Financial Reporting Quality, Structural Problems and the Informativeness of Mandated Disclosures on Internal Controls

Even before firms report internal control weaknesses under the Sarbanes-Oxley Act (SOX), they are characterized by structural problems, are prone to internal control weaknesses, and have low financial reporting quality. If the stock market incorporates much of this information during the pre-disclosure years, investors are less surprised when firms subsequently report internal control weaknesses under SOX. We find that for the pre-disclosure period, firms reporting internal control weaknesses under SOX, (1) had structural problems, (2) were prone to internal control problems, and (3) had low financial reporting quality. Further, we provide direct evidence that stock prices during pre-disclosure years incorporate much of the information about structural problems, the likelihood of internal control weaknesses, and low reporting quality. Finally, we find that many of these value-relevant factors are not related to announcement period returns when firms eventually disclose such problems under SOX and that limited new information about structural problems is generated around this date. Our results provide a compelling explanation for the muted stock price reaction around the mandatory disclosure date.