The Effect of Internal Control Weakness on Firm Valuation: Evidence from SOX Section 404 Disclosures

Transcription

1 The Effect of Internal Control Weakness on Firm Valuation: Evidence from SOX Section 404 Disclosures Yingqi Li a, Ruiqing Shao b, Junli Yu c, Zhou Zhang d and Steven Xiaofan Zheng e This version: November 5, 2014 Abstract We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes- Oxley Act have 13% lower valuation than non-icw firms based on Tobin s q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. Those ICW firms that remedy the internal control weakness in the year after disclosure have much better stock performance compared to those ICW firms who fail to remedy ICW during the same period. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has reflected the negative information associated with SOX 404 ICW reports before the actual disclosures are made. Additional analysis suggests that the market cannot independently reflect the ICW information. More likely, the activities related to the preparation of ICW disclosure generate new information that is reflected in the stock prices. Keywords: Sarbanes-Oxley Act; Internal Control Material Weakness; Firm Valuation; SOX 404; SOX 302; Benchmark Adjusted Returns. JEL: G14; G18; G30. a Shanghai Lixin University of Commerce, Lixin Accounting Research Institute, Shanghai, P.R. China, Tel: 86 (21) , liyingqi@lixin.edu.cn b Shanghai Lixin University of Commerce, Shanghai, P.R. China, Tel: 86 (21) , shaorq@lixin.edu.cn c Shanghai Lixin University of Commerce, Lixin Accounting Research Institute, Shanghai, P.R. China, Tel: 86 (21) , jlyu@lixin.edu.cn d University of Regina, Faculty of Business Administration, Regina, SK, Canada, S4S0A2. Tel: (306) zhou.zhang@uregina.ca. Zhou Zhang acknowledges the financial support from Viterra fellowship and Dean s research grant at University of Regina. e University of Manitoba, I. H. Asper School of Business, Winnipeg, MB, Canada R3T5V4. Tel: (204) zhengxs@cc.umanitoba.ca. Steven X. Zheng acknowledges the financial support from BMO Professorship in Finance at University of Manitoba.

2 I. INTRODUCTION The passage of 2002 Sarbanes-Oxley Act (SOX) greatly increased financial reporting requirements and tightened anti-fraud provisions. Among the many provisions of SOX, Section 404 (hereafter SOX 404 ) is highlighted as the most significant regulation to greatly impact corporate internal control over financial reporting. Specifically, SOX 404 requires U.S. public companies with a public float of $75 million or more (accelerated filers) to include an assessment of internal control effectiveness in their annual reports and requires external auditors to independently attest that they have evaluated the internal control effectiveness (Schneider, Gramling, Hermanson, and Ye 2009). This is in addition to Section 302 of SOX (hereafter SOX 302 ) which requires management to make unaudited disclosure about internal control effectiveness in quarterly reports. As a result, some companies disclose assessments of internal control material weakness (ICW) to the public under SOX 404 and/or SOX 302. Relative to firms with effective internal control, managers in firms with ICW have more discretionary room to intentionally or unintentionally manipulate financial and operational information and create more information noise. Thus, it is more difficult for stakeholders in capital markets to accurately assess the risk and true economic value of these firms in a timely manner based on information in financial reports. Given the common belief that investors usually demand a higher rate of return to compensate for higher information risk (Easley and O Hara 2004; Lambert, Leuz, and Verrecchia 2007), we expect ICW disclosures to have significant negative effects on firm value. However, prior literature on ICW disclosures under SOX 404 shows no noticeable impact on firms cost of equity or stock prices around the announcement date (Ogneva, Subramanyam, and Raghunandan 2007; Beneish, Billings, and Hodder 2008), while ICW disclosures under SOX 302 is associated with higher cost of equity (Beneish et al. 1

3 2008) and negative stock market reaction (Beneish et al. 2008; Hammersley, Myers, Shakespeare 2008; Kim and Park 2009). These results are consistent with the conjecture that the negative information contained in SOX 404 ICW disclosure is already reflected in the equity market prior to the time of disclosure (Beneish et al. 2008; Ashbaugh-Skaife, Collins, Kinney and Lafond 2009). We label this proposition as the early reflection hypothesis. These results can also be attributed to the possibility that many SOX 404 ICW disclosures are caused by lower materiality thresholds and do not have real financial reporting consequences (Doyle, Ge and McVay 2007). We label this explanation as the lower threshold hypothesis. In this paper, we attempt to test the early reflection hypothesis and the lower threshold hypothesis by examining several measures related to firm value: the Tobin s q ratio after SOX 404 ICW disclosure and the stock returns during the two-year window around the ICW disclosure. The two hypotheses have different predictions regarding these measures. The early reflection hypothesis predicts that ICW firms should have lower q ratios than comparable firms and the lower q ratios should result from lower stock returns before disclosure. In contrast, if SOX 404 ICW disclosures do not have real financial reporting consequences, as suggested by the lower threshold hypothesis, then those ICW firms should have similar q ratios and stock returns as comparable firms. Our sample consists of 533 firms with initial ICW disclosure under SOX 404 during the period from 2004 to Using a propensity-score matching procedure, we construct a control sample of firms that have similar characteristics but report effective internal control in their disclosure history (hereafter non-icw firms). When we examine the Tobin s q ratios of ICW firms and the matching non-icw firms, we find that the market valuation of SOX 404 ICW firms is about 13% lower than that of the non-icw firms. The lower q ratios do not seem to be 2

