Investors punish firms that disclose internal control weakness as required by Sarbanes-Oxley provisions, but having a Big Four auditor mitigates the negative price hit, according to new research out of Indiana University.
The findings appear in two separate research papers by Leslie Hodder, assistant professor of accounting at Indiana University's Kelley School of Business. Hodder frames those papers as a rebuke to arguments that the provisions are a waste of an accounting firm's time and money on issues that are of no consequence to investors.
"If that's true, we shouldn't see the market response to a firm's disclosure of material weakness that we did," Hodder said in a statement. "Instead, our research shows that the market does care."
In a project co-authored with Messod Beneish and Mary Billings, also of Indiana University, Hodder found "significant abnormal negative returns," in the range of 1.5 to 2 percent of market capitalization, over three trading days for 336 firms that disclosed internal control weaknesses in 2004, as required by SOX regulations
The negative reaction occurs even when auditors are not saying that they found anything wrong with the numbers, Hodder stresses in the paper. In these cases, auditors are only saying that there was a problem with the process of arriving at those numbers. Hodder speculates that stock prices decline after SOX disclosures because analysts and investors factor in the perceived cost of remediation, and also consider a company with internal control problems to be a riskier investment.
That said, companies reporting internal control problems experienced a milder stock price hit if a Big Four firm conducted the audit. While the negative impact overall might be 1.5 to 2 percent, Hodder found the impact is about 3 percent when a company doesn't have a large auditor.
Even if firms can afford high-priced auditors, not all firms can engage one. In additional work, not yet released, Hodder is investigating auditor turnover incidence in relation to SOX implementation.
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