Internal control weaknesses and acquisition performance
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The Sarbanes-Oxley Act of 2002 (“SOX”) requires most publically traded firms to periodically disclose information about their internal control environments. I study a previously unexplored context where SOX internal control disclosures should be relevant; mergers and acquisitions transactions. Poor internal control quality at the acquiring firm is likely to impact acquisition profitability through a pre-merger “decision effect” and/or a post-merger “integration effect.” Weak internal controls at an acquiring firm suggest that management’s decision to acquire a particular firm is based on less timely/less accurate internal reports and projections – information crucial to selection of profitable acquisitions. Once an acquisition is made, weak internal controls may then impair the acquirer’s ability to quickly and effectively integrate the target to capture anticipated synergies. I expect that these internal control problems will affect acquisition performance, and accordingly I predict that lower internal control quality at the acquiring firm will lead to poorer acquisition performance in both operating performance and stock returns. I find that lower internal control quality predicts significantly lower post-acquisition operating performance. Investors seem to partially understand and anticipate the impact of internal control quality on acquisition performance, as I find a significant relationship between internal control quality and announcement period abnormal returns. However, investors apparently do not fully anticipate the implications of internal control information; I find that SOX material weakness information available pre-announcement predicts significant negative post-acquisition abnormal returns. My findings contribute to both the mergers and acquisitions literature and the SOX cost-benefit debate.