Investor reactions to restatements conditional on disclosure of internal control weaknesses

Abstract

Purpose: The purpose of this paper is to investigate investor reactions to financial restatements conditional on disclosures of internal control weaknesses under Section 404 of the Sarbanes-Oxley Act. Design/methodology/approach: The research uses cumulative abnormal stock returns (CARs) as a proxy for investor reactions. Restatements and internal control reports are available on audit analytics. Multivariate regression analyses were used for testing. Findings: Using a sample of restating firms whose original misstatements are linked to underlying internal control weaknesses, the research finds that cumulative abnormal returns for firms disclosing internal control weaknesses in a timely manner is negative in a three-day window around the restatement announcements. The finding indicates that restatements with early disclosure of internal control weaknesses provide more persuasive evidence of the ineffectiveness of a firm’s internal control over financial reporting, rather than early disclosure lowering the information asymmetry between a firm and investors. Research limitations/implications: This study employs CARs to examine the market reaction to restatements conditional on disclosure of internal control weaknesses. Practical implications: Further study on reactions by creditors who have access to private information on firms could extend the implications of the finding. Originality/value: The study contributes to the existing research by documenting that early disclosure of material weaknesses in internal control affects investors’ reactions to financial restatements.