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November 16, 2006
You are reading: Is cooking the books illegal
While the fines levied by regulators and courts on companies that falsify records may seem substantial, a new study finds that the higher monetary penalties suffered by these companies are the result of a damaged reputation when news of their falsifying was reported. bad behavior.
The study, led by jonathan karpoff, a finance professor at the uw business school, reveals that, on average, companies that have tampered with their books lose 41 percent of their market value after disclosures are made. news about his misdeeds.
“Cooking the books can be extremely expensive,” he said. “Companies lose real value when caught inflating profits, but legal penalties turn out to be only a small part of the total losses experienced by these companies. the biggest losses accumulate because the companies that cheat lose customers and face higher financing costs.”
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karpoff and coauthors d. Scott Lee and Gerald Martin of Texas A&M University examined the sanctions imposed on 585 companies that were sanctioned by the Securities and Exchange Commission and the Department of Justice for financial misrepresentation from 1978 to 2002, and which were traced back to November 2005. He presented his findings, “The Cost to Business of Manipulating the Books,” recently at a conference held at the University of Chicago’s Center for Securities Pricing Research.
Researchers found that while the penalties imposed on companies through the legal system are relatively small, averaging $23.5 million per company, the penalties imposed by the market in terms of reputational damage to a company are colossal.
according to karpoff, the damage done to a company’s reputation as a result of intentionally falsifying financial statements, commonly known as “makeup the books,” is more than 7.5 times the amount of all penalties imposed through of legal and regulatory systems. that is, for every dollar a company 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 anticipated legal penalties and $2.71 is due to loss of reputation. the reputational penalty is defined as the expected loss in the present value of future cash flows due to lower sales and higher hiring costs.
Even before the implementation of the Sarbanes-Oxley Act in 2002, aimed at improving corporate governance, the penalties for tampering with the books were substantial, Karpoff said. but the loss of a company’s reputation is by far the biggest penalty it faces, he added.
Of the 585 companies studied, the researchers found:
- Ninety percent of companies received non-monetary sanctions, including cease and desist orders or permanent injunctions, actions that impose relatively small penalties.
- only 8 percent, or 47 companies, were fined directly by regulators
- 35 companies had 10-day trading suspensions placed on their shares
- 40 companies had their registration revoked
- 231 companies were subject to class-action lawsuits; the average settlement of these lawsuits was $37.7 million
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There are two sections of federal law under which charges of financial misrepresentation can be filed. The Books and Records Provision requires companies subject to the Exchange Act’s reporting requirements to maintain books and records that accurately reflect corporate payments and transactions. the second, the internal controls provision, requires companies to create and maintain internal control that ensures management control over a company’s assets. the researchers found that the majority of enforcement actions (464 of the 585 companies studied) cite violations of both books and records and internal controls provisions. Furthermore, most of these violators also faced charges of fraud and insider trading.
And while other types of corporate misconduct, such as false advertising and product recalls, cause reputational losses, Karpoff and his colleagues say reputational losses from financial misrepresentation are unusually large.
“Financial misrepresentation is an especially costly activity because financial transparency is a particularly valuable asset,” he said. “A company’s hiring and sales costs are highly sensitive to financial misrepresentation because it undermines the company’s credibility with customers, suppliers, and investors.”
Companies can manipulate their books to reduce their tax liabilities or prevent investors from lowering their share prices, Karpoff said. The practice is illegal under SEC, Internal Revenue Service, and Stock Exchange regulations and violates the accounting profession’s code of ethics. He noted that scandals involving Enron, Worldcom and other corporations have helped create a widespread presumption that penalties for financial misrepresentation are nominal at best.
Many politicians and business leaders hold the view that financial misconduct is lightly punished and has a large effect on public policy, Karpoff said. has helped motivate new research into the investment banking and mutual fund industries, as well as potential changes to corporate voting rules and hedge fund regulation.
“however, reputational costs have been almost ignored in political deliberations on sanctions for financial misconduct. it is a mistake to consider only potential legal sanctions when making business decisions or setting public policy. this is because most of the financial penalty for tampering with the books comes from loss of reputation.”
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