Why Do Firms Defer Internal Control Assessments and Does It Matter? Evidence from M&A Transactions

To inform the debate on the merits of internal control audits, we examine managers’ decisions to temporarily exempt newly acquired businesses from Section 404 of the Sarbanes-Oxley Act. We provide evidence that managers are more likely to elect the exemption when expected compliance costs are higher, such as when acquisitions are larger and occur later in the year. We find only modest evidence that managers use the exemption to avoid scrutiny of value-destroying deals. Exemption use, however, is associated with negative post-acquisition outcomes, including lower return-on-assets and higher likelihoods of goodwill impairments and financial statement restatements. These results are consistent with compliance providing benefits by facilitating timely identification and correction of control problems in the newly acquired business. Finally, we document negative abnormal stock returns at the time exemption use is announced and over the subsequent three years, suggesting that investors view exemption use negatively and that their initial price reactions are incomplete.