal year ending on or after June 15, 2004 (July 15, 2007).

324 GHOSH AND LEE
control and procedures, and indicate significant changes in internal control since the
last Form 10-K or Form 10-Q (Ashbaugh-Skaife et al., 2007). Thus, firms reporting
internal control problems under §404 in 2004 and onwards might also have reported
similar problems in 2003 under §302.
(ii) Information Content of Internal Control Disclosures under SOX

The prime purpose of internal control over financial reporting is to foster the prepa-
ration of reliable financial statements. Effective internal control involves people at all
levels of the organization, including those who maintain accounting records, prepare
and disseminate policies, monitor systems, and function in a variety of operating roles
(Ernst & Young, 2005). Effective internal controls improve the reliability of financial
statements, and reduce the risk of material misstatements and fraud (Kinney and
McDaniel, 1989).7
One of the principal motivations for the §404 disclosures about the effectiveness
of internal control over financial reporting is that the new disclosure requirements
will enable more timely identification of internal control weaknesses and how such
disclosures might influence the reliability of earnings (Deloitte & Touche et al.,
2004; and PCAOB, 2004). These claims suggest that mandated disclosures on internal
control systems are expected to generate significant new information around the time
of the announcement of internal control weaknesses.
Several recent studies examine the information content of the disclosures on
internal control systems under §302 and §404 by concentrating on the stock price
reactions to the announcement of these disclosures. The results generally provide
weak economic and statistical evidence supporting the contention that the disclosures
on internal controls are informative. Hammersley et al. (2008) find that the mean size-
adjusted returns for firms disclosing internal control weaknesses under §302 of SOX
are negative and less than 1% on the day of the disclosures. Even though the results
are statistically significant, the economic magnitude of the stock market reaction on
the day of the disclosures is small. Further, the magnitude of the median results is even
smaller and the results are not statistically significant.
Other studies also examining the same question arrive at similar conclusions.
Beneish et al. (2008) find that cumulative abnormal returns over a three-day window
around the disclosures of material weaknesses under §302 are around 2%, which is
statistically significant. Similarly, De Franco et al. (2005) find that the mean cumulative
abnormal returns around the disclosures of internal control weaknesses under §404
are between 0 and 2% with varying degrees of statistical significance depending on
the event window and the definition of abnormal returns. Neither study reports the
median results.
Thus, in contrast to the claims that the mandated disclosures on internal control
over financial reporting under SOX provide valuable new information, prior studies
provide only modest evidence of new information being revealed to investors around
the time of the mandated disclosures.
7 A central purpose of the assessment of internal control over financial reporting is to identify material
weaknesses that have more than a remote likelihood of causing a material misstatement in financial
statements (SEC, 2005a).

(iii) Explanations for Weak Market Reactions around Internal Control Disclosures
Our study investigates several inter-connected explanations for the lack of strong stock
market reaction to disclosures on internal control systems under SOX. First, firms
reporting internal control weaknesses under SOX are typically characterized as having
structural problems. Thus, investors can get new information about the nature and
extent of structural problems from disclosures on the effectiveness of internal controls.
However, an alternative explanation is that firms with weak internal controls had
similar problems for the pre-disclosure years. Because information about structural
problems is an innate value-relevant factor, investors are likely to have incorporated
some of this information in the stock price during the pre-disclosure years when the
problems first arose.
Firms reporting internal control problems under SOX are typically identified as
those having structural problems because of changes in the organizational structure
(i.e., mergers and acquisitions or restructuring activities), complexity and scope of the
firm’s operations, intricate business transactions, and operating in diverse industries or
international markets (Ashbaugh-Skaife et al., 2007; and Doyle et al., 2007a). Because
structural problems tend to develop over a period of time, some of the characteristics
typical of firms with weaknesses in internal controls might be descriptive for the pre-
disclosure years as well.8 Thus, investors can gauge the extent of structural problems
from observable firm attributes.
Second, firms reporting weaknesses in internal controls under SOX may not
come as a surprise to the market if investors had anticipated some of the internal
control problems. Prior research finds that firms with internal control weaknesses are
associated with small size, rapid growth, poor performance, complex operations, weak
financial health and high risk (Ashbaugh-Skaife et al., 2007; and Doyle et al., 2007a).
Because these observable firm attributes tend to be stationary over time, investors can
gauge the extent of internal control problems during the pre-disclosure period.
Third, firms reporting internal control weaknesses under SOX are expected to have
low financial reporting quality. Internal control weaknesses can affect the reliability
of earnings in two principal ways (Ashbaugh-Skaife et al., 2007; and Doyle et al.,
2007b). The first is that random or unintentional errors in accounting accruals
estimations are expected to be larger in firms with internal control weaknesses than
those without such weaknesses because of lack of adequate policies, training or
diligence by company employees. Another reason is that accounting accruals might
be misstated intentionally by management to manage earnings when internal controls
are not effective. While announcement of internal control weaknesses might convey
information about reporting quality, much of the information might be anticipated if
investors recognized that these firms were prone to internal control problems during
the pre-disclosure years. Because structural problems determine financial reporting
quality, reporting quality might be low if these firms also had structural problems
during the pre-disclosure years.
Finally, our fundamental hypothesis is that much of the information contained in
the mandated disclosures on internal controls over financial reporting (structural
problems, proneness to control problems, low reporting quality) is incorporated in
the stock prices during the pre-disclosure years. Hence, when firms with these types
8 Prior studies also find that these firm attributes negatively affect stock prices and the valuation of earnings
because of concerns about the quality of the firm and its financial reports.

326 GHOSH AND LEE
of problems announce weaknesses in internal controls under SOX, markets are less
surprised by the disclosure of such news.9 These related predictions and the linkages
among firm-specific attributes, internal control weaknesses, financial reporting quality,
and stock market behavior are summarized in Figure 1.
3. RESEARCH DESIGN
(i) Firm Attributes and the Probability of Internal Control Weaknesses

Similar to Ashbaugh-Skaife et al. (2007) and Doyle et al. (2007a), we model the
likelihood of firms reporting internal control weaknesses under SOX using the
following logistic regression:
Control weakness = β0 + β1 Segments + β2 Charges + β3 Foreign + β4 Age + β5 ROA

+ β6 Loss + β7 Z -Score + β8 Size + β9 ExtremeGrowth
+ β10 AuditChange + β11 AuditFee + β12 Big6 + β13 Restatement (1)
+ β14 Litigation + β15 EquFin + β16 DebFin + β17 InstOwn
+ β18 CEOChair + β19 GIndex + β20 CFOChange + Industry + v
where Control weakness is an indicator variable that equals one when firms report
internal control problems and zero otherwise.
Equation (1) includes the following twenty determinants of internal control
problems that also indicate firms’ structural problems: Segments is the number of
business or geographic segments reported by a firm; Charges is coded one if a firm
has restructuring charges in the current year or in the previous two years, and zero
otherwise; Foreign is an indicator variable equal to one if a firm has non-zero foreign
currency translation and zero otherwise; Age is the decile rank of the number of
years that a firm has CRSP data; ROA is income before extraordinary items divided
by total assets at the beginning of the year; Loss is an indicator variable that equals
one when income before extraordinary items is negative for the current year; Z-Score
is the decile rank of Altman’s (1968) Z-score with high scores indicating less distress
risk; Size is the average of market value of equity (in US$ billions) at the beginning
and end of the current year; ExtremeGrowth is an indicator variable that equals one if
sales growth falls in the highest tercile, and zero otherwise; AuditChange is an indicator
variable set to one if a firm changes its auditor for the current fiscal year, and zero
otherwise; AuditFee is expressed per US$1,000 of total firm value (market value of
equity and book value of debt); Big6 is an indicator variable that equals one if the
auditor is one of the Big 6 audit firms, and zero otherwise; Restatement is coded one if
a firm has a restatement, and zero otherwise; Litigation is coded one if a firm is in a
litigious industry having SIC codes 2833–2836, 3570–3577, 3600–3674 and 7370, and
zero otherwise; EquFin is coded one if a firm’s equity issuance is greater than 10%
of its total assets in the next year, and zero otherwise; DebFin is coded one if a firm’s
debt issuance is greater than 10% of its total assets in the subsequent year, and zero
9 Consistent with our claims, SEC Commissioner Paul Atkins asks, “Should these (internal control)
disclosures trigger a significant market impact? Are these problems already priced into the stock?” (SEC,
2005b). De Franco et al. (2005) also acknowledge that it is plausible that investors anticipate some of the
internal control problems disclosed under SOX.

