How Markets Punish Material Weaknesses

A new report examines shortcomings that lead to losses in share price; Sarbanes-Oxley requirements are understood poorly by investors, say some observers.

Section 404 of the Sarbanes-Oxley Act requires companies to disclose internal-control deficiencies in their annual reports. The effects on share prices are examined in “Control Deficiencies: Finding Financial Impurities,” a new analysis of 2004 and early 2005 disclosures by shareholder-advisory firm Glass, Lewis & Co.

Glass Lewis examined companies with a market capitalization in excess of $75 million. About 11 percent of these companies disclosed a control deficiency between January 1, 2004, and May 2, 2005. The number of companies that disclosed a material weakness — the most severe control problem — totaled 586 for the first four months of 2005, compared with 313 for all of 2004, according to the report.

On average, the day after a company disclosed a material weakness in its financial controls, its share price dropped 0.67 percent relative to market movement, Glass Lewis found. After 7 days, the share price dropped 0.90 percent; after 30 days, 1.96 percent; and after 60 days, 4.06 percent. “The mere announcement of a material weakness, independent of the auditor opinion, appears to solicit a negative reaction from investors,” according to the study.

Average Share Price Movement,
Relative to Market, vs. Seven Days before Announcement
1 day after 7 days after 30 days after 60 days after
All Deficiencies -0.72% -0.81% -1.50% -3.02%
Material Weaknesses -0.67% -0.90% -1.96% -4.06%
Qualified Opinions -0.23% -0.66% -2.30% -3.56%
Qualified Opinions,
No Warning
-0.04% -0.16% -2.49% -3.94%
Sources: Glass Lewis, FactSet.

Revelations of material weaknesses related to personnel issues seemed to raise the greatest concerns among investors, the report also found. On average, the day after a company disclosed such an issue, its share price dropped 0.92 percent relative to market movement; after 7 days, the share price dropped 1.19 percent; after 30 days, 2.31 percent; and after 60 days, 4.80 percent. Although material weaknesses related to documentation or tax-accounting issues were not punished as immediately by the market, after 60 days companies disclosing such weaknesses suffered an even greater loss in share than companies with personnel issues, the report found.

Average Share Price Movement by Category,
Relative to Market, vs. Seven Days before Announcement
1 day after 7 days after 30 days after 60 days after
Financial Systems and Procedures -0.34% -0.71% -1.35% -3.75%
Personnel Issues -0.92% -1.19% -2.31% -4.80%
Documentation 0.14% 0.12% -0.41% -5.29%
Revenue Recognition 1.04% 0.12% -0.41% -5.29%
Lease Accounting -1.39% -0.71% -0.13% -0.86%
Tax Accounting -0.27% -1.20% -4.22% -5.77%
Other -2.59% -2.15% -0.06% -3.31%
Sources: Glass Lewis, FactSet.

Discuss

Your email address will not be published. Required fields are marked *