Internal control failures and corporate governance structures: A post Sarbanes-Oxley Act (SOX) analysis

Recent corporate scandals suggest a breakdown in internal controls and the lack of adequate corporate governance mechanisms. In 2002, Congress passed the Sarbanes-Oxley Act, which requires firms to assess internal controls and report internal control weaknesses. My study examines the causes and consequences of material weaknesses (MW) reported under Section 302 of SOX. The study has four main objectives. First, I investigate whether firms that report MW are associated with less effective audit committees and boards of directors. Using 184 firms that reported MW from August 2003 to December 2004 and a matched-pair sample of control firms, I find that firms with lower audit committee financial expertise, smaller audit committees, and lower board independence are more likely to have MW. Second, I examine whether the managerial labor market imposes penalties on top management, audit committees, and boards of directors for internal control failures. I find that MW firms have significantly higher turnover of their audit committee members and outside directors than the control firms following the MW detection. Audit committee members and outside directors in the MW firms also lose more outside directorships than their counterparts in the control firms. There is some empirical support that the top management in the MW firms is more likely to leave the firm than their counterparts in the control firms. Additional analyses show that the extent of reputational penalties increase with the severity of the MW detected. Third, I examine whether the MW firms improve their governance structures upon the MW detection. The results indicate that MW firms experience greater improvement in their governance structures than the control firms. By the second year following the MW detection, the MW and control firms no longer differ in terms of audit committee independence, audit committee financial expertise, audit committee size, and board independence. Last, I examine whether the market reacts positively to the improvement in governance structures. I find a positive relation between the two-year buy-and-hold abnormal returns and the MW firms' improvement in audit committee size and board independence. This result is consistent with the improvement in governance structures restoring investor confidence in financial reporting.