February 13, 2014
It Is Not Just Your Accounting Fraud
Posted by Urska Velikonja

Since Mary Jo White took over at the SEC, the agency has announced that it will strengthen its efforts to prosecute financial reporting fraud. In July, the SEC created the Financial Reporting and Audit Task force and the Center for Risk and Quantitative Analytics, described as an "internal think-tank." The plan is to enhance the Commisson's use of econometric analysis to detect possible financial reporting fraud. It is about time, in particular since accounting fraud is a really inefficient way to steal.

Eveyone knows that stock prices of firms that reveal accounting improprieties decline. The range of that decline varies, but is usually significant. Studies report mean stock-price declines between 8% and 39%, and everything in between. What fewer people know is that unmasking fraud at one firm also has a small, but statistically significant effect on stock prices of its competitors. Three recent empirical studies put the 3-day cumulative abnormal return of rival stock prices around the announcement date at 0.34%, 0.5% and 0.54%. In the aggregate, however, rivals lose four-times as much in market capitalization as the firm that is caught cooking the books.

There are several explanations for why rivals are affected by fraud by industry peers. First, firms copy each other. When Apple comes out with a tablet and it sells well, its rivals are likely to follow suit. In similar vein, rivals sometimes copy fraudulent accounting. Second, a restatement of earnings suggests that the entire industry's prospects are not as good as we thought. Finally, while they are manipulating their earnings, fraud-committing firms change their current investments, and rivals copy firms that appear to be successful. A restatement reveals that firms in the industry misdirected investments, which forces an adjustment in the stock prices after fraud is unmasked.

In securities regulation, we like to see the regulator tread carefully. As one widely-used textbook cautions, "onerous disclosure obligations and their accompanying liability are like rain--they fall on the good and the bad alike." But it turns out that fraud, too, harms both honest and dishonest firms. 

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