Stock Investors’ Response to Disclosures of Material Weaknesses in Internal Control

There has been some controversy regarding the burden that the Sarbanes-Oxley Section 404 (SOX 404) casts on American public companies and whether the benefits outweigh the costs of compliance. Starting with November 15, 2004, Section 404 of the Act requires all accelerated firms (with at least $75 million in public equity) to report on the effectiveness of their internal controls over financial reporting. Reporting under SOX is meant to improve investor confidence concerning the stock of a specific company by adding credibility to its financial statements. An increase in the quality of financial information should determine a reduction in information asymmetry among stock investors, narrowing the bid-ask spread. I use the model developed by Bollen, Smith and Whaley (2004) to separate the cost components of the bid-ask spread for a sample of compliant firms in the period surrounding the implementation of SOX 404. The expectation is that the passage did have a positive effect, by reducing the bid-ask spread.