Investor Perceptions of Government Deregulation: Evidence from Section 404 of the Sarbanes-Oxley Act

Abstract

SYNOPSIS We investigate the stock market's reaction to events leading up to the Securities and Exchange Commission's and Public Company Accounting Oversight Board's 2007 regulatory changes that reduced the scope of and documentation requirements for assessments of firms' internal controls over financial reporting (ICFR), as required by the Sarbanes-Oxley Act, Section 404. We examine abnormal returns surrounding key dates leading to the passage of these regulations and offer two main findings. First, investors reacted negatively on key event dates, suggesting that investors viewed the regulations as likely to reduce financial reporting quality rather than to drive audit efficiencies. Second, this negative market reaction is larger when ICFR effectiveness should matter most—when firms are more complex, have higher litigation risk, and greater fraud risk. Overall, our results may imply that investors prefer stronger government regulation when it comes to the assessments of a firm's internal controls over financial reporting.