Hostname: page-component-7b7567c8c-wxvwp Total loading time: 0 Render date: 2026-11-15T02:20:03.348Z Has data issue: false hasContentIssue false
  • English
  • Français

The Cost to Firms of Cooking the Books

Part of:JFQA William F. Sharpe Best Paper Award Winner

Published online by Cambridge University Press:  06 April 2009

Jonathan M. Karpoff,
D. Scott Lee and
Gerald S. Martin
Jonathan M. Karpoff
Affiliation:
karpoff@u.washington.edu, Foster School of Business, University of Washington, Box 353200, Seattle, WA 98195
D. Scott Lee
Affiliation:
slee@tamu.edu, Mayes Business School, Texas A&M University, 4218 TAMU, College Station, TX 77843
Gerald S. Martin
Affiliation:
gmartin@american.edu, Kogod School of Business, American University, 4400 Massachusetts Ave NW, Washington, DC 20016.
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the 'Save PDF' action button.

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.

Information

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 43 , Issue 3 , September 2008, pp. 581 - 611
Copyright
Copyright © School of Business Administration, University of Washington 2008

References

Agrawal, A.; Jaffe, J.; and Karpoff, J. M.. “Management Turnover and Governance Changes following the Revelation of Fraud”. Journal of Law and Economics, 42 (1999), 309–342.CrossRefGoogle Scholar
Alexander, C. R. “On the Nature of the Reputational Penalty for Corporate Crime: Evidence”. Journal of Law and Economics, 42 (1999), 489–526.CrossRefGoogle Scholar
Arlen, J. H. “The Potentially Perverse Effects of Corporate Criminal Liability”. Journal of Legal Studies, 23 (1994), 833–867.CrossRefGoogle Scholar
Arlen, J. H., and Carney, W. J., “Vicarious Liability for Fraud on Securities Markets: Theory and Evidence”. University of Illinois Law Review (1992), 691–740.Google Scholar
Arlen, J., and Kraakman, R.. “Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes”. New York University Law Review, 72 (1997), 687–779.Google Scholar
Beatty, R. P.; Bunsis, H.; and Hand, J. R. M.. “The Indirect Economic Penalties in SEC Investigations of Underwriters”. Journal of Financial Economics, 50 (1998), 151–186.CrossRefGoogle Scholar
Beneish, B. D. “Incentives and Penalties Related to Earnings Overstatements that Violate GAAP”. Accounting Review, 74 (1999), 425–457.CrossRefGoogle Scholar
Bhagat, S., and Romano, R.. “Event Studies and the Law: Part I: Technique and Corporate Litigation”. American Law and Economics Review, 4 (2002a), 141–167.CrossRefGoogle Scholar
Bhagat, S., and Romano, R.. “Event Studies and the Law: Part II: Empirical Studies of Corporate Law”. American Law and Economics Review, 4 (2002b), 380–422.CrossRefGoogle Scholar
Bonner, S. E.; Palmrose, Z. V.; and Young, S. M.. “Fraud Type and Auditor Litigation: An Analysis of SEC Accounting and Auditing Enforcement Releases”. Accounting Review, 73 (1998), 503–532.Google Scholar
Cohen, M. A. “Environmental Crime and Punishment: Legal/Economic Theory and Empirical Evidence on Enforcement of Federal Environmental Statutes”. Journal of Criminal Law & Criminology, 82 (1992), 1054–1108.CrossRefGoogle Scholar
Committee of Sponsoring Organizations (COSO). “Fraudulent Financial Reporting: 1987–1997 An Analysis of U.S. Public Companies”. (03 1999), http:/www.coso.org/publications.htm.Google Scholar
Cox, J. D.; Thomas, R. S.; and Kiku, D.. “SEC Enforcement Heuristics: An Empirical Inquiry”. Duke Law Journal, 53 (2003), 737–779.Google Scholar
Dechow, P.; Hutton, A.; and Sloan, R.. “Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC”. Contemporary Accounting Research, 13 (2006), 1–36.CrossRefGoogle Scholar
Drawbaugh, K. “U.S. SEC's Cox Sees Corporate Penalties Agreement”. Reuters News Service (12 14, 2005).Google Scholar
DuCharme, L. L.; Malatesta, P. H.; and Sefcik, S. E.. “Earnings Management, Stock Issues, and Shareholder Lawsuits”. Journal of Financial Economics, 71 (2004), 27–49.CrossRefGoogle Scholar
Elson, C. M., and Gyves, C. J.. “In Re Caremark: Good Intentions, Unintended Consequences”. Wake Forest Law Review, 39 (2004), 691–706.Google Scholar
Feroz, E. H.; Park, K.; and Pastena, V. S.. “The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases”. Journal of Accounting Research, 29 (1991), 107–148.CrossRefGoogle Scholar
Fich, E., and Shivdasani, A.. “Financial Fraud, Director Reputation, and Shareholder Wealth”. Journal of Financial Economics, 86 (2007), 306–336.CrossRefGoogle Scholar
Gande, A., and Lewis, C. M.. “Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers”. Journal of Financial and Quantitative Analysis, forthcoming (2009).CrossRefGoogle Scholar
Gerety, M., and Lehn, K.. “The Causes and Consequences of Accounting Fraud”. Managerial and Decision Economics, 18 (1997), 587–599.3.0.CO;2-R>CrossRefGoogle Scholar
Glass Lewis & Co. “Restatements-Traversing Shaky Ground An Analysis for Investors”, (05 31, 2005).Google Scholar