4 caused by sudden stock price declines around disclosures because the average abnormal stock return for ICW firms during the 3-day window around disclosure is not statistically different from zero. Instead, ICW firms underperform non-icw firms by more than 13% in the year before disclosure. Collectively, these results are consistent with the early reflection hypothesis rather than the low threshold hypothesis. If the lower valuation and stock returns are caused by the negative information related to a SOX 404 ICW report, as predicted by the early reflection hypothesis, then the market should also react to the positive information when the ICW conditions are subsequently remedied. Consistent with this implication, our tests show that firms reporting remedied ICW situations later perform significantly better than those failing to remedy in the year after the initial ICW disclosure. Our results suggest that the market does consider internal control effectiveness as a very important factor in the valuation of a firm. Most likely, the lower valuation for ICW firms results from the leakage of new information generated in the preparation for the SOX 404 disclosure. However, it is also possible that the information generated in the preparation process is not new to the market. If the market is very efficient, the information may have already been incorporated into stock prices before managers and auditors start working on SOX 404 disclosure. The assessments for SOX 404 just acknowledge the problems that the market has already recognized. If this is true, SOX 404 will lose one important reason to exist. To explore this possibility, we examine the stock return of firms reporting ICW in their first ever SOX 404 disclosure. Some of these firms could have long-standing ICW conditions before their initial SOX 404 disclosure. If the stock prices of these firms have already declined to incorporate information about ICW some time before SOX 404 disclosure is required, then they 3

5 should not have much additional price decline in the year before ICW disclosure. Our test results show that this is not the case. Firms reporting ICW in their first ever SOX 404 disclosure have similar declines in stock prices as other ICW firms in the year before disclosure. This result suggests that the market is not able to detect ICW before SOX 404 disclosure is required. Instead, it appears that the information reflected in the market before disclosure comes from the activities for SOX 404 reporting. We further test the early reflection hypothesis from another angle. Some firms report ICW under Section 302 well before their initial SOX 404 ICW disclosure. Based on the early reflection hypothesis, the market should incorporate the negative ICW information into the stock prices of these firms even earlier and the information from SOX 404 ICW disclosure should have much less impact in the market. Therefore, we examine the stock returns of SOX 404 ICW firms with prior SOX 302 ICW reports. We find that the firms reporting ICW under SOX 302 more than one year before their initial SOX 404 ICW disclosure perform significantly better in the year before SOX 404 ICW disclosure. However, their Tobin s q ratios are not significantly different from those of other ICW firms. In other words, they must have underperformed in earlier periods, most likely when the information related to SOX 302 ICW disclosures was reflected in the market. This is consistent with the early reflection hypothesis. Our paper makes several contributions to the literature. First, we apply new methodology to examine the valuation effects of SOX 404 disclosure. Several recent studies have examined whether SOX 302 or 404 convey meaningful information to the equity market (Hammersley et al. 2008; Beneish et al. 2008; Ashbaugh-Skaife et al. 2009). These studies mainly rely on a narrow event window of about three days and implicitly assume the ICW disclosure date to be the accurate announcement date. However, if the information is leaked to the market earlier or if any 4

6 confounding event occurs on the same date, the narrow event window will not capture the valuation effect of ICW. We avoid this problem by examining the Tobin s q ratio after disclosure and stock return in the one year window around disclosure instead. Second, we provide new evidence about the information content of SOX 404 ICW disclosure. Existing studies report either insignificant price reaction or price decline of about 1% or 2% around ICW announcements. We show that SOX 404 ICW disclosure is associated with firm value decline of more than 13% based on q ratio and one-year stock return before disclosure. Third, our analysis shows that the information generated in efforts to satisfy SOX disclosure requirements seems to contain new information that has not been previously reflected in the market. In other words, the reporting requirements in SOX do enhance corporate transparency. The remainder of the paper is organized as follows. In Section II, we review prior literature and develop two hypotheses linking ICW with firm valuation. In Section III, we discuss the data, sample and empirical methodology. In Section IV, we present univariate evidence, main regression results, and further elaboration on the findings. We conclude the paper in Section V. II. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT Prior literature suggests that the quality and quantity of information affect asset pricing. In their seminal work, Easley and O Hara (2004) examine how information risk affects a firm s cost of capital. They argue that because informed investors have more private information about the risk and return of stocks, uninformed traders always hold too much stock with bad news and too little stock with good news. Therefore, investors require a higher return to compensate for the higher risk of holding stocks with greater private information. Their work suggests that firms can 5

