The Market Reaction to Internal Control Weakness by Investor Types－Evidence from the Korean Stock Market－

Prior literature found that investors react negatively to the disclosure of material weakness in internal control (hereafter ICW) due to the lower financial reporting quality or higher cost of capital. Investors, however, are a heterogeneous group of individuals in terms of the ability of understanding financial information. Therefore, this paper examines how different types of investors react to the disclosure of ICW in Korean stock market. First, we examine investor reaction in terms of abnormal trading volume. Second, using the unique data of order imbalance from Korean stock market, we investigate whether trading behavior during the event window varies by investor types：domestic individuals, domestic institutions, and foreigners. We find that trading volume significantly decreases around the ICW disclosure. Additionally, we find that foreigners and domestic institutions tend to net sell while domestic individuals tend to net buy at the disclosure of ICW. This finding indicates that domestic individual investors react to ICW less negatively than other investors or their understanding of the ICW disclosure is less sophisticated. This study is the first to examine market reaction to ICW by investor types. Given that individual investors show a tendency to overlook an important accounting information, we suggest that regulators focus more on the disclosure activities to draw individual investors’ attention on the potential risk of investing in ICW firms.