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The Cost to Firms of Cooking the Books

31 Pages Posted: 2 Feb 2005 Last revised: 21 Jun 2017

Jonathan M. Karpoff

University of Washington - Michael G. Foster School of Business

D. Scott Lee

University of Nevada, Las Vegas - Lee Business School

Gerald S. Martin

American University - Kogod School of Business

Date Written: 2008

Abstract

We examine the penalties imposed on all 585 firms that were 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 reputational penalty 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.

Keywords: Financial reporting violations, fraud, financial disclosure, penalties, reputation

JEL Classification: G38, K22, K42, L51, M41

Suggested Citation

Karpoff, Jonathan M. and Lee, D. Scott and Martin, Gerald S., The Cost to Firms of Cooking the Books (2008). Journal of Financial and Quantitative Analysis, 43, September 2008, 581-612.. Available at SSRN: https://ssrn.com/abstract=652121 or http://dx.doi.org/10.2139/ssrn.652121

Jonathan Karpoff (Contact Author)

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)

D. Scott Lee

University of Nevada, Las Vegas - Lee Business School ( email )

4505 S. Maryland Parkway
Box 456008
Las Vegas, NV 89154-6008
United States
702-895-2526 (Phone)
702-895-4630 (Fax)

HOME PAGE: http://faculty.unlv.edu/slee

Gerald 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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