otherwise; InstOwn is the percentage of shares held by institutional investors divided

by the number of institutions that own the stock as of the fiscal-year-end; CEOChair
is coded one if the CEO also serves as chair of the board, and zero otherwise; GIndex
is a composite of the twenty-four variables, adding one point if any of the provisions is
present, where a higher score indicates more restrictions on shareholder rights or a
greater number of anti-takeover measures (see Gompers et al., 2003); and CFOChange
is coded one if there is a change in the chief financial officer’s (CFO) position and zero
otherwise.
Drawing on the recent studies, we categorize our determinants of internal control
weaknesses into ten groups: (1) complexity (Segments, Charges, Foreign and Age), (2)
firm performance (ROA and Loss), (3) financial health (Z-Score), (4) size (Size), (5)
growth (ExtremeGrowth), (6) auditor characteristics (AuditChange, AuditFee, and Big6),
(7) restatements (Restatement), (8) industries with high litigation risk (Litigation),
(9) reliance on external financing (EquFin and DebFin), and (10) management and
governance attributes (InstOwn, CEOChair, GIndex and CFOChange).
Firms with complex operations are more likely to have internal control weaknesses
because complex business transactions impose greater accounting application risks.
The likelihood of firms reporting internal control problems is higher for firms with
poor performance because such firms may not have adequate resources for proper
controls. Good internal controls require both time and resources which may not be
the priority for firms trying to improve profitability. Firms with poor financial health
may not have enough resources to devote towards effective internal control systems.
Firm size is inversely related to the internal control problems because larger firms
are more likely to have resources to devote towards internal controls. Firms with
more growth opportunities have a higher likelihood of reporting material weaknesses
because of possible problems with internal controls processes. Higher audit risk might
be associated with a higher likelihood of reporting material weaknesses, leading to a
greater frequency of auditor changes and higher audit fees.
While the Big 6 audit firms are more likely to uncover internal control weaknesses,
firms with internal control problems might avoid using big audit firms. Therefore,
an ex ante relationship between Big6 and Control weakness is ambiguous. Managers’
incentives to discover and report internal control weaknesses are higher for firms
with restatements because firms are more likely to be forthcoming about control
problems when the quality of their financial statements has been questioned by
market regulators or auditors (Ashbaugh-Skaife et al., 2007). Firms with high
litigation risk have greater incentives to disclose internal control problems in a timely
manner to minimize potential share price declines which often leads to shareholder
lawsuits (Ashbaugh-Skaife et al., 2007). Firms issuing equity or debt are less likely to
disclose internal control weaknesses (Hermanson and Ye, 2009). Higher institutional
ownership provides managers with greater incentives to discover and disclose internal
control problems because of increased monitoring. When the CEO serves as chair
of the board, management is less likely to disclose internal control weaknesses
because monitoring is not as strong. A higher G-index indicates more restrictions on
shareholder rights or more entrenched management, in which case management is
less likely to disclose material weaknesses. Finally, a new CFO has stronger incentives to
disclose internal control problems and then blame the prior administration for such
problems.

328 GHOSH AND LEE
We estimate equation (1) using internal control effectiveness data as reported

under §302 or §404 requirements. Using the coefficient estimates from the logistic
regression, we compute the probability of firms having internal problems using:
Pr (ICW)i,t = eXβ /(1 + eXβ ) (2)
where β is the vector of coefficients estimated using data for firms reporting material
weaknesses and 2004 control sample. X is the matrix of independent variables
identified in equation (1).
Prior studies find that observable firm characteristics are associated with the
likelihood of firms having internal control weaknesses. To the extent that the estimated
coefficients from equation (1) and firm attributes are stationary over time, it is reason-
able to expect that capital markets can gauge some of the internal control problems
even in the absence of mandated disclosures based on firm-specific characteristics.
To address this issue, we first examine whether the firm attributes that are associated
with internal control weaknesses pre-date the disclosures under SOX (“firm attributes
test”). We then test whether firms reporting internal control problems under SOX
are also prone to internal control problems for the pre-disclosure period compared
to other firms without such problems (“control problems test”). Our probability
measure, Pr(ICW), for the pre-disclosure period is expected to be higher for firms
reporting internal control problems under mandated disclosures than those without
such problems.
(ii) Constructs for Financial Reporting Quality

We use two measures of financial reporting quality. The first measure is AccrualsQuality
as defined in Dechow and Dichev (2002). This measure is the absolute value of the
residuals from the following equation:
WC t = β0 + β1 CFO t−1 + β2 CFO t + β3 CFO t+1 + β4 Sales t + β5 PPE t + μt (3)
The residuals from the regression measure the extent to which current working
capital accruals (WC) do not effectively map into past, present or future cash flows
(CFO). Following Francis et al. (2005), we also include the current year change in
sales (Sales) and the current year level of property, plant and equipment (PPE). We
estimate the above regression for each year- industry combination.
The second measure is Performance-Matched AbnormalAccruals, which is AbnormalAc-
cruals modified based on portfolio-matching approach, as in Francis et al. (2005).
AbnormalAccruals is the absolute value of abnormal accruals estimated from the
modified Jones (1991) model as described in Dechow et al. (1995). Specifically, we
estimate the following regression:
Accruals = β0 + β1 Sales + β2 PPE + η (4)
where Accruals are income before extraordinary items less operating cash flow from
continuing operations, Sales is changes in sales, and PPE is the gross value of plant,
property and equipment. To control for cross-sectional differences in firm size, we

scale all the variables in equation (4), including the intercept, by total assets at the
beginning of the year. We estimate the equation for each year-industry grouping and
the resulting coefficients are used to estimate the firm-specific normal accruals as
follows:
β0 +
Predicted accruals = β1 (Sales − AR) +
β2 PPE (5)
where AR is the change in accounts receivable between the current year and the
preceding year, scaled by beginning assets. Consistent with Dechow et al. (1995), we
adjust the reported revenues of the sample firms for changes in accounts receivable
to capture any potential accounting discretion arising from credit sales. We measure
AbnormalAccruals as the absolute value of the difference between Accruals and Predicted
accruals.
To implement the portfolio-matching approach, we sort companies in each two-
digit SIC using ROA for each industry and then identify the median abnormal accrual
in each quintile. To obtain the performance-adjusted abnormal accrual, we subtract
the median abnormal accrual of the relevant quintile from each firm’s abnormal
accrual. For both measures of financial reporting quality, a higher value indicates a
lower quality of financial reporting.
To the extent that firms disclosing internal control weaknesses under SOX were
prone to control issues for the pre-disclosure period, financial reporting quality is
expected to be low for this period. Financial reporting quality might also be low
as a direct outcome of the structural problems during the pre-disclosure period.
We investigate these possibilities by testing whether firms reporting internal control
weaknesses under SOX had low financial reporting quality for the pre-disclosure years
(“reporting quality test”).
(iii) Investor Perceptions of Structural Problems, Control Problems and Reporting

Quality
The main objective of this study is to explore whether stock prices incorporate
structural problems, potential internal control weaknesses, and financial reporting
quality concerns even before firms disclose such problems under SOX. Accordingly,
we decompose the time period leading up to the announcement of internal control
problems under SOX into three sub-periods: (1) pre-disclosure year, i.e., 2002; (2) the
interim period between 2002 and the year before the announcement date; and (3) the
announcement date. If the stock market incorporated much of the information before
the announcement date, the stock price over the pre-disclosure and interim years is
expected to be associated with structural problems, latent internal control problems,
and low financial reporting quality over this period. Further, these three factors are
unlikely to be associated with the stock market reaction to the announcement of
internal control weaknesses.
(a) Pre-disclosure Year (2002)

To test whether stock prices in the pre-disclosure period (year 2002) incorporate
structural problems, potential control weaknesses, and reporting quality concerns, we

330 GHOSH AND LEE
estimate the following regression:10
CAR Pr e = β0 + β1 Pr (ICW)Pre + β2 SP -Score Pre + β3 AccrualsQualityPre
+ β4 Earnings Pre + v (6)
where CARPre is compounded buy-and-hold return less the return on the value-
weighted market portfolio over a 12-month period ending three months after the 2002
fiscal year-end,11 SP-ScorePre is the sum of 14 binary signals constructed for our first eight
groups of firm attribute variables as of the 2002 fiscal year-end, AccrualsQualityPre is a
measure of accruals quality for 2002, and EarningsPre is the change in annual earnings
before extraordinary items during 2002, scaled by market value of beginning equity.
To compute SP-Score, we first convert Segments and AuditFee into binary variables and
set them equal to one if the value falls in the highest tercile of the distribution for
that year and zero otherwise. Similarly, we convert Age, ROA, Z-Score, and Size into
binary variables and set them equal to one if the value falls in the lowest tercile
of the distribution for that year and zero otherwise. The remaining variables, i.e.,
Charges, Foreign, Loss, ExtremeGrowth, AuditChange, Big 6, Restatement and Litigation,
are all defined as binary variables. Thus, SP-Score can take a value between zero
and fourteen with a higher SP-Score indicating more severe structural problems. If
potential internal control weaknesses, structural problems, and financial reporting
quality concerns were priced by the market in the pre-disclosure period, β 1 , β 2 and
β 3 in equation (6) are expected to be negative.12
(b) Interim Period