7 reduce the cost of capital by enhancing information disclosure. Lambert et al. (2007) present a theoretical framework modeling accounting information as a noisy signal of future cash flows. Following the CAPM framework, Lambert et al. (2007) define the cost of capital as the expected equity return and allow cash flows among multiple firms to be correlated. They argue that higher quality of information can reduce the investors assessed variance of future cash flows which is also diversifiable in a large economy. They point out that the quality of accounting information can further impact the assessed covariance between the cash flows of a firm and those of other firms, which is non-diversifiable. In addition, the indirect effect arises because accounting information impacts firm s real decisions, which subsequently impact expected firm value and covariance of firm cash flows. Because ICW disclosure reflects the poor quality of accounting information, both Easley and O Hara (2004) and Lambert et al. (2007) imply that firms with ICW should face higher cost of capital, and consequently, have lower valuation than firms with effective internal controls. Motivated by the theoretical work above, several papers empirically examine the relation between the cost of capital and ICW disclosure under SOX 302 or SOX 404. Ashbaugh-Skaife et al. (2009) use both SOX 302and SOX 404 disclosures to assess how changes in internal control quality affect firm risk and cost of equity. They find that ICW firms have significantly higher systematic risk and firm-specific risk. After controlling for other risk factors, Ashbaugh-Skaife et al. (2009) document that when firms report changes in internal control effectiveness under SOX 404, their costs of equity incur significant changes that range from 50 to 150 basis points. These test results are consistent with the idea that ICW affects investors risk assessments and increases firms cost of equity. Ogneva et al. (2007) also find higher implied cost of equity for SOX 404 ICW firms than non-icw firms. However, the higher cost of equity associated with ICW 6

8 disappears after controlling for primitive firm characteristics and for analyst forecast bias. Ogneva et al. (2007) interpret their results as evidence that ICW is not directly associated with higher cost of equity. Beneish et al. (2008) find that the cost of equity increases by 68 basis points for firms disclosing ICW under SOX 302 but does not change significantly for SOX 404 ICW firms. Overall, the prior studies report mixed evidence on whether and to what extent SOX 404 disclosures impact a firm s cost of equity. Studies examining the relation between cost of debt and ICW seem to be more consistent. For example, Kim et al. (2011) find that companies reporting SOX 404 ICW have higher loan spreads, tighter non-price terms and fewer lenders. Dhaliwal, Hogan, Trezevant, and Wilkins (2011) find that firms reporting SOX 404ICW have higher credit spreads. Elbannan (2009) and Ghosh and Lubberink (2006) also find lower credit ratings or higher costs of debt for ICW firms. Based on Easley and O Hara (2004) and Lambert et al. (2007) s prediction that ICW could result in lower firm value, some studies examine whether the disclosure of ICW elicits negative market reactions. Using a small sample of 98 SOX 302 ICW firms, Hammersley et al. (2008) find an abnormal event day return of -0.95%, which is significant at the 10% level. They further show that some ICW characteristics, such as vagueness of the disclosures and severity of weakness (ranking from least severe to most severe: control deficiencies, significant deficiencies, and material weaknesses), are informative. Kim and Park (2009) find a mean abnormal return of -1.32% for SOX 302 ICW firms over a three-day event window around the initial ICW announcement date. With a sample of 787 ICW disclosures under either SOX 302 or 404, Ashbaugh-Skaife et al. (2009) find an average decline of 0.76% in market adjusted buy and hold return during the three-day event window. Beneish et al. (2008) find a significantly negative abnormal return (-1.8%) during the three-day event window around the announcement of SOX 7

9 302 ICW. However, they report an insignificant market reaction for firms disclosing SOX 404 ICW. The market reaction studies above are based on the assumption that the ICW announcement is a negative information surprise to the market. Given the fact that material weakness in internal control is not a sudden event in most cases, this assumption may not be valid, especially for larger firms followed by several analysts. The existing level of corporate internal control over financial reporting for any firm is a gradual process whereas the disclosure of ICW or non-icw is an outcome. The market can establish an opinion in regards to the probability of firms reporting ICW prior to the actual internal control disclosure. It also takes some time for the auditors to assess the internal control situation in a company and the information generated in this process can easily leak to the market. Beneish et al. (2008) use this argument to explain why the market reaction to SOX 404ICW disclosure is insignificant. Even for unaudited SOX 302 ICW disclosures which include smaller firms, it is hard to believe that the small market reaction at around 1% or 2% fully reflects the impact of ICW on firm value. If ICW indeed has negative impact on company valuation, most of the negative impact probably may already occur prior to the time of ICW disclosure. Consistent with this argument, Ashbaugh-Skaife et al. (2009) show that higher risks for ICW firms predate the first ICW disclosure and suggest that market participants incorporate expectations about internal control risks prior to firms initial reporting of internal control problems. Doyle et al. (2007) propose another possible explanation. They find that ICWs are generally associated with poorly estimated accruals that are not realized as cash flows. Interestingly, material weakness disclosures made under SOX 302 seem to be more strongly associated with lower accruals quality while SOX 404 disclosures are not associated with poorer 8

