The Disclosure Of Internal Control Weakness And Market Reaction

Regulators require listed companies to strengthen their internal control as well as disclosing relevant information, in order to improve the level of management of these listed companies and ensure the overall transparency of information in the business environment. By inquiring and implementing internal control standards and mandatory disclosure of information, internal control of information has become a pivotal part of companies’ public disclosure of information. The economic effect this will have has ultimately become an important part of our study on internal control.The existing domestic literature regarding internal control of information focuses largely on voluntary disclosure, concentrating less on the internal control weaknesses (ICW) due to the limited samples provided. This paper will examine whether the market will assess and establish a price for the disclosure of ICWs and their severity, or whether the market will further inspect the authenticity of the "no ICW exists" conclusion. This is based on the level of realization of internal control objectives, assuming that the proportion of ICW disclosure is still low.This paper will also argue that existence of ICW is typically "bad" news. Under the supervision of mandatory disclosure regulations and internal control audit, the disclosed ICWs should be real, and therefore indicating that the company may not in fact achieve their proposed internal control objectives such as operating legally, making true financial statements etc. The more serious the weakness is, the greater chance of deviation from proposed targets. As a result, companies that disclose ICWs will experience negative market response; and those who have either a material weakness or suffer from a more strenuous weakness will in turn receive worse market response compared to companies with general weaknesses. Furthermore, investors will assess the authenticity of the "no ICW exists" conclusions. For companies that provide results which is far worse in performance than the ICW-companies but still drawing a "no ICW exists" conclusion, they will experience poorer response.Companies examined in this paper are listed companies that are included in the mandatory disclosure practice in 2012. Their market response to the disclosure of internal control self-evaluation reports are examined in short window periods. The empirical results illustrate that ICW-companies indeed experience worse market reaction as hypothesized, however investors are not particularly sensitive about the severity of ICWs. Furthermore, evidence shows that compared to companies who have material or serious weakness, those having general ICWs demonstrate higher risk characteristics as well as a lower level of realization of their internal control targets. This indicates that Chinese listed companies have a tendency to lower the severity of their ICWs. Finally, no evidence showing that the market will set a price for the authenticity of "no ICW exists" conclusions is found, indicating that investors also agree that ICW doesn’t exist if companies choose to not disclose this themselves.Due to the restricted availability of resources and sample size, this paper has certain limitations. With the gradual implementation of the mandatory disclosure policy, findings within the paper can then be further examined with a larger pool of companies, and research can also expand to SME board or GEM companies. Similarly, ICW information includes the classification (financial-reports-related or non-financial-reports-related) and number of ICW, the standards in which we identify ICW by, whether the ICW has been fixed and etc. We can follow-up our studies focusing on how these information influence investors’decisions.