Internal Control Material Weakness, Analysts' Accuracy and Bias, And Brokerage Reputation

Abstract

Using a sample of firms that disclose internal control material weaknesses under Sections 302 and 404 of the Sarbanes-Oxley Act, we investigate the relations between the accuracy and bias of financial analysts' earnings forecasts and disclosed internal control material weaknesses. We find that forecast accuracy is negatively related to material weaknesses in internal control when disclosed internal control material weaknesses are related to controls over firms' broader control environment (firm-level internal control). We also hypothesize and find that optimistic forecast bias is higher for firms disclosing firm-level internal control material weaknesses, suggesting that, due to the increased complexity related to inefficient internal control at firm-level, analysts intentionally bias their forecasts upward to gain favorable access to firms' internal information. In addition, we find that the optimistic bias only exists in forecasts issued by analysts who are affiliated with less reputable brokerage houses.