Healy, P. M., and Palepu, K. G.. “The Fall of Enron”. Journal of Economic Perspectives, 17 (2003), 3–26.CrossRefGoogle Scholar
Helland, E. “Reputational Penalties and the Merits of Class Action Securities Litigation”. Journal of Law & Economics, 49 (2006), 365–396.CrossRefGoogle Scholar
Jarrell, G., and Peltzman, S.. “The Impact of Product Recalls on the Wealth of Sellers”. Journal of Political Economy, 93 (1985), 512–536.CrossRefGoogle Scholar
Jensen, M. C. “Agency Costs of Overvalued Equity”. Financial Management, 34 (2005), 5–19.CrossRefGoogle Scholar
Karpoff, J. M.,; Lee, D. S.; and Martin, G. S.. “The Consequences to Managers for Financial Misrepresentation”. Journal of Financial Economics, 88 (2008a), 193–215.CrossRefGoogle Scholar
Karpoff, J. M.; Lee, D. S.; and Martin, G. S.. “The Legal Penalties for Financial Misrepresentation”. Working Paper, University of Washington and Texas A&M University (2008b).Google Scholar
Karpoff, J. M.; Lee, D. S.; and Vendrzyk, V. P.. “Defense Procurement Fraud, Penalties, and Contractor Influence”. Journal of Political Economy, 107 (1999), 809–842.CrossRefGoogle Scholar
Karpoff, J. M., and Lott, J. R. Jr, “The Reputational Penalty Firms Bear from Committing Criminal Fraud”. Journal of Law and Economics, 36 (1993), 757–802.CrossRefGoogle Scholar
Karpoff, J. M.; Lott, J. R., and Wehrly, E. Jr. “The Reputational Penalties for Environmental Violations: Empirical Evidence”. Journal of Law and Economics, 68 (2005), 653–675.CrossRefGoogle Scholar
Kedia, S., and Philippon, T.. “The Economics of Fraudulent Accounting”. Review of Financial Studies (forthcoming 2008).Google Scholar
Klein, B., and Leffler, K. B.. “The Role of Market Forces in Assuring Contractual Performance”. Journal of Political Economy, 89 (1981), 615–641.CrossRefGoogle Scholar
Landes, W., and Posner, R.. “Trademark Law: An Economic Perspective”. Journal of Law and Economics, 30 (1987), 265–309.CrossRefGoogle Scholar
Lie, E., and Lie, H. J.. “Multiples Used to Estimate Corporate Value”. Financial Analysts Journal, 58 (2002), 44–54.CrossRefGoogle Scholar
Lucas, W. R. “A Practitioner's Guide to the SEC's Investigative and Enforcement Process”. Temple Law Review, 53 (1997), 53–70.Google Scholar
Maher, M. W. “The Impact of Regulation on Controls: Firms' Response to the Foreign Corrupt Practices Act”. Accounting Review, 56 (1981), 751–770.Google Scholar
Maksimovic, V., and Titman, S.. “Financial Policy and Reputation for Product Quality”. Review of Financial Studies, 4 (1991), 175–200.CrossRefGoogle Scholar
Mitchell, M. L., and Maloney, M. T.. “The Role of Market Forces in Promoting Air Travel Safety”. Journal of Law and Economics, 32 (1989), 329–355.CrossRefGoogle Scholar
Mulford, C. W., and Comiskey, E. E.. “The Financial Numbers Game: Detecting Creative Accounting Practices”. New York, NY: John Wiley and Sons (2002).Google Scholar
Mullin, W. P., and Snyder, C. M.. “Targeting Employees for Corporation Crime and Forbidding Their Indemnification”. Working Paper, George Washington University and Dartmouth College (2005).Google Scholar
Murphy, D. L.; Shrieves, R. E.; and Tibbs, S. L.. “Determinants of the Stock Price Reaction to Allegations of Corporate Misconduct: Earnings, Risk, and Firm Size Effects”. Journal of Financial and Quantitative Analysis, forthcoming (2009).Google Scholar
Palmrose, Z.-V.; Richardson, V. J.; and Scholz, S.. “Determinants of Market Reactions to Restatement Announcements”. Journal of Accounting & Economics, 37 (2004), 59–89.CrossRefGoogle Scholar
Peltzman, S. “The Effects of FTC Advertising Regulation”. Journal of Law and Economics, 24 (1981), 403–448.CrossRefGoogle Scholar
Polinsky, A. M., and Shavell, S.. “Should Employees Be Subject to Fines and Imprisonment Given the Existence of Corporate Liability?” International Review of Law and Economics, 13 (1993), 239–257.CrossRefGoogle Scholar
Sadka, G. “The Economic Consequences of Accounting Fraud in Product Markets: Theory and a Case from the U.S. Telecommunications Industry (WorldCom)”. American Law and Economics Review, 8 (2006), 439–475.CrossRefGoogle Scholar
Securities and Exchange Commission. “Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002” (01. 24, 2003).Google Scholar
Securities and Exchange Commission. “Commencement of Enforcement Proceedings and Termination of Staff Investigations””. Release No. 5310 (02. 28, 1973).Google Scholar
Titman, S. “The Effect of Capital Structure on a Firm's Liquidation Decision”. Journal of Financial Economics, 13 (1984), 137–151.CrossRefGoogle Scholar
Volcker, P., and Levitt, A. Jr, “In Defense of Sarbanes-Oxley”. The Wall Street Journal (06 14, 2004), A16.Google Scholar
Wu, M. “Restatements by Year 1977–2005”. (03 2006) http://ihome.ust.hk/∼acwu/Media/Restatement-year.pdf.Google Scholar