To examine whether stock prices in the interim period (i.e., the period between 2002
and one year before the announcement of internal control weaknesses under SOX)
reflect the information about structural problems, potential control weaknesses and
reporting quality concerns, we estimate the following regression:
CAR Interim = β0 + β1 Pr (ICW )Interim + β2 SP -Score Interim + β3 AccrualsQualityInterim

(7)
+ β4 Earnings Interim + v
where the subscript Interim indicates observations for each firm-year during the interim
period. If the information about potential internal control weaknesses, structural
problems and financial reporting quality concerns was incorporated by investors in
the interim period, β 1 , β 2 and β 3 in equation (7) are expected to be negative.
10 We use returns as the dependent variable because some of our explanatory variables are flow
(change) variables. To the extent that our explanatory variables capture the level of the firms’ structural
problems, stock price could also be used as the dependent variable. We get consistent results using
stock price regressions, but the concern is that stock price regressions are prone to omitted variables
problems.
11 When computing CAR, we do not use a risk-adjusted measure because doing so could mechanically
result in a negative CAR for firms with internal control problems. This is because firms with internal control
problems tend to have higher systematic risk (Ashbaugh-Skaife et al., 2009).
12 We do not include both Pr(ICW) and SP-Score in the same regression because these two variables are
constructed based on the same information which results in a high correlation.

(c) Announcement Date

We investigate the market reactions to the announcement of internal control weak-
nesses using the following regression:13
CAR = β0 + β1 SP -Score Pre + β2 SP -Score Interim + β3 SP -Score + β4 AccrualsQualityPre

+ β5 AccrualsQualityInterim + β6 AccrualsQuality + β7 EarningsSurprise + v
(8)
where CAR is three-day abnormal returns cumulated around the announcement date
of internal control weaknesses (days –1 to +1), SP-ScoreInterim is the difference in
SP-Score between the year before the announcement and the pre-disclosure year
(2002), SP-Score is SP-Score for the disclosure year, AccrualsQualityInterim is the difference
in AccrualsQuality between the year before the announcement and 2002, Accrual-
sQuality is AccrualsQuality for the disclosure year, and EarningsSurprise represents the
difference between income before extraordinary items for the most recent quarter
before the disclosure date and the corresponding number four quarters prior scaled
by total market value of equity four quarters prior.
If the information about structural problems and financial reporting quality from
the pre-disclosure periods were incorporated in the stock price before the announce-
ment date, the pre-disclosure period factors are unlikely to be associated with the
stock market reaction around the announcement of internal control problems under
SOX. Therefore, β 1 , β 2 , β 4 and β 5 are expected to be insignificant. However, if the
announcements of internal control problems contain new information, β 3 and β 6 are
expected to be significant because the stock market anticipates year-end information
about structural problems and financial reporting quality.
4. DATA AND SAMPLE SELECTION

We obtain our sample of firms with new disclosures on internal control over financial
reporting from Audit Analytics (AA), a subsidiary of the IVES Inc group. In addition to
the §302 and §404 data, AA provides detailed audit firm related data. AA’s Disclosure
Controls (SOX 302) and Internal Controls (SOX 404) data files contain detailed
information on the effectiveness of a firm’s internal controls. If internal control is
found to be ineffective, the underlying causes of the ineffectiveness are also reported
in AA. AA records several categories of causes of internal control ineffectiveness. We
find that internal control weaknesses and GAAP/FASB application failures dominate
the sample of firms with ineffective internal controls (100% and 95%, respectively).
We obtain accounting data from Compustat and stock return information from
CRSP. Data for institutional investors are retrieved from the Thomson Reuters
database. Information about the board chair and governance index is obtained
from the Risk Metrics database. We obtain CFO related information from the
ExecuComp.14
13 In the analysis of market reactions to the announcement of internal control weaknesses, we exclude
the three variables related to the likelihood of reporting internal control weaknesses for the pre-disclosure
year, interim period and the disclosure year. The probability of reporting internal control problems in the
disclosure year is one by construction for firms that disclosed internal control weaknesses.
14 We use an approach similar to Chava and Purnanandam (2010) to ensure that we do not miss CFOs with
various titles such as Vice President-finance. We run a text search on the annual title string and capture all
executives with “finance”, “treasurer” or “controller” in the title string. In a few cases, if we find more than

332 GHOSH AND LEE
Table 1
Sample Selection and Distribution
Panel A: Sample Selection Procedure – Full Sample
Firms announcing material internal control weaknesses under §302 or §404, as 3,669
identified by Audit Analytics for fiscal years ending in Jan 2003 through
December 2007
Less:
Firms not covered by Compustat (1,716)
Firms with day 0 returns not available from CRSP (346)
Firms in financial industries (SIC = 6000s) (252)
Firms without at least 15 observations for each industry-year combination, where (35)
industry is identified by the 2-digit SIC code
Firms with insufficient Compustat data (310)
Firms without 2002 data (338)
Final sample of distinct firms that disclosed a material weakness 672
Firms in 2004 with sufficient Compustat and CRSP data meeting the above 4,172
industry-related requirements
Less:
Firms with identified material weakness disclosures (672)
Firms without an internal control disclosure (1,444)
Final sample of control firms 2,056
Panel B: Sample Distribution by Year and Industry – Full Sample
Industry (SIC Codes) 2003 2004 2005 2006 2007 Total
Mining and Construction (1000–1999) 1 4 2 2 9 1.3%
Food (2000–2111) 1 3 7 5 16 2.4%
Textiles and printing/publishing (2200–2799) 2 2 11 6 5 26 3.9%
Chemicals (2800–2824, 2840–2899) 7 4 3 14 2.1%
Pharmaceuticals (2830–2836) 5 2 12 9 7 35 5.2%
Extractive (1300–1399, 2900–2999) 1 3 12 3 1 20 3.0%
Durable manufactures
(3000–3999 exc. 3570–3579 & 3670–3679) 6 17 71 65 30 189 28.1%
Transportation (4000–4899) 1 5 21 6 2 35 5.2%
Utilities (4900–4999) 2 3 15 3 3 26 3.9%
Retail (5000–5999) 4 36 23 12 75 11.2%
Services (7000–8999 excluding 7370–7379) 1 9 31 16 10 67 10.0%
Computers (3570–3579, 3670–3679, 7370–7379) 7 19 69 40 23 158 23.5%
Others 1 1 2 0.3%
Total 26 66 293 184 103 672 100.0%
Table 1, Panel A outlines our sample selection process. We begin with a sample
of 3,669 distinct firms that disclosed material weaknesses under §302 or §404 for
fiscal years ending in Jan 2003 through December 2007. We eliminate the following
observations: 1,716 firms not covered by Compustat, 346 firms for which no stock price
data are available on CRSP on the day the internal control weakness is disclosed, 252
firms in financial industries, 35 firms with fewer than 15 observations for each industry-
year combination required for the computation of abnormal accruals, and 310 firms
not having sufficient Compustat variables to conduct our analyses. We further remove
one person with the finance title in the top five managers, we give preference to “chief financial officer”,
“CFO” or “VP-finance” over “controller” or “treasurer”. If this still does not eliminate duplicates, we take the
executive with the highest compensation as the CFO of the firm.

all firms with missing observations in 2002. This sample selection procedure results in a
final sample of 672 distinct firms that disclosed a material weakness during our sample
period. The control sample consists of all firms listed on Compustat that disclosed in
2004 as having effective internal control over financial reporting. A total of 2,056 firms
meet this requirement.
Panel B of Table 1 details the industry composition of our sample of 672 firms with
material weaknesses. The most common industry is durable manufactures (28.1%),
which is followed by computers (23.5%) and retail (11.2%). Panel B also reveals that
our sample firms are concentrated between 2005 through 2007 because most of these
firms made the first disclosure of internal control problems under §404.15
5. EMPIRICAL RESULTS
(i) Firm Attributes Test

