The Effect of Internal Control Problems on the Bid-Ask Spread under SOX Section 302

Abstract

This study examines the relationship between firms’ internal control problems and the bid-ask spread using a sample of firms that disclose the effectiveness of internal controls in financial reports under Section 302 of the Sarbanes-Oxley Act (SOX). The bid-ask spread has been used as a proxy for information asymmetry among market participants. By controlling other variables that affect the bid-ask spread, this study shows that the bid-ask spread of ineffective firms has different patterns from that of effective firms in three windows (before, around, and after disclosure). Even though the bid-ask spread of ineffective and effective firms before disclosure is the same, the ineffective firms show higher (lower) bid-ask spread than did effective firms around (after) disclosure. Moreover, the results show that the difference in the bid-ask spread between the two groups of firms after disclosure disappears over time. These results indicate that internal control problems affect market participants’ perceptions of financial statements initially, but over time, participants attempt more actively to understand the financial reporting of firms with internal control problems than of those without.