10 accruals quality on average. Because SOX 404 requires external auditors to provide opinions on the effectiveness of internal control, Doyle et al. (2007) conjecture that external auditors may apply a lower effective threshold for SOX 404 compared to management s threshold under SOX 302, and therefore may identify a greater number of material weaknesses that lack real financial reporting consequences. If this lower threshold hypothesis is true, then ICW reported under SOX 404 will not have significant impact on cost of capital and firm valuation. This is consistent with the lack of relation between SOX 404 ICW and cost of equity as reported by Ogneva et al. (2007) and Beneish et al. (2008) and the lack of stock price reaction to SOX 404 ICW disclosures as documented by Beneish et al. (2008). Based on the above discussion, we test two competing hypotheses the early reflection hypothesis predicts a lower firm value for ICW firms whereas the lower threshold hypothesis predicts an insignificant valuation difference between ICW firms and firms with effective internal controls. III. THE SAMPLE AND RESEARCH DESIGN Data and the Sample We use three databases for the empirical analysis. We first use Audit Analytics database to identify ICW (estimation sample) and non-icw (control sample) firms. We also use Compustat database for financial statement data and employ the CRSP database for stock return and market return information. In the Audit Analytics database, for any given fiscal year a firm may have two records under SOX 404 disclosure based on management review or independent assessment by external auditors. Our analysis follows that of Ashbaugh-Skaife et al. (2009) and uses the disclosure by external auditors because the main difference between SOX 302 and 404 9

11 is that SOX 404 disclosure is certified by auditors. For the ICW sample, we include only the first ICW disclosure under SOX 404 for each firm. We further exclude firms who made any previous ICW disclosure under SOX 302 before the initial ICW 404 date. By doing so, we can focus on those SOX 404 ICW disclosures that are more likely to be associated with new information. We follow two steps to construct a control sample of non-icw firms. First, for any given year during our sample period, we identify a sample of firms who never filed material weakness under SOX 404 or SOX 302 in prior years. These companies are classified as clean companies. The sample size of the non-icw firms, however, is quite large (21,368 firm-year observations). Because we aim to explore the valuation difference between ICW and non-icw firms, keeping a disproportionally large sample of non-icw firms will make the comparison less meaningful and the valuation difference could be driven by the difference in firm characteristics. Thus, following the prior literature (e.g., Lennox, Francis, and Wang 2011), we use propensity score matching (PSM) approach to construct a one-to-one matched ICW and non-icw sample. To make the PSM matching more precise, we first compute the propensity score using the probit regression under the PSM approach. The probit model uses SOX 404 ICW dummy as the dependent variable and control for common determinants of ICW used by many internal control studies (see e.g., Ashabugh-Skaife et al., 2006; Doyle et al., 2007). The probit model results are reported in Appendix B. Almost all coefficients on control variables are significant at the 1% level and their signs are consistent with prior ICW literature. For example, firms with larger size, longer history, higher profitability, and audited by Big 4 accounting firms are less likely to report ICW. In contrast, firms experiencing loss and restructure in the past three years and with foreign exposure are more likely to report ICW. Next, for each ICW firm, we match a non-icw firm based on filing year, industry (classified by Fama and French 48-industry), and propensity score that is as 10

12 close as possible. We find that no statistical difference among most of mean and median values of the determinants between ICW and non-icw firms, indicating that our PSM approach results in a control sample with similar firm characteristics (results are not tabulated for brevity). [Insert Table 1 about here] Similar to many studies in accounting and finance, we further remove firms that belong to banks, insurance, real estate, security trading companies (Fama and French 48-industry: 44-47). Using the initial ICW disclosure date as the event day 0, we require the ICW and non-icw firms to have complete (-252, +2) trading days price and return data available from the CRSP database. In addition, we require sample firms to have complete control variables data available for our empirical analysis. Our final sample consists of 1,066 firms (533 ICW firms and 533 non- ICW matching firms). The detailed sample selection steps and corresponding observation numbers are reported in Table 1. Research Design Valuation Measures: Tobin s q Ratio and Benchmark Adjusted Return We apply two commonly used valuation measures to examine the impact of ICW disclosure on firm value. The first measure is Tobin s q ratio. Following La Porta, Lopez-de- Silanes, Shleifer, and Vishny (2002), we use the book value of assets as the denominator of q. The numerator of q is the book value of assets minus the book value of common equity and deferred taxes plus the market value of common equity. For each ICW firm and its matching firm, the market value of common equity is calculated using stock price on the second day after ICW disclosure (day 2) and the book values are from the most recent fiscal year before the disclosure. If the ICW announcement delivers any unexpected information to the market, using 11

