The Cost to Firms of Cooking the Books
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
Journal of Financial and Quantitative Analysis, 43, September 2008, 581-612.
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.
Number of Pages in PDF File: 49
Keywords: Financial reporting violations, fraud, financial disclosure, penalties, reputation
JEL Classification: G38, K22, K42, L51, M41
Date posted: February 2, 2005 ; Last revised: September 18, 2012