Investor Perceived Earnings Quality and Disclosure of Internal Control Weaknesses

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He, Luo
Perceived Earnings Quality , Sarbanes Oxley Act , Internal Control Material Weakness , E-Loading , SOX 302 , SOX 404
This study investigates whether disclosures of material weaknesses in a firm’s internal control over financial reporting are associated with lower investor perceived earnings quality. I measure investor perceived earnings quality by a market returns based representation of earnings quality called e-loading developed by Ecker et al. (2006). My empirical tests use sample firms that disclosed at least one material weakness from August 2002 to October 2005. The cross-sectional univariate analysis shows that firms disclosing internal control material weaknesses have lower investor perceived earnings quality than matched firms that disclose no internal control problems. However, further cross-sectional multivariate regression analysis reveals that after controlling for firm characteristics, only disclosures of company-level material weaknesses have an incremental impact on investor perceived earnings quality, while disclosures of the less pervasive account-specific material weaknesses do not have a measurable effect on perceived earnings quality. From intertemporal within-firm analysis, I find no evidence that firms experienced a change in their perceived earnings quality after their first disclosure of internal control material weaknesses as per SOX 302 or 404. In contrast, I find that firms experienced an increase in perceived earnings quality after they received their first unqualified SOX 404 audit report indicating remediation of previously disclosed material weaknesses. This suggests that, although investors did not find the initial SOX disclosures of internal control weaknesses to be incrementally informative, the legislation motivated firms to remediate weak controls; moreover, the SOX-induced improvement in weak internal controls enhanced investors’ perception of the offending firms’ financial reporting quality.
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