Panel A of Table 2 reports the differences in firm attributes between firms reporting
internal control problems (ICW), under the new disclosures, and those without such
problems (Control). It also presents tests of differences between the two groups based
on t-tests and Wilcoxon rank-sum tests.
The descriptive statistics in Panel A are generally consistent with prior studies (e.g.,
Ashbaugh-Skaife et al., 2007; Doyle et al., 2007a; and Hermanson and Ye, 2009). We
find that, compared to control firms, ICW firms have more restructuring activities,
have more foreign operations, and are younger. ICW firms also have significantly lower
ROA and report losses more frequently. While Size is significantly smaller for ICW
firms, the difference in ExtremeGrowth is not consistent with prior studies. Further, ICW
firms change auditors more frequently, pay more audit fees, and are less likely to have
Big 6 audit firms relative to control firms. Restatement and Litigation are significantly
higher for ICW firms. Additionally, ICW firms are more likely to issue equity. Finally,
ICW firms have higher institutional ownership, are less likely to have the CEO also
serving as chair of the board, have greater shareholder rights (lower G-index), and are
more likely to have CFO changes.
In Panel B, we compare the differences in structural problems between the two
groups of firms for the pre-disclosure period (2002). We find that a half of the firm
attributes are significantly different between the two groups of firms this period.
Overall, the results from Table 2 suggest that, because structural problems associated
with internal control weaknesses persist over time, capital markets can draw inferences
about internal control problems from firm characteristics even before firms publicly
disclosure such problems.
For capital markets to draw inferences about internal control problems, one
underlying assumption is that differences in structural problems for firms with internal
control problems persist over time, i.e., firm attributes are “sticky”. We directly test
this assumption in Table 3 by comparing firm-specific attributes between the pre-
and post-disclosure periods for ICW firms. Moreover, significant shifts in some of
firm attributes might also cause firms to develop internal control weaknesses. We find
15 Even though all firms had to comply with §302 from August 29, 2002, we find no firms in our sample
disclosing weaknesses in internal control over financial reporting for this year. Therefore, we view fiscal year
2002 as the pre-disclosure period.

334 GHOSH AND LEE
Table 2
Comparison of Firm Attributes between Material Weakness Firms and Control
Firms
Panel A: Disclosure Period
ICW Firms Control Firms Difference
Predicted
Variable Difference Mean Median n Mean Median n Mean Median
Segments + 5.374 5.000 672 5.274 5.000 2,056 0.100 0.000
Charges + 0.125 0.000 672 0.082 0.000 2,056 0.043*** 0.000***
Foreign + 0.320 0.000 672 0.279 0.000 2,056 0.041** 0.000**
Age − 16.432 12.000 672 17.879 12.000 2,056 −1.447** 0.000
ROA − −0.043 0.010 672 0.001 0.048 2,056 −0.044*** −0.037***
Loss + 0.454 0.000 672 0.253 0.000 2,056 0.200*** 0.000***
Z-Score − 1.146 0.993 672 1.122 0.967 2,056 0.024 0.026
Size − 1.296 0.264 672 3.587 0.520 2,056 −2.291*** −0.256***
ExtremeGrowth + 0.280 0.000 672 0.324 0.000 2,056 −0.044** 0.000**
AuditChange + 0.198 0.000 672 0.077 0.000 2,056 0.121 ***
0.000***
AuditFee + 4.363 2.845 672 1.878 0.989 2,056 2.485*** 1.856
Big6 ± 0.851 1.000 672 0.901 1.000 2,056 −0.050*** 0.000***
Restatement + 0.464 0.000 672 0.048 0.000 2,056 0.417*** 0.000***
Litigation + 0.317 0.000 672 0.279 0.000 2,056 0.038* 0.000*
EquFin + 0.210 0.000 672 0.150 0.000 2,056 0.060 ***
0.000***
DebFin + 0.095 0.000 672 0.104 0.000 2,056 −0.008 0.000
InstOwn + 0.009 0.008 507 0.007 0.006 1,523 0.002*** 0.002***
CEOChair − 0.620 1.000 150 0.777 1.000 728 −0.157*** 0.000***
GIndex − 8.658 9.000 237 9.195 9.000 951 −0.536*** 0.000***
CFOChange + 0.254 0.000 240 0.082 0.000 722 0.172*** 0.000***
Panel B: Pre-disclosure Period (2002)
Segments + 5.336 5.000 672 5.133 5.000 2,056 0.203 0.000
Charges + 0.091 0.000 672 0.096 0.000 2,056 −0.006 0.000
Foreign + 0.225 0.000 672 0.211 0.000 2,056 0.014 0.000
Age − 13.027 8.000 672 15.879 10.000 2,056 −2.852*** −2.000***
ROA − −0.060 0.007 672 −0.028 0.027 2,056 −0.032*** −0.020***
Loss + 0.466 0.000 672 0.355 0.000 2,056 0.111*** 0.000***
Z-Score − 1.077 0.895 672 1.095 0.951 2,056 −0.018 −0.056
Size − 1.055 0.195 672 2.799 0.357 2,056 −1.744*** −0.162***
ExtremeGrowth + 0.348 0.000 672 0.337 0.000 2,056 0.012 0.000
AuditChange + 0.199 0.000 672 0.190 0.000 2,056 0.010 0.000
AuditFee + 2.809 1.354 672 2.239 0.773 2,056 0.570*** 0.581***
Big6 ± 0.921 1.000 672 0.906 1.000 2,056 0.015 0.000
Restatement + 0.048 0.000 672 0.028 0.000 2,056 0.020** 0.000**
Litigation + 0.317 0.000 672 0.279 0.000 2,056 0.038* 0.000*
EquFin + 0.205 0.000 672 0.152 0.000 2,056 0.053*** 0.000***
DebFin + 0.100 0.000 672 0.102 0.000 2,056 −0.002 0.000
InstOwn + 0.010 0.008 452 0.008 0.006 1,481 0.002*** 0.002***
CEOChair − 0.769 1.000 173 0.819 1.000 684 −0.050 0.000
GIndex − 8.660 9.000 282 9.169 9.000 951 −0.510*** 0.000**
CFOChange + 0.117 0.000 188 0.085 0.000 647 0.032 0.000

Table 2 (Continued)
Notes:
Panel A presents the differences in firm characteristics between firms with internal control weaknesses
(ICW) and firms without internal control weaknesses (Control) in the disclosure period. Panel B presents
the differences in firm attributes between these two groups of firms for the pre-disclosure period (year
2002). Each continuous variable is winsorized at the top and bottom 1%. Variables are measured as follows:
Segments = The number of reported business or geographic segments.
Charges = An indicator variable equal to 1 if a firm has restructuring charges in the current year or in the
previous two years, and 0 otherwise.
Foreign = An indicator variable equal to 1 if a firm has a non-zero foreign currency translation, and 0
otherwise.
Age = Decile rank of the number of years that a firm has CRSP data.
ROA = Income before extraordinary items divided by total assets at the beginning of the year.
Loss = An indicator variable equal to 1 if a firm’s income before extraordinary items is negative, and 0
otherwise.
Z-score = Decile rank of Altman’s (1968) Z-score with high scores indicating less distress risk.
Size = Average of market value of equity (in $ billions) at the beginning and end of the current year.
ExtremeGrowth = An indicator variable equal to 1 if year-over-year industry-adjusted sales growth falls into the
top quintile, and 0 otherwise.
AuditChange = An indicator variable equal to 1 if a firm’s auditor changed during the fiscal year, and 0
otherwise.
AuditFee = Audit fees expressed per $1,000 of total firm value (market value of equity and book value of
debt).
Big6 = An indicator variable equal to 1 if the auditor is one of the Big 6 audit firms, and 0 otherwise.
Restatement = An indicator variable equal to 1 if a firm has a restatement, and 0 otherwise.
Litigation = An indicator variable coded one if a firm is in a litigious industry having SIC codes 2833–2836,
3570–3577, 3600–3674, and 7370, and 0 otherwise.
EquFin = An indicator variable coded one if a firm’s equity issuance is greater than 10% of its total assets in
the next year, and 0 otherwise.
DebFin = An indicator variable coded one if a firm’s debt issuance is greater than 10% of its total assets in
the next year, and 0 otherwise.
InstOwn = The percentage of shares held by institutional investors divided by the number of institutions
that own the stock as of the fiscal-year-end.
CEOChair = An indicator variable coded one if the CEO also serves as chair of the board, and 0 otherwise.
GIndex = A composite of the twenty-four variables, adding one point if any of the provisions is present,
where a higher score indicates more restrictions on shareholder rights or a greater number of anti-takeover
measures (Gompers et al. 2003).
CFOChange = An indicator variable coded one if a firm experiences a change in its chief financial officer,
and 0 otherwise .
*** , ** , * denotes significance at < 0.01, < 0.05 and < 0.10 levels, respectively, for two-tailed tests.
that Segments, ROA, Loss, AuditChange, Litigation, EquFin, DebFin and GIndex are not
significantly different when comparing firms with internal control problems between
the pre- and post-disclosure periods, suggesting that these variables are sticky and thus
might predict weaknesses in internal controls.
However, we also find that some attributes are not sticky, i.e., there are significant
changes in attributes between pre- and post-disclosure periods. Foreign is significantly
higher in the post-disclosure period relative to the pre-disclosure period which
suggests that ICW firms expand foreign operations.16 CEOChair is lower in the post-
disclosure period which could capture structural changes in corporate rooms around
this time. CFOChange is significantly higher in the post-disclosure period which suggests
that CFOs are mostly likely to be replaced subsequent to reporting of internal control
16 Many firms, including ICW firms, expanded foreign operations over the post-disclosure period because
of global opportunities. Therefore, the increase in foreign operations for ICW firms can also be explained
by the changing opportunities in the global economy.

