The financial penalties imposed by the courts on public companies that falsify accounting records are miniscule compared with the costs associated with the loss of reputation incurred after news spreads about their misdeeds.
While fines imposed by regulators and courts on companies that falsify records may seem substantial, a new study led by Jonathan Karpoff, a professor of finance at the University of Washington Business School, reveals than on average, companies that have cooked their books lose 41 per cent of their market value as their reputation plummets.
"Cooking the books can be extremely costly," he said. "Firms lose real value when they are caught inflating their earnings, but the legal penalties turn out to be only a small part of the total losses experienced by these firms. The largest losses accrue because firms that cheat lose customers and face higher financing costs."
Karpoff and co-authors D. Scott Lee and Gerald Martin of Texas A&M University examined 585 companies that were disciplined by the Securities and Exchange Commission and the Department of Justice for financial misrepresentation between 1978 and 2002 and tracked their performance to November 2005.
They found that while the penalties imposed on firms through the legal system are relatively small, averaging $23.5 million per firm, the penalties imposed by the market are colossal.
Indeed according to Professor Karpoff, damage done to a firm's reputation as a result of cooking the books is more than 7.5 times the amount of all penalties imposed on it through legal and regulatory systems.
That is, 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, Karpoff calculates that $0.36 is due to expected legal penalties and $2.71 is due to lost reputation - by far the biggest penalty a company faces.
Underlining this, analysis of the 585 companies studied found that nine out of 10 received non-monetary sanctions, including cease-and-desist orders or permanent injunctions – actions that impose relatively small penalties.
Fewer than one in 10 - only 8 per cent, or 47 companies - were fined directly by regulators, 35 companies had 10-day trading suspensions imposed on their stocks and 40 had their registrations revoked.
Yet 231 companies were subject to class-action lawsuits, the average settlement for which was $37.7 million.
While other types of corporate misconduct such as false advertising and product recalls cause reputational losses, Karpoff and his colleagues contend that reputational losses for 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 sales and contracting costs are very sensitive to financial misrepresentation because it undermines the company's credibility with customers, suppliers and investors."
The view that financial misconduct is punished lightly is held by many politicians and business leaders and has a large effect on public policy, he added. But this perception ignores the cost of lost reputation.
"Reputational costs, however, have been all but ignored in policy deliberations over penalties for financial misconduct. It is a mistake to consider only prospective legal penalties in making business decisions or setting public policy. This is because most of the financial penalty for cooking the books comes from lost reputation."