Stock Investors' response to SOX 404 Material Weakness Disclosures
A Study on the Effects of Section 404 of the Sarbanes-Oxley Act over Financial Reporting Credibility
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Brief Synopsis: This paper investigates the market effects of Section 404 of the Sarbanes-Oxley Act by looking at the changes that the passage has brought in trader s information asymmetry, proxied by market makers bid-ask spreads. Before the enactment of Sarbanes-Oxley, firms were only required to publicly disclose internal control deficiencies if there was a change in auditor. I hypothesize that if compliance with SOX 404 increases internal control over financial reporting, investor confidence in annual reports will also increase. Superior disclosures available to all traders lead to a reduc...
Brief Synopsis: This paper investigates the market effects of Section 404 of the Sarbanes-Oxley Act by looking at the changes that the passage has brought in trader s information asymmetry, proxied by market makers bid-ask spreads. Before the enactment of Sarbanes-Oxley, firms were only required to publicly disclose internal control deficiencies if there was a change in auditor. I hypothesize that if compliance with SOX 404 increases internal control over financial reporting, investor confidence in annual reports will also increase. Superior disclosures available to all traders lead to a reduction of information asymmetry. An increase in the quality of financial information should determine a narrowing of market maker s bid-ask spreads because the adverse selection cost is lower. I identify the cost components of the bid-ask spread for a sample of stocks surrounding the implementation of SOX 404. My expectation is that market makers react to the implementation of Section 404 as if information asymmetry has diminished, considering that the chances of trading against better informed traders are lower.
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