336 GHOSH AND LEE
Table 3
Stickiness of Firm Attributes within Material Weakness Firms
Difference
PRE (2002) POST (Disclosure Year) (= POST – PRE)
Variable Mean Median n Mean Median n Mean Median
Segments 5.336 5.000 672 5.374 5.000 672 0.037 0.000
Charges 0.091 0.000 672 0.125 0.000 672 0.034** 0.000**
Foreign 0.225 0.000 672 0.320 0.000 672 0.095*** 0.000***
Age 13.027 8.000 672 16.432 12.000 672 3.405*** 4.000***
ROA –0.063 0.007 672 –0.043 0.010 672 0.019 0.004
Loss 0.466 0.000 672 0.454 0.000 672 –0.012 0.000
Z-Score 1.075 0.895 672 1.143 0.993 672 0.068* 0.098**
Size 0.938 0.195 672 1.192 0.264 672 0.255* 0.069***
ExtremeGrowth 0.348 0.000 672 0.280 0.000 672 –0.068*** 0.000***
AuditChange 0.199 0.000 672 0.198 0.000 672 –0.001 0.000
AuditFee 2.842 1.354 672 4.505 2.845 672 1.662*** 1.491***
Big6 0.921 1.000 672 0.851 1.000 672 –0.070*** 0.000***
Restatement 0.048 0.000 672 0.464 0.000 672 0.417*** 0.000***
Litigation 0.317 0.000 672 0.317 0.000 672 0.000 0.000
EquFin 0.205 0.000 672 0.210 0.000 672 0.004 0.000
DebFin 0.100 0.000 672 0.095 0.000 672 –0.004 0.000
InstOwn 0.010 0.008 452 0.009 0.008 507 –0.001* 0.000
CEOChair 0.769 1.000 173 0.620 1.000 150 –0.149*** 0.000***
GIndex 8.660 9.000 282 8.658 9.000 237 –0.001 0.000
CFOChange 0.117 0.000 188 0.254 0.000 240 0.137*** 0.000***
Notes:
Variables definitions can be found in the note to Table 2.
problems in the post-disclosure period. Finally, we also find significant increases in

Charges, AuditFee and Restatement in the post-disclosure period. While we document
changes in certain firm attributes in Table 3, we are unable to comment whether these
changes are the outcome or cause of internal control problems.
(ii) Control Problems Test

In addition to the univariate analysis, we also model the likelihood of firms reporting
internal control problems based on firms attributes identified in Table 2. We estimate
a logistic regression where the dependent variable is an indicator variable which
equals to one if the firm disclosed a material weakness in internal control, and zero
otherwise. The results are reported in Panel A of Table 4. We present four models
because data for some variables are limited. The first model includes 14 firm attributes
but without including industry indicators, while in the second model we additionally
include industry indicators. In the third model we include three additional attributes
(EquFin, DebFin, and InstOwn) and in the fourth model we include three additional
governance attributes (CEOChair, GIndex and CFOChange).17
17 To minimize the effect of outliers in the logistic regression, we winsorize each continuous variable at the
top and bottom 5%. Our conclusions remain unchanged when we do not winsorize that data.

Table 4
C

Likelihood of Internal Control Weaknesses
Panel A: Logistic Regression for the Disclosure Period
Variable Prediction Estimate p-value Estimate p-value Estimate p-value Estimate p-value
Intercept −2.793 0.000*** −4.606 0.000*** −4.802 0.000*** −3.792 0.165

Segments + 0.034 0.056* 0.034 0.062* 0.032 0.128 0.078 0.113
Charges + 0.377 0.036** 0.359 0.050** 0.272 0.211 0.474 0.311
Foreign + −0.014 0.539 −0.013 0.575 −0.006 0.839 0.025 0.747
Age − 0.264 0.037** 0.275 0.034** 0.291 0.053* 0.174 0.644
ROA − 1.972 0.001*** 1.766 0.003*** 2.660 0.000*** 3.497 0.205
2013 Blackwell Publishing Ltd

Loss + 0.520 0.004*** 0.499 0.006*** 0.755 0.000*** 1.465 0.017**
Z-Score − −0.037 0.091* −0.041 0.112 −0.033 0.272 0.057 0.530
Size − −0.029 0.140 −0.030 0.143 −0.026 0.267 0.043 0.459
ExtremeGrowth + 0.124 0.310 0.144 0.253 0.097 0.507 −0.450 0.259
AuditChange + 0.760 0.000*** 0.735 0.000*** 0.571 0.004*** −0.935 0.276
AuditFee + 0.298 0.000*** 0.299 0.000*** 0.307 0.000*** 0.469 0.003***
Big6 ± −0.071 0.682 −0.077 0.658 −0.318 0.113 0.854 0.654
Restatement + 2.832 0.000*** 2.873 0.000*** 2.909 0.000*** 4.006 0.000***
Litigation + 0.276 0.023** 0.384 0.013** 0.416 0.022** −0.424 0.408
EquFin + 0.378 0.039** −0.433 0.572
DebFin + −0.023 0.912 −0.711 0.329
InstOwn + 9.542 0.466 193.014 0.072*
CEOChair − −0.192 0.010**
GIndex − 0.010 0.979
CFOChange + 0.687 0.140
Industry indicators No Yes Yes Yes
Pseudo R2 0.288 0.293 0.294 0.469
Likelihood Ratio 877.626 893.856 670.031 248.073
Percent Concordant 84.681 84.882 84.712 92.071
n 2,728 2,728 2,030 596
INFORMATIVENESS OF INTERNAL CONTROL DISCLOSURES
Panel B: Predicted Probability for the Pre-disclosure Period (2002)
ICW Control Difference
Pr(ICW) 0.209 0.135 672 0.169 0.106 2,056 0.041*** 0.028***

337
Notes:
Variables definitions can be found in the note to Table 2.
338 GHOSH AND LEE
In the first two models, the pseudo R2 is around 29% for both models, which is
substantially higher than the R2 reported by prior studies. We also find that percent
concordant exceeds 84% in both specifications. Therefore, our model seems to
perform reasonably well in predicting internal control problems correctly.18
Individual coefficients are mostly consistent with the results from prior studies.
The coefficients on Segments and Charges are positive, suggesting that the likelihood
of firms reporting internal control weaknesses increases with business complexity. The
coefficient on ROA is significantly positive, which is surprising, but the coefficient on
Loss is significantly positive as expected. Because the proportion of firms with losses
is relatively high in our sample, the association between Loss and material weaknesses
dominates that between ROA and material weaknesses. Also, the coefficient on Age
is not consistent with prior studies. The significantly negative coefficient on Z-score
confirms that material weakness firms are financially distressed. We also find that ICW
firms change auditors more frequently and pay more audit fees. The coefficients on
Restatement and Litigation are also significant, consistent with prior research. On the
other hand, the coefficients on Foreign, Size, ExtremeGrowth and Big6 are insignificant.
Our findings suggest that the explanatory power of these variables might have declined
over time.
The third model includes the institutional ownership variable, InstOwn, and the
external financing variables, EquFin and DebFin. Including InstOwn reduces the sample
size by about 26%. Results are somewhat weaker for this specification; only one of the
three additional variables is significant. The fourth model includes CEOChair, GIndex
and CFOChange. The number of observations declines by about 71% relative to the
third specification. Most of firm attributes are no longer significant in this specification
possibly because of the size bias from requiring governance data.
Overall, the results from Panel A of Table 4 demonstrate that our second model
performs reasonably well in predicting internal control problems correctly as well as
capturing the determinants of such problems. For the remainder of this study, we rely
on the second model when computing Pr(ICW) and SP-Score.
In Panel B of Table 4, we compute an “implied probability” for ICW firms
for the pre-disclosure period based on the estimated coefficients from the second
specification of the logistic regression in Panel A and firm-specific attributes for 2002.
We find that, for firms reporting internal control problems under SOX, the mean
(median) implied probability is 20.9% (13.5%) for the pre-disclosure period, whereas
the mean (median) implied probability for the control sample for the corresponding
period is 16.9% (10.6%). The differences in implied probabilities between the two sets
of firms are significant at the 1% level. Thus, firms reporting internal control problems
under SOX also had a higher probability of reporting such problems in 2002. Our
results from Table 4 are consistent with the assertion that market participants can
discriminate between firms with high and low likelihood of having internal control
problems even in the absence of mandated disclosures.
18 We further check the predictive accuracy of our model using a “cross-validation” approach. Specifically,
we randomly divide the sample of 2,728 firms (672 ICW firms and 2,056 control firms) into an analysis-
sample and holdout-sample of equal-size. We then compare the classification accuracy between the two
subsamples. We find that the classification accuracy for the analysis sample is 79.0% and that for the holdout
sample is 82.6%. This enhances our confidence in the accuracy of our prediction model.

