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Financial Manipulation - CLOSER LOOK SERIES TOPICS ISSUES...

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C LOSER L OOK S ERIES : T OPICS , I SSUES , AND C ONTROVERSIES IN C ORPORATE G OVERNANCE CGRP-07 D ATE : 07/23/10 Professor David F. Larcker and Brian Tayan prepared this material as the basis for discussion. The Corporate Governance Research Program is a research center within the Stanford Graduate School of Business. For more information, visit: http://www.gsb.stanford.edu/cldr/cgrp/ . Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. F INANCIAL M ANIPULATION : W ORDS D ON T L IE I NTEGRITY OF F INANCIAL S TATEMENTS Reliable financial reporting is critical to the efficiency of capital markets. When financial statements are prepared according to sound accounting principles, investors are able to make informed investment decisions and either buy or sell assets at prices that are appropriate given their potential risk and return. When financial statements are unreliable—either because of intentional or unintentional misrepresentation—investment decisions will suffer and asset prices will be inappropriate given their prospects for future return. As a result, accurate and transparent disclosure is essential to a well-functioning capital market. Despite the importance of accurate financial reporting, management may have incentive to misrepresent financial results for personal gain. For example, management may be tempted to inflate current period results in order to increase the size of a performance bonus. They may also do so in order to beat Wall Street estimates for quarterly earnings in order to boost the company’s share price and increase the value of their equity holdings. Even in the absence of financial payment, management may gain psychological rewards from inflating corporate returns, in the form positive press coverage and the admiration of peers. While sound governance systems are expected to have controls in place that prevent or detect such maneuvers, they may not always be effective. 1 1 The audit committee oversees the reporting process and monitors the choice of accounting principles. The external auditor reviews management assumptions and tests selected accounts for material misstatements. The internal audit committee implements corporate controls and ensures compliance with financial reporting procedures. The Sarbanes Oxley Act of 2002 requires that both the CEO and CFO certify the integrity of financial statements and holds them personally liable for misrepresentation. Still, restatements occur. According to Glass Lewis, between 200 and 500 publicly traded companies listed in the U.S. restate their earnings each year (approximately 5 to 12 percent of the total). Glass Lewis & Co., “Trend Report: Restatements,” Mar. 19, 2009. Distributed by The Case Centre North America Rest of the world www.thecasecentre.org t +1 781 239 5884 t +44 (0)1234 750903 All rights reserved e [email protected] e [email protected] case centre This case has been made available as part of the Stanford GSB free case collection www.thecasecentre.org/stanfordfreecases
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