Financial reporting quality and credit default swaps: evidence from SOX 404 internal control disclosures

Abstract

This paper explores the importance of financial reporting quality to credit investors using credit default swaps (CDS). We proxy internal control disclosures under Sarbanes-Oxley Section 404 (SOX404) for financial reporting quality. Analyzing CDS transaction data over the period between 2005 and 2007, we show that 5-year CDS spreads are 56 basis points higher for firms with internal control material weaknesses (MW) than firms with effective internal controls. This internal control effect on CDS spreads concentrates on firms with high information uncertainty. Moreover, we find that CDS trading volume is 2.3 times higher for firms reporting material weaknesses. Our findings suggest that improving financial reporting quality could lower the cost of credit protection.