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We propose reduced investment as a potential explanation for why firms with internal control weakness (ICW) exhibit lower valuation relative to non-ICW firms. We show that ICW firms significantly reduce investment around ICW disclosure and also have poor stock performance. Additional evidence shows that many of the investment reductions have been announced during the year before ICW disclosure. A possible explanation for investment reductions is the higher costs of financial friction associated with ICW. Consistent with this explanation, we show that ICW firms with credit ratings do not reduce their investment as much and have much better stock performance than ICW firms without credit ratings.

We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes–Oxley Act (SOX) have 13% lower valuation than non-ICW firms based on Tobin's q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. The ICW firms that remedy the internal control weakness in the subsequent year have much better stock performance compared to those firms that fail to remedy existing ICW problems. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has incorporated the negative information associated with SOX 404 ICW reports before the actual disclosures are made.