Financial misreporting – to penalise or not?

The problem

Regulators penalise firms that misreport financial information as a way to protect investors and ensure fair markets. Since it is difficult to hold individual managers accountable, it is firms that are penalised. The idea is that such punishment will enhance firms’ long-term value by encouraging greater investment in internal controls. Yet opponents argue that penalties would harm the very investors already harmed by misreporting, since penalties reduce their returns. With little research into the effects of corporate penalties, it is unclear whether the benefits outweigh the costs and enhance long-term value, like regulators argue.

The research

A recently published study develops a theoretical model to study how corporate penalties affect firm value. In the model, a manger can misreport information to inflate short-term stock prices and a board invests in internal controls to limit such behaviour. After financial reports are released, investors competitively set prices and then a regulator investigates and penalises the firm if misreporting is detected. Findings show that corporate penalties are not always beneficial, only improving firm value in cases of weak governance and low transparency, but in many situations actually reduce firm value.

The impact

Showing when corporate penalties are and are not effective  provides relevant insights for regulators, investors, firms and the public. Regulators should be careful levying corporate penalties and shouldn’t treat them as a panacea. Investors can better assess risk. For firms and boards, the study highlights the importance of governance quality and transparency. Overall, the research can support fairer and more efficient markets, stronger accountability, better transparency, and more effective regulation that ultimately benefits the public.

Department: Accounting 
Area: Financial misreporting, corporate penalties