The Impact of Disclosures of Internal Control Weaknesses and Remediations on Investors' Perceptions of Earnings Quality

Abstract

We hypothesize and find that firms making SOX-mandated disclosures of material weaknesses in internal control over financial reporting (ICOFR) exhibit lower investor-perceived earnings quality (IPEQ) than nondisclosers. We measure IPEQ using e-loading, a market-returns–based representation of earnings quality developed by Ecker, Francis, Kim, Olsson, and Schipper (2006). Firms do not exhibit decreases in IPEQ after initially disclosing material weaknesses. This is consistent with investors having anticipated ICOFR strength based on observable firm characteristics. However, firms exhibit increases in IPEQ after receiving their first clean audit reports that confirm the remediation of previously disclosed weaknesses. This indicates that, although investors do not find initial weakness disclosures to be incrementally informative, SOX motivates firms to remediate weak controls and provides a venue for credible remediation disclosures, thus enhancing investors’ perception of financial reporting reliability. These findings are consistent with the existence of regulatory benefits associated with SOX’s internal control disclosure and audit requirements.