Table 5
Quality of Financial Reporting
Panel A: Disclosure Period
ICW Firms Control Firms Difference
AccrualsQuality 0.119 0.076 672 0.118 0.071 2,056 0.002 0.004
Performance-Matched 0.097 0.051 672 0.073 0.042 2,056 0.023*** 0.009***
AbnormalAccruals
Panel B: Pre-disclosure Period (2002)
AccrualsQuality 0.146 0.073 672 0.127 0.066 2,056 0.018* 0.008*
Performance-Matched 0.115 0.052 672 0.104 0.046 2,056 0.011 0.006*
AbnormalAccruals
Notes:
Panel A presents the differences in financial reporting quality between firms with internal control
weaknesses (ICW) and firms without internal control weaknesses (Control) in the disclosure period. Panel
B presents the differences in financial reporting quality between these two groups of firms for the pre-
disclosure period (year 2002). The variables are winsorized at the top and bottom 1%. Our measures of
financial reporting are as follows:
AccrualsQuality = The absolute value of the residuals from the Dechow and Dichev (2002) accruals quality
measure, as adjusted by Francis et al. (2005). See Section 3 for more details.
Performance-Matched AbnormalAccruals = AbnormalAccruals modified based on Francis et al.’s (2005) portfolio-
matching approach, where AbnormalAccruals is the absolute value of abnormal accruals estimated from the
modified Jones (1991) model as described in Dechow et al. (1995). See Section 3 for more details.
***, **, *denotes significance at < 0.01, < 0.05 and < 0.10 levels, respectively, for two-tailed tests.
(iii) Reporting Quality Test

Table 5, Panel A reports the difference in financial reporting quality between ICW
firms and control firms for the disclosure period. We find that the mean (median)
Performance-Matched AbnormalAccruals is 0.097 (0.051) for ICW firms while the corre-
sponding number for the control firms is 0.073 (0.042). The mean/median difference
between the two groups of firms is significant at the 1% level. However, AccrualsQuality
does not significantly differ between the two groups of firms.
In Panel B of Table 5, we examine whether ICW firms have low earnings quality even
before firms report such problems under SOX (pre-disclosure period). Our results
provide some evidence consistent with the conjecture that the pre-disclosure financial
reporting quality is also low for ICW firms compared to control firms. For the pre-
disclosure period, the mean (median) AccrualsQuality is 0.146 (0.073) for ICW firms
while the corresponding number for control firms is 0.127 (0.066). The mean/median
difference between the two groups of firms is significant at the 10% level. We also find
that the median Performance-Matched AbnormalAccruals is significantly larger for ICW
firms than control firms. This provides some support for the prediction that ICW firms
are likely to have low financial reporting quality in the pre-disclosure period.
(iv) Market Pricing Test

In this sub-section, we explore whether stock prices reflect information about in-
ternal control problems, firm attributes and reporting quality in each of the three

340 GHOSH AND LEE
sub-periods, i.e., (1) pre-disclosure year (2002), (2) the interim period between 2002
and the year before the announcement date, and (3) the announcement date.
(a) Pre-disclosure Year (2002)

Table 6 provides the results for market pricing of potential control weaknesses,
firm attributes, and reporting quality for the pre-disclosure period. We present five
estimations of the regression model described in equation 6. The coefficient on
Pr(ICW)Pre is significantly negative (β = –0.495, p-value<0.001) in the first model.
The same coefficient is also significantly negative (β = –0.522, p-value<0.001) in
Model 4 when we additionally include the proxy for reporting quality, AccrualsQuality.
Our results suggest that stock prices incorporate information about potential control
weaknesses even before firms report internal control problems under SOX.
In Model 2, we find that the coefficient on SP-ScorePre is negative and significant
(β = –0.034, p-value = 0.009). The same coefficient is also significantly negative (β =
–0.037, p-value = 0.005) in Model 5 when we additionally include AccrualsQuality. Thus,
stock prices appear to incorporate information about structural problems even before
firms report internal control problems under SOX. However, AccrualsQualityPre is not
significantly negative in any regression.
(b) Interim Period

We also test whether stock prices incorporate information about potential control
weaknesses, structural problems, and reporting quality in the interim period, which
is the period between 2002 and one year before firms first disclose control problems
under SOX. In contrast to Table 6, Table 7 incorporates annual observations for
multiple years for each firm which increases the number of observations.
In Model 1, we find that the coefficient on Pr(ICW)Interim is significantly negative
(β = –0.227, p-value = 0.001). The same coefficient is also significantly negative (β =
–0.224, p-value = 0.001) in Model 4 when we additionally include AccrualsQuality. Thus,
the results from Tables 6 and 7 suggest that the negative information about a firm’s
latent internal control problems is incorporated in stock prices during the interim
period and the pre-disclosure year (2002). In other specifications, however, we find
that the coefficient on SP-ScoreInterim is insignificant and AccrualsQualityInterim is marginally
significant in Model 3. These results imply that the information contained in these
variables is generally not negatively reflected in stock prices during the interim period.
Overall, the results reported in Table 7, as well as those reported in Table 6, provide
evidence that stock prices reflect information about the likelihood of internal control
weaknesses and structural problems during the pre-disclosure year. The results also
suggest that some new information about the likelihood of internal control weaknesses
is generated during the interim period.
(c) Announcement Date

We next examine whether stock returns around the disclosure date of internal
control problem are associated with new or prior period information about control
weaknesses, i.e., structural problems and reporting quality concerns.

C

Table 6
Market Pricing over the Pre-disclosure Year (2002)
Model 1 Model 2 Model 3 Model 4 Model 5

Variable Estimate p-value Estimate p-value Estimate p-value Estimate p-value Estimate p-value
Intercept −0.188 0.625 −0.082 0.833 −0.248 0.524 −0.228 0.553 −0.110 0.778
Pr(ICW)Pre −0.495 0.000*** −0.522 0.000***
SP-ScorePre −0.034 0.009*** −0.037 0.005***
AccrualsQualityPre 0.204 0.180 0.268 0.077* 0.268 0.080*
EarningsPre 0.657 0.000*** 0.651 0.000*** 0.597 0.000*** 0.651 0.000*** 0.647 0.000***
Industry indicators Yes Yes Yes Yes Yes
Adjusted R2 0.124 0.115 0.108 0.127 0.118
N 654 654 654 654 654
Notes:
This table reports parameter estimates from the following OLS regression for the pre-disclosure year (2002): CARPre = β 0 + β 1 Pr(ICW)Pre + β 2 SP-ScorePre +
β 3 AccrualsQualityPre + β 4 EarningsPre + ν . Each continuous variable is winsorized at the top and bottom 5%. The variables are measured as follows:
CARPre = Compounded buy-and-hold return less the return on the value-weighted market portfolio over a 12-month period ending three months after the 2002 fiscal
year-end.
Pr(ICW)Pre = The predicted probability of reporting internal control weaknesses based on the estimated coefficients from the logistic regression (Model 2 in Table 4)
and the values of the independent variables from 2002.
SP-ScorePre = The sum of binary signals constructed for each of the first 14 structural problem variables in Table 2 for the pre-disclosure year. See Section 3 for more
details.
AccrualsQualityPre = The absolute value of the residuals from the Dechow and Dichev (2002) accruals quality measure as adjusted by Francis et al. (2005) for 2002.
See Section 3 for more details.
INFORMATIVENESS OF INTERNAL CONTROL DISCLOSURES
EarningsPre = The change in annual earnings before extraordinary items, scaled by market value of beginning equity, for 2002.
341
342
Table 7
Market Pricing Over the Interim Period
Model 1 Model 2 Model 3 Model 4 Model 5
Variable Estimate p-value Estimate p-value Estimate p-value Estimate p-value Estimate p-value
Intercept −0.132 0.715 −0.160 0.659 −0.134 0.711 −0.093 0.796 −0.125 0.731
Pr(ICW)Interim −0.227 0.001*** −0.224 0.001***
SP-ScoreInterim −0.004 0.602 −0.003 0.736
AccrualsQualityInterim −0.156 0.093* −0.147 0.113 −0.153 0.102
EarningsInterim 1.364 0.000*** 1.356 0.000*** 1.355 0.000*** 1.367 0.000*** 1.358 0.000***
Industry indicators Yes Yes Yes Yes Yes
Year indicators Yes Yes Yes Yes Yes
Adjusted R2 0.234 0.228 0.229 0.235 0.229
N 1,566 1,566 1,566 1,566 1,566
Notes:
This table reports parameter estimates from the following OLS regression for the interim period (i.e., the period between 2002 and one year before the announcement
GHOSH AND LEE
of internal control weaknesses under SOX): CARInterim = β 0 + β 1 Pr(ICW)Interim + β 2 SP-ScoreInterim + β 3 AccrualsQualityInterim + β 4 Earnings Interim + ν. Each continuous
variable is winsorized at the top and bottom 5%. The variables are measured as follows:
CARInterim = Compounded buy-and-hold return less the return on the value-weighted market portfolio over a 12-month period ending three months after each fiscal
year-end during the interim period.
Pr(ICW)Interim = The predicted probability of reporting internal control weaknesses based on the estimated coefficients from the logistic regression (Model 2 in Table
C
4) and the values of the independent variables from each year during the interim period.

