The Prevalence and Costs of Financial Misrepresentation

60 Pages Posted: 25 Feb 2020

See all articles by Abdullah Alawadhi

Abdullah Alawadhi

University of Washington

Jonathan M. Karpoff

University of Washington - Michael G. Foster School of Business

Jennifer L. Koski

University of Washington - Michael G. Foster School of Business

Gerald S. Martin

American University - Kogod School of Business

Date Written: January 29, 2020

Abstract

We use a comprehensive database of regulatory enforcement actions for financial misrepresentation and apply Receiver Operating Characteristics theory to construct a misrepresentation prediction model. The model performs well both in and out of sample, with an average area under the curve (AUC) of 0.78 in out-of-sample tests. The model’s base case 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 7.2% of firms initiate new programs of financial misrepresentation each year. Of these, 3.5% eventually are caught and sanctioned. These findings yield numerical estimates of the size of the price distortions imposed by misrepresentation on the shares of both misrepresenting and non-misrepresenting firms, and the size of firms’ ex ante expected costs – incorporating both the probability of getting caught and the penalties if caught – of engaging in financial misrepresentation.

Keywords: 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 Costs of Financial Misrepresentation (January 29, 2020). 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)

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)

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
158
Abstract Views
523
rank
202,584
PlumX Metrics