The Predictability of Earnings After the Implementation of SOX 404

Abstract

We investigate how weak internal control affects the quality of financial reporting by examining the predictability of earnings after the implementation of Sarbanes-Oxley Section 404 reporting. Weak internal control over financial reporting can result in both unintentional errors and deliberate misrepresentations that affect the predictability of earnings but in opposite ways. If managers use the additional discretion available in weak internal control environments to deliberately bias earnings in a desired direction in order to achieve their financial reporting objectives, i.e., engage in earnings management, earnings will be more predictable. In contrast, if weak internal control culminates in unintentional random errors, then there will be more noise in financial reporting leading to less predictable earnings. We find that firms with weak internal control have poorer earnings predictability relative to firms with effective internal control. We also find the predictability of earnings improves once firms remediate their internal control weaknesses. The results are robust to using analyst forecasts and management forecasts as well as controlling for firm characteristics known to be associated with weak internal control. Our results suggest that one benefit of effective internal control is a reduction of noise in financial reporting thereby increasing the predictability of earnings.