A Critical Analysis of Databases Used in Financial Misconduct Research

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The electronic availability of data on financial restatements, class action lawsuits, and regulatory actions has facilitated significant advances in our understanding of the causes and effects of financial misconduct. Nearly 100 published studies examining aspects of financial misconduct rely on data from one of four publicly available databases: the Government Accountability Office (GAO) and Audit Analytics (AA) databases of restatement announcements, the Securities Class Action Clearinghouse (SCAC) database of securities class action lawsuits, and the Securities and Exchange Commission’s series of Accounting and Auditing Enforcement Releases (AAERs). In this paper we describe and document five types of potential problems in these databases that, if not recognized and addressed, can affect the validity and interpretation of empirical findings in this area.


Short Sellers and Financial Misconduct

We examine whether short sellers detect firms that misrepresent their financial statements, and whether their trading conveys external costs or benefits to other investors. Abnormal short interest increases steadily in the 19 months before the misrepresentation is publicly revealed, particularly when the misconduct is severe. Short selling is associated with a faster time-to-discovery, and it dampens the share price inflation that occurs when firms misstate their earnings. These results indicate that short sellers anticipate the eventual discovery and severity of financial misconduct. They also convey external benefits, helping to uncover misconduct and keeping prices closer to fundamental values when firms provide incorrect financial information.

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The Legal Penalties for Financial Misrepresentation


The Monetary Benefit of Cooperation in Regulatory Enforcement Actions for Financial Misrepresentation

We examine the monetary benefits of cooperation for 1,059 enforcement actions initiated by the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) for financial misrepresentation from 1978-2011. We estimate that firm cooperation results in a 12% increase in the probability of regulators bringing charges against firms. However, using a Heckman full maximum likelihood estimator, we find that being credited for cooperation by regulators reduces the monetary penalties firms pay by 35% (conversely, non-cooperation increases monetary penalties by 53%).


The Cost to Firms of Cooking the Books

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.


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