SP-ScoreInterim = The sum of binary signals constructed for each of the first 14 structural problem variables in Table 2 for each year during the interim period. See
Section 3 for more details.
AccrualsQualityInterim = The absolute value of the residuals from the Dechow and Dichev (2002) accruals quality measure as adjusted by Francis et al. (2005) for each
year during the interim period. See Section 3 for more details.
EarningsInterim = The change in annual earnings before extraordinary items, scaled by market value of beginning equity, for each year during the interim period.

Table 8
Market Pricing around Disclosures of Internal Control Problems
Model 1 Model 2 Model 3
Variable Estimate p-value Estimate p-value Estimate p-value
Intercept 0.014 0.705 −0.001 0.969 0.005 0.885
SP-ScorePre 0.002 0.261 0.002 0.251
SP-ScoreInterim −0.001 0.709 0.000 0.803
SP-Score −0.002 0.291 −0.002 0.174
AccrualsQualityPre 0.007 0.729 0.004 0.834
AccrualsQualityInterim 0.032 0.111 0.033 0.110
AccrualsQuality 0.027 0.188 0.028 0.181
EarningsSurprise 0.059 0.194 0.059 0.184 0.051 0.254
Industry indicators Yes Yes Yes
Adjusted R2 −0.006 −0.003 0.000
N 654 654 654
Notes:
This table reports parameter estimates from the following OLS regression for the full sample around
the date of internal control disclosure: CAR = β 0 + β 1 SP-ScorePre + β 2 SP-ScoreInterim + β 3 SP-Score +
β 4 AccrualsQualityPre + β 5 AccrualsQualityInterim + β 6 AccrualsQuality + β 7 EarningsSurprise +ν. Each contin-
uous variable is winsorized at the top and bottom 5%. The variables are measured as follows:
CAR = Cumulative abnormal returns over the event window [days –1, 1], where day 0 is the date of internal
control disclosure and abnormal returns are defined as the difference between raw returns and value-
weighted market returns.
SP-Score = The sum of binary signals constructed for each of the first 14 structural problem variables in Table
2. See Section 3 for more details.
SP-ScorePre = SP-Score for 2002.
SP-ScoreInterim = Difference in SP-Score between the year before the internal control disclosure and 2002.
AccrualsQuality = The absolute value of the residuals from the Dechow and Dichev (2002) accruals quality
measure, as adjusted by Francis et al. (2005). See Section 3 for more details.
AccrualsQualityPre = AccrualsQuality for 2002.
AccrualsQualityInterim = Difference in AccrualsQuality between the year before the internal control disclosure
and 2002.
EarningsSurprise = For the most recent quarter before the first date of internal control disclosure,
the difference between income before extraordinary items for the current quarter and income before
extraordinary items announced four quarters prior, scaled by total market value of equity four quarters
prior.
In Table 8, we consider three variables for each of our two constructs (i.e., structural
problems and financial reporting quality) related to the pre-disclosure year, the
interim period, and the disclosure year. We find that the coefficients on SP-ScorePre
and SP-ScoreInterim are both insignificant in Models 1 and 3. This finding, combined
with the results from Tables 6 and 7, suggests that much of the information about
structural problems is incorporated in the stock price prior to the announcement of
internal control problems and, therefore, stock returns around the disclosure date
are not associated with the prior period information. In addition, SP-Score is not
significant in any regression specification, implying that the disclosure of internal
control problems provides little new information about the extent of a firm’s structural
problems.
In Models 2 and 3, we use our proxies for financial reporting quality from the
three periods as the main explanatory variables. We find that the coefficients on all
three variables are insignificant. These results suggest that reporting quality concerns

344 GHOSH AND LEE
in the disclosure year as well as those in the prior years convey little information
to the market when a firm announces internal control weaknesses under SOX. The
insignificant coefficient on AccrualsQuality implies that no new adverse information
about financial reporting quality is conveyed to the market around the announcement
date.19
Overall, the results from Tables 6, 7 and 8 reveal that most of the value-relevant
information about latent internal control problems is incorporated in the stock price
over the pre-disclosure year and the interim period. This partially explains the weak
stock market reactions to the mandated disclosures on internal control.
(v) Out-of-Sample Test

We complement our market pricing test by comparing three-day cumulative abnormal
returns around the announcement dates of internal control weaknesses between firms
with high Pr(ICW) and those with low Pr(ICW), where Pr(ICW) is computed using
observations in 2002 as in Panel B of Table 4. If the information about the likelihood
of internal control weaknesses was priced during the pre-disclosure period, firms
with low Pr(ICW) are likely to be associated with more negative reaction around the
announcement of internal control weakness disclosures under SOX relative to firms
with high Pr(ICW).
Consistent with this prediction, in untabulated results, we find that the mean
cumulative abnormal returns for 168 firms in the lowest quartile of Pr(ICW) is
–0.73%, which is negative and significant at the 10% level. In contrast, the mean
cumulative abnormal returns for 168 firms in the highest quartile of Pr(ICW) is
–0.15%, which is not significantly different from zero. This result implies that the
firms with low Pr(ICW) experience negative market reactions when the internal control
problem is announced, whereas the firms with high Pr(ICW) do not. The out-of-
sample tests strengthen our argument that much of the information associated with
internal control problems is priced during the pre-disclosure period and limited new
information is revealed when firms eventually disclose their problems.
(vi) Sensitivity Analysis

Most firms do not announce internal control problems via a separate press release
or a separate 8-K filings. Instead, they include such information on their financial
statements. We use the financial statement filing date with the SEC (10-K or 10-Q) to
measure stock market reaction for our market pricing tests around the disclosure date.
However, using the filing date to measure stock market reaction to internal control
problems is noisy as firms disclose other value relevant information in their financial
statements. Therefore, as a sensitive analysis, we repeat our analyses for a sub-sample
of firms with uniquely identified internal control problem announcement dates.
We search Factiva Press Release Service for press releases (articles) containing the
words “internal control” or “material weakness” within 12 months before the disclosure
date identified by Audit Analytics which is invariably the financial statement filing
date. We find 85 firms that separately announce internal control problems via a press
19 We use AccrualsQuality as the proxy for financial reporting quality in the market pricing tests. We also use
Performance-Matched AbnormalAccruals and obtain qualitatively similar results.

release. Because smaller firms might report internal control problems via separate
8-K filings without having a press release, we also search the LexisNexis Academic
database for 8-K filings using “internal control” or “material weakness” as the search
criteria. This search results in 30 additional dates. Thus, we were able to identify
115 ( = 85 + 30) unique internal control weakness announcement dates.
For our announcement sample of 115 firms, we find that the mean of three-day
cumulative abnormal returns is –1.98% (untabulated), which is significantly negative
and comparable to the mean abnormal returns of around –2% documented in
Beneish et al. (2008). When we replicate the market pricing tests for this sample of 115
firms, in untabulated results, we find that the coefficient on Pr(ICW)Pre is significantly
negative in Models 1 and 4 for the announcement sample when we examine the
market pricing of Pr(ICW)Pre , SP-ScorePre and AccrualsQualityPre over the pre-disclosure
year (Table 6 results). The coefficients on the other two variables are not significant.
These results generally confirm that, for the firms in the announcement sample, stock
prices incorporate information about the likelihood of reporting internal control
problems even before those firms do so under SOX. We also find that none of the
three variables are significant in the interim period for the announcement sample
(Table 7 results). Finally, in the market pricing tests around the mandated disclosure
date (Table 8 results), we do not find any variable for the pre-disclosure and interim
periods to be significant. Only the coefficient on SP-Score is negative and significant
at the 10% level in Model 3. Overall, the results from using this sub-sample with
uniquely identified disclosure date are very similar to those from using the full
sample.
(vii) ADR Firms

