The prevalence and price distorting effects of undetected financial misrepresentation: Empirical evidence

62 Pages Posted: 25 Feb 2020 Last revised: 26 Apr 2023

See all articles by Abdullah Alawadhi

Abdullah Alawadhi

University of Washington

Jonathan M. Karpoff

University of Washington - Michael G. Foster School of Business; European Corporate Governance Institute (ECGI)

Jennifer L. Koski

University of Washington - Michael G. Foster School of Business

Gerald S. Martin

American University - Kogod School of Business

Date Written: April 18, 2023

Abstract

We use a comprehensive database of regulatory enforcement actions for financial misrepresentation to estimate prediction models using logistic, machine learning, and bivariate probit classifiers. Our parsimonious logistic model and three versions of a Support Vector Machine learning model perform well, each with an average area under the ROC curve (AUC) of 0.78 in out of sample tests. The base logistic model implies that 22.3% of Compustat-listed firms are engaged in financial misrepresentation that is potentially sanctionable by regulators in an average year. The average violation period is 3.1 years, implying that 22.3%/3.1 = 7.2% of firms initiate financial reporting practices each year that are potentially sanctionable. Of these firms, 3.5% eventually are sanctioned by regulators. We use these findings infer the fraction of firms that misrepresent their financials and yet never face regulatory penalties, to estimate the size of the price distortions imposed by misrepresentation on the shares of both misrepresenting and non-misrepresenting firms, and to estimate the size of firms’ ex ante expected costs of engaging in financial misrepresentation that incorporate both the probability of getting caught and the penalties if caught.

Keywords: Misrepresentation, fraud, prediction, enforcement, social cost

JEL Classification: G38, K22, L51, M48

Suggested Citation

Alawadhi, Abdullah and Karpoff, Jonathan M. and Koski, Jennifer Lynch and Martin, Gerald S., The prevalence and price distorting effects of undetected financial misrepresentation: Empirical evidence (April 18, 2023). Available at SSRN: https://ssrn.com/abstract=3532053 or http://dx.doi.org/10.2139/ssrn.3532053

Abdullah Alawadhi

University of Washington ( email )

Seattle, WA 98195
United States

Jonathan M. Karpoff

University of Washington - Michael G. Foster School of Business ( email )

Box 353226
Seattle, WA 98195-3200
United States
206-685-4954 (Phone)
206-221-6856 (Fax)

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Jennifer Lynch Koski (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353226
Seattle, WA 98195-3226
United States
206-543-7975 (Phone)
206-685-9392 (Fax)

Gerald S. Martin

American University - Kogod School of Business ( email )

Kogod School of Business
4400 Massachusetts Ave., N.W.
Washington, DC 20016-8044
United States
202-885-3914 (Phone)

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