13 the stock price on day 2 allows the q ratio to fully incorporate the announcement effect of ICW disclosure. Following Grinblatt and Moskowitz (2004), Faulkender and Wang (2006) and Denis and Sibilkov (2010), we use the benchmark adjusted return as the second valuation measure. It is calculated as the difference between the buy-and-hold (BHR) return of a stock and the corresponding return of its benchmark portfolio:,,, 1 Throughout the paper, we use Fama and French 25 portfolios based on size and book-tomarket (BE/ME) as the default benchmark portfolio. To form the benchmark portfolios, we first calculate ICW and non-icw firms BE and ME value using data on the most recent fiscal year end before the initial ICW filing date. We then obtain the ME and BE/ME breakpoints from Kenneth French s website as benchmark cutoffs. 1 Based on the cutoffs, every ICW firm and non- ICW matching firm is matched with one of the 25 size and BE/ME portfolios before we calculate the BHRs and benchmark adjust returns. To check the robustness of our results, we also report results based on other alterative benchmarks in later part of the paper. We calculate the benchmark adjusted return for both the ICW firms and the matching firms for the following windows around initial ICW disclosure date: (-504, -253), (-252, -1), (-1, 1), and (0, +252). Prior studies (Beneish et al. 2008; Ashbaugh-Skaife et al. 2009; Kim and Park 2009) usually focus on the (-1, 1) window. This requires the disclosure date to be very accurate. If the information is leaked to the market earlier or if any confounding event occurs on the same date, the (-1, 1) window will not capture the valuation effect of ICW. By examining additional time windows, we can largely avoid this problem. Empirical Methodology

14 We regress Tobin s q ratio and the benchmark adjusted return on ICW dummy and other control variables to explore the association between ICW and firm value 2. Our control variables are similar to those used by Kim and Park (2009) and Ashbaugh-Skaife et al. (2009) and include variables related to firm valuation and determinants affecting ICW (see the detailed variable description in Appendix A). To reduce the impact of outliers, we winsorize our continuous variables at the 1% and 99% levels. We first estimate regression (2) below to find out how ICW relates to Tobin s q ratio:,, 2 In the regression, ICW is a dummy variable that takes the value of one for ICW companies and the value of zero for non-icw companies. The subscript Y0 denotes the year before SOX 404 ICW disclosure date. The early reflection hypothesis predicts that the firm value is lower for ICW firms relative to non-icw firms at the time of disclosure. In this case the coefficient of ICW dummy will be negative. In contrast, the lower threshold hypothesis predicts that the firm value of ICW firms is similar to non-icw firms. Therefore, an insignificant coefficient of ICW dummy will be consistent with the lower threshold hypothesis. The early reflection hypothesis also predicts that the lower firm value result from lower stock returns before disclosure. Thus, we estimate regression (3) below using benchmark adjusted returns for different periods as dependent variable:,,,, 3 In regression (3) we add book-to-market ratio to the control variables (Fama and French 1992). 2 Faulkender and Wang (2006) and Denis and Sibilkov (2010) also estimate regressions using benchmark adjusted return as dependent variable. 13

15 Similarly, when benchmark adjusted return prior to disclosure is used as dependent variable in regression (3), the early reflection hypothesis predicts a negative coefficient for the ICW dummy whereas the lower threshold hypothesis predicts an insignificant coefficient for the ICW dummy. IV. EMPIRICAL RESULTS ICW and Tobin s q The statistical distribution of Tobin s q for the ICW firms and the non-icw matching firms is reported in Table 2. The mean Tobin s q of ICW firms is while that of non-icw firms is This result suggests that the ICW firms are valued 13.86% lower than the non- ICW firms. With a t-statistic of 3.541, the difference in means is statistically significant at 1% level. Because Tobin s q is a ratio, the mean can be distorted by extreme observations. So we should also look at the medians. The ICW firms have a median Tobin s q ratio of 1.433, which is 14.81% lower than the median for non-icw firms. The z-statistic shows that this difference in medians is also significant at any traditional significance level. The ICW firms also have lower q at the 1 st quartile and the 3 rd quartile. Overall, these numbers suggest that, on the second day after the date of initial ICW disclosure under SOX 404, a typical ICW firm is valued more than 13% lower than its non-icw peer. [Insert Table 2 about here] We report the regression analysis about how Tobin s q relates to ICW in Table 3. First we regress Tobin s q on the ICW dummy only and the results are reported in column (1) of Table 3. The coefficient of the ICW dummy is and it is statistically significant. This is consistent with the univariate results in Table 2. In column (2) of Table 3, we show the 14

16 regression results after including the control variables. The coefficient of the ICW dummy becomes , which implies that ICW firms are still valued more than 13% (=-0.284/2.126) lower than non-icw firms on average after we consider many other factors known to affect valuation. These results suggest that ICW has significant negative effects on firm valuation. They are consistent with the early reflection hypothesis. [Insert Table 3 about here] If ICW reduces the value of a firm, then the value of the firm should be lower when a firm reports multiple numbers of ICW. To test this conjecture, we use the number of ICW reported under SOX 404 to measure the degree of ICW and run alternative regressions by regressing Tobin s q on the number of ICW. The results are reported in columns (3) and (4) of Table 3. In column (3) we include the number of ICW as the only independent variable. In column (4) we add the remaining control variables. In both columns, the coefficients of the number of ICW are negative and significant at the 1% level. This shows that when a company reports a larger number of ICW, its Tobin s q ratio is much lower than that of the matching non- ICW firm. This is also consistent with the early reflection hypothesis. ICW and Stock Return If the market assigns a lower valuation for the ICW firms, a natural follow-up question is when the lower valuation begins. If the ICW disclosure brings completely new negative information to the market, then the lower valuation should result from a sudden drop in stock price around the disclosure date. This is the rationale for previous studies to examine the stock market reaction in a short event window around the announcement date. However, they do not find significant price reactions to SOX 404 ICW disclosures. According to the early reflection hypothesis, the market reflects the information about ICW some time before the public disclosure. 15

