Why Do Some Accelerated Filers with SOX Section 404 Material Weaknesses Provide Early Warning under Section 302?

Abstract

SUMMARY: During the first year of the SOX Section 404 reporting requirements (effective November 15, 2004), many adverse Section 404 audit reports were a “surprise” in that management had not previously warned investors of the internal control deficiencies (ICDs) in SEC filings under Section 302 (effective August 29, 2002). Based on 451 accelerated filers with adverse initial Section 404 reports, we look back in time to previous disclosures under Section 302 and find that only 27 percent of the companies provided early warning of any of the ICDs during the fiscal year. We examine the association of early warning during the fiscal year under Section 302 with material weakness characteristics, litigation risk, subsequent financing, auditor characteristics, and management and governance traits. We find that early warning of ICDs is positively associated with the severity and number of material weaknesses, prior earnings restatements, auditor independence and effort, CFO change, the number of institutional investors, and the number of audit committee meetings, and negatively associated with future equity financing activities and CEO/board chair duality. Overall, the results underscore previous research documenting the effect of management incentives on disclosure behavior and the benefits of rigorous auditing and monitoring. We offer implications and directions for future research.