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Fouling Up: Can higher penalties encourage good companies to manipulate their financial reports?

Monday, April 1, 2019

Financial Reporting

In September 2018, Orlando-based SeaWorld Entertainment and its former CEO agreed to pay a penalty of more than $5 million to the Securities and Exchange Commission for misleading investors about the impact of the documentary film Blackfish on the company’s reputation and business.

SeaWorld had failed to acknowledge, in a timely manner, that the 2013 film — critical of SeaWorld’s treatment of its orcas — was partly responsible for declining attendance. As a result, SeaWorld’s stock price plummeted, shareholders suffered significant losses and the SEC’s hammer fell.

SeaWorld joined a long list of companies that have paid penalties to the SEC for financial reporting and disclosure violations. Companies often face scrutiny and potential penalties when they perform poorly after raising expectations through glowing financial reports, laudatory press releases, or even hyperbolic tweets.

Penalty costs can be immense, going well beyond what’s paid to the SEC. They can include settlements to class-action lawsuits, secondary liabilities, attorney fees and reputational losses.

Penalties can deter bad firms from financial manipulation, but higher penalties may actually encourage good firms to manipulate their reports more, according to a new study by Lin Nan, associate professor of accounting at Purdue’s Krannert School of Management, and Xiaoyan Wen, assistant professor of accounting at TCU’s Neeley School of Business.

The study, entitled “Penalties, Manipulation, and Investment Efficiency” and forthcoming in the journal Management Science, explores whether penalties imposed on companies that perform poorly following positive reports help to improve investment efficiency, creating an environment where good projects are funded and investors are protected from bad projects.

Using a model to analyze various settings, Nan and Wen found that larger penalties induce good firms to manipulate their reports more in two particular scenarios: when a good firm has a much better chance of success than a bad firm and when the reimbursement proportion — the amount of any penalty that’s returned to investors — is high.

Good firms are willing to manipulate more in these scenarios because they’re confident of success and want to do everything they can to attract investors, Nan says.

“That’s a little counter-intuitive, but our model shows that sometimes it happens,” she says. “They know that they are good. They are on the right track. They want to show the world that they are on the right track.”

Is this type of manipulation a bad thing? No, it’s actually beneficial for good firms to show their best side, Nan says.

“The point is that manipulation does not always bring damage,” she says. “Sometimes you want the truth. You want to manipulate to tell the truth.”

However, there’s always a chance that a good firm will fall short of expectations, incurring a penalty itself.

Whether such penalties, which could potentially cripple a good firm, create a healthier investment environment is a major focus of Nan’s and Wen’s study.

The researchers found that penalties are ideal when a good project has a far better chance of success than a bad project or when investors are reimbursed at a high rate through the penalties.

“The reimbursement plays a very interesting role here,” Nan says. “If a large part of the penalty can be reimbursed to investors, then the investors are not as concerned, because even if they invest in the wrong project, they will still get reimbursed. The investors are more likely to fund a project.”

But when the reimbursement rate is low and a good project’s prospects aren’t much better than a bad project’s, it’s best to impose no penalty.

This is particularly true in high-risk industries, Nan says. “If you impose a large penalty based on a good signal at an earlier date and a bad outcome, then you actually kill a lot of innovative ideas,” she says. “Due to the high risk of failure, firms may be reluctant to innovate and investors reluctant to invest.”

Source: Lin Nan

Writer: Melvin Durai

A downloadable PDF of "Penalties, Manipulation, and Investment Efficiency" is available at https://ssrn.com/abstract=3044082 or http://dx.doi.org/10.2139/ssrn.304408.