The Cost to Firms of Cooking the Books

We examine the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978–2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $23.5 million per firm. The penalties imposed by the ma...

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Bibliographic Details
Published in:Journal of financial and quantitative analysis 2008-09, Vol.43 (3), p.581-611
Main Authors: Karpoff, Jonathan M., Lee, D. Scott, Martin, Gerald S.
Format: Article
Language:English
Subjects:
Business structures
Capital costs
Commercial regulation
Companies
Cooking
Corporate finance
Enforcement
False information
Financial misrepresentation
Financial regulation
Financial reporting
Financing methods
Fines & penalties
Fraud
Investors
Law enforcement
Lawsuits
Legal system
Market value
Misconduct
Misrepresentation
Penalties
Present value
Quantitative analysis
Reputations
Sales
Sanctions
Securities and Exchange Commission regulation
Shareholders
Stock exchange
Stock prices
U.S.A
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Summary:We examine the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978–2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $23.5 million per firm. The penalties imposed by the market, in contrast, are huge. Our point estimate of the reputational penalty—which we define as the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs—is over 7.5 times the sum of all penalties imposed through the legal and regulatory system. For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation. In firms that survive the enforcement process, lost reputation is even greater at $3.83. In the cross section, the reputation loss is positively related to measures of the firm's reliance on implicit contracts. This evidence belies a widespread belief that financial misrepresentation is disciplined lightly. To the contrary, reputation losses impose substantial penalties for cooking the books.
ISSN:0022-1090
1756-6916
DOI:10.1017/S0022109000004221