IMPACT OF INTERNAL CONTROL OVER FINANCIAL REPORTING UNDER THE SARBANES-OXLEY ACT ON A FIRM'S STOCK PRICE AND STOCK VOLATILITY.

• Author: Hassan, Morsheda

INTRODUCTION

The Sarbanes-Oxley (SOX) Act was enacted July 30, 2002. It was a reaction to major corporate and accounting scandals. Under the Act, the management of a public company must report on the internal control of its annual financial reporting. Under SOX, a public company is responsible for having an internal control system and for reporting on its effectiveness. Also, management is required to disclose any internal control deficiencies and material weakness. The Sarbanes-Oxley Act gave more independence to the outside auditors and required them to verify the accuracy of the corporate financial reports. SOX requirements are intended to provide transparency in reporting, help companies avoid mistakes in financial reporting, and prevent fraud. At the time it was enacted, Sox was criticized as being costly for public companies to implement and that it would harm the stock market At the same time, there was no clear indication of the benefits that may be accrued.

Companies encounter extra cost in meeting the new regulations in reporting and it is of interest to determine if there is compensation in accrued benefits in terms of an increase in stock price and stability.. In this empirical study, we analyze a random sample of sound public companies on the New York Exchange in order to determine if there has been a change in stock prices and stock volatilities for these public companies after their first accounting disclosure as required by SOX. The use of first filing after SOX was motivated by the recent study by Gupta, Sami and Zhou (2018). The companies for this study were sound in the sense that management disclosed, in their annual 10-K financial report, effective internal control with no deficiencies or material weaknesses, which was verified by the independent auditors. We employ statistical and time series techniques to analyze the magnitude and direction of change in stock price and price volatility after the first filing of form 10-K with the Securities and Exchange Commission (SEC). Results of this study are of importance to public companies in that they shed light on the effect the SOX 2002 Act has on companies and investors in terms of market returns.

LITERATURE REVIEW

Gupta et al. (2018) empirically investigated the market effect of management and auditor reporting on effective internal controls over financial reporting by publicly listed companies after the Sarbanes-Oxley Act (SOX). The authors conducted a cross-sectional regression analysis of companies 50 weeks before and after the first time disclosure of management report and audit report according to the Sarbanes-Oxley Act. Results indicated that after the management report on internal control, companies showed a decrease in bid-ask spread and market price volatility and an increase in trade volume. However, no such results were manifested after the report by auditors on the internal control of companies. Time series intervention analysis by company showed that 70% of the companies experienced a reduction in bid-ask spreads due to Section 302 of SOX. Only 30% had such reduction after the implementation of Section 404 of SOX. The conclusion is that reports by management and auditors on internal control would provide useful information for investors about the firm's future prospect which leads to favorable market reactions.

In an earlier study, Gupta and Nayar (2007) reported on the effect of internal control weakness disclosures (under the Sarbanes-Oxley Act) on the stock returns of 90 public companies. The authors used regression analysis on a sample of companies at a point in time when they first disclosed the internal control deficiency within the period November 2003 to July 2004 Results indicated that weakness in internal control disclosures had a negative effect on market price. This negative effect was mitigated if management specified steps that had been implemented in order to correct the deficiencies. Also, the negative effect was diminished for companies using the big-4 auditing firms as outside auditors. However, the negative effect on price was increased for companies with larger liability to asset ratios

In a similar study Beneish, Billings and Hodder (2008) investigated the effect of weakness disclosure in internal control under Section 302 of the Sarbanes-Oxley Act on market returns and equity cost of capital in a sample of 330 firms. Using descriptive statistics and cross-sectional regression, the authors reported that weakness disclosures under Section 302 of SOX were associated with negative returns of -1.8% and with an increase in equity cost of capital of 88 basis points or 0.88%. On the other hand, Section 404 disclosure had no effect on stock prices or firm's cost of capital. Furthermore, auditor quality and early filing diminished the rate of negative returns.

Bartov and Faure (2016) investigated the effect of executive stock option exercise disclosures due to the Sarbanes-Oxley Act on stock returns. Using data over the period January 1, 1997 to October 1, 2011, (which is pre and post the SOX Act of August 2002) and regression analysis, the authors reported that executive disclosures had a negative effect on stock price and a positive effect on trade volume.in the post-Sox period (where timely disclosure was required), but not the pre-SOX period, where timely disclosure was not required.

Brochet (2010) studied the effect of timely disclosure of insider sales under Section 403 of SOX on stock returns and trading volumes. Using regression analysis with stock return and volume around filing dates of insider trades as dependent variables, the author found that abnormal stock returns and trading volumes around filing dates of insider trades were significantly greater post-SOX than pre-SOX.

Burks (2011) investigated the effect of accounting restatement announcements after the Sarbanes Oxley Act on investors. At the time of the passage of SOX, concern has been raised by the Treasury Secretary and the Security and Exchange Commission that restatements can unnecessarily cause confusion on the part of the investor that may lead to a negative effect on stock price or trading volume. Using least square regression...