Prior to SOX, foreign firms cross-listed in the US were granted exceptions because
of distinct law and practice limitations from internal control disclosure requirements
(Huang, 2009). However, foreign firms cross-listed in the US must comply with the
§404 requirements pertaining to internal control disclosures. Even though foreign
firms might have distinctly different culture and organizational structures from the
US counterparts, they must now bear this added cost. While prior studies document
that foreign firms benefit from US cross-listing (e.g., Lang et al., 2003; Huijgen and
Lubberink, 2005; and Charitou et al., 2007), recent studies also document that foreign
listings on US stock exchanges have declined for the post-SOX period and that a key
explanation for this decline is linked to SOX-related compliance costs for foreign
cross-listed firms (Engel et al., 2007; and Piotroski and Srinivasan, 2008).
Because cross-listed firms are differentially affected by the mandated internal
control disclosure requirement under SOX, we also examine our results for a sub-
sample of foreign firms that are cross-listed in the US and trade on US exchanges as
American Depositary Receipts (ADRs). Our objective is to analyze whether our results
are descriptive for a sub-sample of foreign cross-listed firms. The results can potentially
provide some evidence on the costs and benefits of the disclosures on internal controls
under SOX for ADR firms especially because many ADR firms are not required to
report on the effectiveness of internal controls in their home countries. Further, our
results might serve as an input for the merits of mandated disclosures on internal
control in countries where these disclosures are not mandated.

346 GHOSH AND LEE
When we decompose our sample of 672 firms with internal control problems, we
find 18 ADR firms. Because the sample size is small, our results need to be interpreted
with caution. In untabulated results, similar to the full sample results from Panel B of
Table 4, we find that the mean (median) Pr(ICW) for ADR firms is 15.3% (10.8%) while
that for control firms is 10.9% (8.8%) and the difference in Pr(ICW) between the two
sets of firms is statistically significant. Thus, our results suggest that market participants
may have been able to discern that some ADR firms were prone to internal control
problems even in the absence of such disclosures.
We also find that the coefficient on SP-ScorePre is significantly negative at the 10%
level in Models 2 and 5 for ADR firms when we examine the market pricing of
Pr(ICW)Pre , SP-ScorePre and AccrualsQualityPre over the pre-disclosure year for ADR firms
(Table 6 results). The coefficients on the other two variables are not significant. Thus,
for ADR firms, stock prices incorporate information about structural problems even
before those firms report internal control problems under SOX. None of the variables
are significant in the interim period for ADR firms (Table 7 results). Finally, for the
market pricing tests around the mandated disclosure date (Table 8 results), we again
do not find any variable to be significant either for the pre-disclosure, interim, or
disclosure periods. Also, the mean (median) CAR around the announcement date is
0.35% (0.36%) and statistically insignificant which indicates that no new information is
revealed to the market around the internal control disclosures. In general our results
again suggest that limited new information is generated around the announcement
date for foreign cross-listed firms.
6. CONCLUSIONS
Contrary to the claims that internal control disclosures under SOX provide valuable
new information, prior studies provide weak evidence supporting this conjecture.
We hypothesize that some of the innate value-relevant factors including structural
problems, potential internal control problems, and poor financial reporting quality
that are typically associated with firms’ weak internal controls pre-date the mandated
disclosure period. To the extent that the information contained in the internal control
disclosures under SOX is incorporated in the stock price prior to the disclosures,
market participants are less surprised when firms subsequently report internal control
weaknesses under SOX and, therefore, the announcement period stock returns is
muted.
We employ a four-step procedure to provide insights into the related hypotheses
by examining whether (1) the firm attributes that are associated with internal control
weaknesses pre-date disclosures under SOX (firm attributes test), (2) firms reporting
internal control problems under SOX were also prone to such problems for the
pre-disclosure period (control problem test), (3) firms reporting internal control
weaknesses under SOX had lower quality of financial reporting for the pre-disclosure
years (reporting quality test), and (4) equity prices for the pre-disclosure and interim
periods are consistent with the expectation that investors incorporated information
about structural problems, potential internal control weaknesses, and low financial
reporting quality into security prices prior to disclosures (market pricing test).
Based on a sample of 672 firms that complied with the reporting requirements
under §302 or §404, we find evidence consistent with our predictions. Specifically, we

find that: (1) the firm attributes that distinguish between firms with internal control
weaknesses under SOX and those without such problems also discriminate the two
sets of firms for the pre-disclosure year; (2) firms reporting weaknesses in internal
controls over financial reporting under SOX also had higher probabilities of having
internal control problems for the pre-disclosure year relative to those without such
problems; (3) the pre-disclosure financial reporting quality is low for firms reporting
internal control weaknesses under SOX, compared to those without such problems;
and (4) much of the value-relevant factors associated with internal control problems
are priced over the pre-disclosure and interim periods; only some new information
about the extent of structural problems is generated around the announcement of
internal control weaknesses.
Because much of the information contained in the announcement of internal
control weaknesses is incorporated in the stock price during the periods leading up to
the announcement date, and considering that these announcements contain little new
information, it is not surprising that the market reaction to the mandated disclosures
on internal control is relatively weak.
We also extend our tests to a sub-sample of firms cross-listed in the US and
find similar results. One potential inference from our results is that the benefits
of mandating disclosure on internal controls is limited because market participants
are able to assess much of the information embedded in the mandated disclosures
even when such disclosures are not mandated. Because the costs of reporting on the
effectiveness on internal controls by management and auditors may be non-trivial, the
net benefits from such disclosures remain unclear. Our research has the potential to
provide insights into the debate on whether countries should regulate the disclosures
on internal control over financial reporting.
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Journal of Business Finance & Accounting

Financial Reporting Quality, Structural

ALOKE (AL) GHOSH AND YONG GYU LEE*

and 350 Main Street, Malden, MA 02148, USA. 318

Pre-disclosure period (2002) Disclosure period (2003–2007)

Explanations for weak stock market reaction to disclosures on internal controls

Internal Control Problems

Stock Market Pricing

2. INTERNAL CONTROL OVER FINANCIAL REPORTING

(ii) Information Content of Internal Control Disclosures under SOX

(i) Firm Attributes and the Probability of Internal Control Weaknesses

Control weakness = β0 + β1 Segments + β2 Charges + β3 Foreign + β4 Age + β5 ROA

otherwise; InstOwn is the percentage of shares held by institutional investors divided

We estimate equation (1) using internal control effectiveness data as reported

Pr (ICW)i,t = eXβ /(1 + eXβ ) (2)

(ii) Constructs for Financial Reporting Quality

WC t = β0 + β1 CFO t−1 + β2 CFO t + β3 CFO t+1 + β4 Sales t + β5 PPE t + μt (3)

Accruals = β0 + β1 Sales + β2 PPE + η (4)

(iii) Investor Perceptions of Structural Problems, Control Problems and Reporting

(a) Pre-disclosure Year (2002)

estimate the following regression:10

CAR Pr e = β0 + β1 Pr (ICW)Pre + β2 SP -Score Pre + β3 AccrualsQualityPre

+ β4 Earnings Pre + v (6)

(b) Interim Period

CAR Interim = β0 + β1 Pr (ICW )Interim + β2 SP -Score Interim + β3 AccrualsQualityInterim

(c) Announcement Date

CAR = β0 + β1 SP -Score Pre + β2 SP -Score Interim + β3 SP -Score + β4 AccrualsQualityPre

4. DATA AND SAMPLE SELECTION

(i) Firm Attributes Test

problems in the post-disclosure period. Finally, we also find significant increases in

(ii) Control Problems Test

Intercept −2.793 0.000*** −4.606 0.000*** −4.802 0.000*** −3.792 0.165

2013 Blackwell Publishing Ltd

Panel B: Predicted Probability for the Pre-disclosure Period (2002)

ICW Control Difference

Variable Mean Median n Mean Median n Mean Median

Pr(ICW) 0.209 0.135 672 0.169 0.106 2,056 0.041*** 0.028***

(iii) Reporting Quality Test

(iv) Market Pricing Test

(a) Pre-disclosure Year (2002)

(b) Interim Period

(c) Announcement Date

2013 Blackwell Publishing Ltd

2013 Blackwell Publishing Ltd

(v) Out-of-Sample Test

(vi) Sensitivity Analysis

(vii) ADR Firms

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Intercept −2.793 0.000* −4.606 0.000* −4.802 0.000*** −3.792 0.165

Pr(ICW) 0.209 0.135 672 0.169 0.106 2,056 0.041* 0.028*