17 This implies a drop in stock price during a certain period before disclosure. On the other hand, it is also possible that ICW firms are always valued lower relative to non-icw firms. This could happen if the market is very efficient and reflects the ICW information from the beginning. Or, if the lower threshold hypothesis is true, SOX 404 ICW itself does not have any valuation effect, but maybe it is associated with some other characteristics that cause ICW firms to have lower valuation long before ICW disclosure. To distinguish the different possibilities, we look at the buy and hold returns and benchmark adjusted returns for ICW firms and non-icw firms. The univariate evidence of returns on various windows is reported in Table 4. [Insert Table 4 about here] We first look at the returns for the three-day window of (-1, 1) in Panel A and Panel B. This window is the same as that used in previous studies about the announcement effect around ICW disclosure. Consistent with previous studies, both the buy and hold return and the benchmark adjusted return are close to zero at % and %, respectively. Not surprisingly, the non-icw matching firms also have returns close to zero during the same period. The difference in returns between ICW and non-icw firms are statistically insignificant. These results suggest that the lower valuation for ICW firms, as evidenced in lower Tobin s q in Table 2 and Table 3, is not caused by a sudden price drop during the three-day window around the disclosure date. Panel C and Panel D of Table 4 report the returns for the window of (-504, -253), which starts about two years before the disclosure date and ends about one year before the disclosure date. In this window, the mean buy and hold return of ICW firms is very close to that of non- ICW matching firms. The mean benchmark adjusted return of ICW firms is only about 2.4% lower than that of non-icw firm. The t-tests for both buy and hold return and benchmark 16

18 adjusted return show that the difference in mean values between ICW firms and non-icw firms is not statistically different from zero. The median returns of ICW firms are lower, suggesting that the returns of ICW firms are more skewed in this window. Overall, it seems that the lower valuation for ICW firms is not caused by abnormal return in the window of (-504, -253). Panel E and Panel F report the returns for the window of (-252, -1), which starts from about one year before disclosure and ends one day before disclosure. During this window, the ICW firms underperform significantly relative to matching non-icw firms. For buy and hold returns, the mean values are -1.4% and 11.7% for ICW and non-icw firms, respectively. For benchmark adjusted returns, the mean values are -12.7% and 0.4% for ICW and non-icw firms, respectively. These results suggest that the stocks of ICW firms underperform non-icw stocks by about 13% and the differences are all significant at the 1% level. We also observe similar results for median values. Considering the evidence we reported earlier that ICW firms are valued at least 13% lower than non-icw firms based on Tobin s q, the return numbers above suggest that the lower valuation of ICW firms is likely the result of stock underperformance in the year before disclosure. We also report the returns for the post-disclosure window of (0, 252) in Panels G and H of Table 4. We find that on average the ICW firms underperform the non-icw firms by about 3% in the year after ICW disclosure, but the difference between them is not statistically significant at any conventional level. In sum, the BHR and benchmark adjusted return for various windows suggest that the large underperformance for ICW firms relative to non-icw firms occurs during the window of one year prior to ICW disclosure. Table 4 only shows the cumulative performance for four windows. To enhance our understanding about the change in returns over time, we also plot the mean benchmark adjusted 17

19 cumulative returns in Figure 1 with a starting date of 504 days before disclosure for every subsequent trading day up to 252 days after disclosure for the ICW firms and non-icw firms. Consistent with the evidence in Table 4, we observe that ICW firms start to underperform significantly about one year before disclosure date and this underperformance seems to end a few days before the disclosure date. After disclosure date, ICW firms and non-icw firms seem to have similar stock performance. Therefore, in the following regression analyses, we first focus on the window of (-252, -1) and report the evidence in Table 5. [Insert Figure 1 and Table 5about here] In column 1, we regress the benchmark adjusted returns of ICW firms and non-icw matching firms for the window of (-252, -1) on the ICW dummy. The coefficient of the ICW dummy is , suggesting that the ICW firms underperform the matching firms by 13.1% in the year before disclosure. Next, we add all the control variables to the regression and report the evidence in column (2) of Table 5. The results show that the coefficient of the ICW dummy is still negative (-0.079) and significant (t=-3.055). We also replace the ICW dummy with the number of ICW disclosures and re-estimate the regressions in column (3) and column (4) of Table 5. In both of the two columns, the coefficients of the number of ICW disclosures are negative and significant, suggesting that an ICW stock underperforms more in the year before disclosure if the number of ICW is larger. This is consistent with earlier evidence that firms with more severe ICW are valued lower. 3 3 In an untabulated analysis, we also use CRSP value-weighted market adjusted return and size adjusted return as alternative dependent variables to check the robustness of our results in Table 5. We find that our findings hold under different benchmark adjusted returns. We also use a conventional matching approach to construct the matching ICW and non-icw firms. We require that matched non-icw firms should have the same industry, same year, 50% to 150% of total assets, and as close as possible in operating profit margin as the ICW firms. Our regression results show that results under the conventional matching approach are quantitatively similar to that of PSM approach. These results are not reported for simplicity and are available upon request. 18

