Year: 2025
Type: article
Abstract: ABSTRACT We investigate whether investors underreact to material weakness disclosures in internal controls, leading to a subsequent negative stock return drift. Using SOX Section 302 disclosures (2007–2023), we find negligible market reaction around announcement dates but document economically large negative drift over the following two quarters, representing approximately 10%–16% annualized underperformance. This negative drift survives risk‐based explanations, the post‐earnings‐announcement drift, and other anomalies linked to accruals, momentum, distress risk, and penny stocks. Additional results indicate that the mispricing is confined to firms with low institutional ownership. We offer a behavioral explanation: investors fail to incorporate differences in conditional (79%) and unconditional (6%) probabilities of subsequent material weaknesses. Following material weakness announcements, the negative drift in returns arises as investors gradually revise their expectations about the persistence of internal control problems. Our results provide a plausible alternative explanation for the puzzling weak stock market reaction to internal control disclosures.
DOI: 10.1111/jbfa.70012
Language: English
Subfield: Accounting
Domain: Social Sciences
Open Access status: hybrid
Estimated APC paid: $3,800
OpenAlex ID: W4414303180