Investor reactions to disclosures of material internal control weaknesses

Purpose - The purpose of this paper is to examine investor reactions to material internal control weakness disclosures. In particular, the abnormal returns, the change in volatility, and the change in systematic risk are analyzed around auditors' material weakness reports. Design/methodology/approach - The sample consists of 342 firms with initial Sarbanes‐Oxley Act, Section 404 weakness disclosures issued between 2005 and 2007. The paper uses three measures for investor reactions: abnormal returns and the change in volatility and systematic risk. The hypotheses of the paper are investigated using univariate analysis. Findings - The initial results imply surprisingly that the material weakness disclosure is good news to investors. However, after controlling for the preceding management's internal control disclosure, the results show that the abnormal reaction is positive only when the audit report is consistent with the preceding management report. In addition, the results show a significant change in volatility after the auditor's weakness disclosure. Research limitations/implications - These results imply that the investor reactions to auditors' material weakness disclosures depend on the content of the preceding report issued by management: there is a positive reaction if management has identified and reported the existing material weaknesses before the auditor, and a negative reaction when management has failed to identify or report the material weaknesses before the auditor. Originality/value - The findings of this paper emphasize that the value of the information contained in the auditors' material internal control weakness disclosures vary significantly depending on management disclosures.