20 Overall, the results above suggest that the information contained in ICW report is negative but it has been reflected in stock prices during the year before disclosure. This is consistent with the early reflection hypothesis. ICW Remedy The underperformance of ICW stocks in the year before disclosure is consistent with the early reflection hypothesis. However, supporters of the lower threshold hypothesis may suggest that the underperformance is not related to ICW. There may be some unidentified factors that are shared by many ICW stocks causing them to underperform. To explore this possibility, we examine the effect of ICW remedy on the stock performance. Several recent studies have shown that weak internal controls result insignificant negative economic consequences for ICW companies, such as higher auditing costs (Hammersley, Myers, and Zhou 2012), lower credit ratings (Elbannan 2009), higher cost of capital (Dhaliwal et al. 2011; Crabtree and Maher 2012) and higher agency costs (Skaife et al. 2013). Thus, after ICW disclosure, the board and investors may demand active steps to improve the quality of internal control system and remedy the ICW situation. Many ICW companies do subsequently report remedy of ICW. This provides us with another setting to test the early reflection hypothesis. If the underperformance of ICW stocks in the year before disclosure is caused by the negative information associated with ICW as predicted by the early reflection hypothesis, then the remedy of ICW should be considered as positive information that helps mitigate adverse selection and lead to higher quality of disclosure. As a result, companies reporting remedy of ICW should outperform those reporting continued ICW. To test this remedy effect, we use the ICW subsample and regress the benchmark adjusted return of ICW companies on a dummy of Remedied ICW. This dummy takes the value 19

21 of one if in the year after disclosure, the company reports that the ICW situation has been remedied and zero otherwise. The results are reported in column (1) and column (2) of Table 6. [Insert Table 6 about here] In column (1) we include only the Remedied ICW dummy in the regression. The coefficient of the Remedied ICW dummy is and statistically significant at 1% level, suggesting that those companies that are able to remedy their ICW situation outperform other ICW companies by 11.2%. In column (2) we include the control variables used in Regression (3). The coefficient of the Remedied ICW dummy remains above 0.11 and significant at the 1% level. We also estimate the regression using the full sample with ICW and non-icw matching firms. This time the regression includes two dummies: the ICW dummy and the Remedied ICW dummy. The results are reported in column (3) and column (4) of Table 6. They are very similar to those in columns (1) and (2). The coefficients of the Remedied ICW dummy are positive and significant at similar magnitudes of and 0.08 respectively, implying that those companies that remedy their ICW situation outperform other ICW companies by at least 8% in the year after initial SOX 404 ICW disclosure. So we not only find underperformance of ICW stocks before disclosure, we also find stock outperformance when ICW is remedied. These results are consistent with the idea that ICW is negatively associated with firm valuation and the remedy of ICW leads to positive valuation effect. This finding further supports the early reflection hypothesis instead of the lower threshold hypothesis. ICW in First Ever SOX 404 Disclosure The early reflection hypothesis only argues that the market has already incorporated the information associated with ICW when the disclosure occurs, but does not necessarily assume 20

22 that the information comes from activities related to the disclosure. It is possible that the process of assessment about internal control effectiveness generates new information that is reflected in stock prices before the ICW disclosure is formally made. It is also possible that the market has already independently incorporated information about ICW before the assessment is done. The first possibility is consistent with the view that SOX 404 disclosure delivers valuable information to the market. The second possibility is consistent with the view that SOX 404 just imposes additional regulatory burden on managers and does not have much economic benefit. We try to distinguish the two possibilities by utilizing the information of whether the initial ICW disclosure is the firm s first ever SOX 404 disclosure.sox 404 became effective on November 15, Some firms may have pre-existing ICW conditions long before this date but were not required to report it. After November 15, 2004, these old patients report ICW in their first ever SOX 404 disclosure. Other ICW firms in our sample are new patients who disclose ICW after previously reporting effective internal control under SOX 404. Most likely the internal control in these new patients deteriorates not long before the disclosure. If the market is able to capture the negative information associated with ICW without the mandatory disclosure required by SOX 404, the stocks of those old patients should have declined/underperformed long before their first ever SOX 404 disclosure. In the year prior to disclosure, they should not decline/underperform as much as the new patients. On the other hand, if the market needs the information generated from the SOX 404 disclosure to value companies, the stock price decline of the old patients will also occur in the year before disclosure and the magnitude of decline before disclosure should be similar to that of the new patients. We use regressions to test these conjectures. The test results are reported in column (1) and column (2) of Table 7. [Insert Table 7 about here] 21

23 The regressions in column (1) and column (2) of Table 7 use the original sample of ICW and non-icw matching firms. The First Ever dummy takes a value of one if the firm s initial ICW disclosure is its first ever SOX 404 disclosure, and zero otherwise. In column (1) we regress the benchmark adjusted return in the year before disclosure on the ICW dummy and the First Ever dummy. The coefficient of the First Ever dummy is not statistically different from zero. Then we include the control variables in the regression and the results are reported in column (2). Again the coefficient on the First Ever dummy is statistically insignificant. This result indicates that the stock performance of those ICW firms who report ICW in their first ever SOX 404 disclosure is not significantly different from that of other ICW firms in the year before disclosure. This is not consistent with the conjecture that the market is able to independently reflect the negative information associated with ICW. Instead, it seems the activities for preparing SOX 404 disclosure generate useful new information that helps the market value stocks. Prior SOX 302 ICW Now we examine the early reflection hypothesis from another angle. Our results so far restrict the sample to ICW firms who reports their initial ICW under SOX 404 and remove those ICW firms with prior ICW disclosure under SOX 302. This design allows us to get a clean test on how the market evaluates the initial ICW 404 disclosure. However, it may be useful to consider those firms who reported ICW under SOX 302 before their initial SOX 404 ICW report. If the ICW stocks underperform in the year before the actual SOX 404 disclosures because the market reflects the ICW information early, then the underperformance will be less severe for those stocks with prior SOX 302 ICW disclosure because the negative information related to the SOX 404 ICW disclosure is not as surprising to the market as before. To test this conjecture, we 22

24 first create an expanded sample by adding those ICW firms with prior SOX 302 ICW report and their matching firms to our main sample. Then we create two additional dummies. One dummy,i302a, takes the value of one if the firm has any SOX 302 ICW report in the period of 253 or more days before its initial SOX 404 ICW disclosure date, and zero otherwise. In the former case the stock price should have already reflected the SOX 302 ICW information before the window of (-252, -1), so the benchmark adjusted return in the year before SOX 404 ICW disclosure should be better. Another dummy, I302B, takes the value of one if the SOX 302 ICW disclosure occurs during the window of (-252, -1), and zero otherwise. The two dummies are added to our earlier regressions on benchmark adjusted return in the year before disclosure. We expect the coefficient of I302A to be positive and significant. However, it is not clear what the coefficient of I302B should be like. For those SOX 302 ICW disclosures occurring in earlier part of the year before ICW 404 disclosure, the information may have been reflected in the previous year and subsequent stock performance should be better. For those SOX 302 ICW disclosures occurring in latter part of the year, the information may have negative effect on the stock performance in the year. The two effects may offset each other in the regression. We report the regression results in column (3) and column (4) of Table 7. In column (3) we include only the ICW dummy, the First Ever dummy and I302A and I302B dummies. Consistent with our expectation, the coefficient of I302A is positive and significant at 10% level. In column (4), we include the control variables. Again the coefficient of I302A is positive and significant at 10% level. Not surprisingly, the coefficients of I302B are insignificant in both regressions. So if a firm reports ICW under SOX 302 more than one year before its initial SOX 404 ICW disclosure, it will have better stock performance in the following year. This is consistent with the early reflection hypothesis. 23

25 However, there is a possible caveat: if the stocks of SOX 404 ICW firms with prior SOX 302 ICW disclosures perform better in the year before disclosure, would this cause these stocks to be valued higher than other ICW stocks? The early reflection hypothesis predicts that they should not be valued higher because the market should reflect the information that they still have ICW condition. We regress Tobin s q on the prior SOX 302 dummies using the expanded sample to test this prediction. The results are also reported in column (5) and column (6) of Table 7. In column (5) we include only the four dummies among the independent variables. The coefficient of I302A is actually negative and significant at 10% level, implying that ICW firms with prior SOX 302 ICW report more than one year before SOX 404 ICW report are valued even lower than other ICW firms. This is not surprising because SOX 302 ICW reports followed by SOX 404 ICW reports may convey a higher degree of ICW than SOX 404 ICW report only. After we include other control variables in column (6), the coefficient of I302A is still negative but becomes insignificant. These results suggest that the better stock performance in the year before SOX 404 disclosure for these ICW firms with prior SOX 302 ICW reports does not drive their valuation level above that of other ICW firms. In other words, the stocks of these firms must have underperformed in previous years. Given that they have SOX 302 reports in previous years, the results are consistent with the early reflection hypothesis. V. CONCLUSION In this paper we examine the valuation effects of ICW disclosure under SOX 404. We show that ICW firms are valued more than 13% lower than non-icw firms based on Tobin s q. This significant lower valuation for ICW firms is mainly caused by stock underperformance of more than 13% in the year before ICW disclosure. The ICW firms that remedy the ICW in the 24

26 year after disclosure have much better stock performance than those ICW firms who fail to remedy ICWs during the same period. If a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier, its stock performs better in the year before disclosure although this does not drive their Tobin s q higher than other ICW firms. All these results are consistent with the hypothesis that the market has reflected the negative information associated with SOX 404 ICW reports before the actual disclosures are made. In addition, firms reporting ICW in their first ever SOX 404 disclosure have similar performance as other ICW firms in the year before disclosure, suggesting that the market cannot independently reflect the ICW information. Most likely, the activities related to the preparation of ICW disclosure generate new information that is reflected in the market. This is consistent with the view that SOX 404 requirements improve transparency by providing new information to the public. 25