Financial Manipulation - CLOSER LOOK SERIES TOPICS ISSUES...

C
LOSER
L
OOK
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ERIES
: T
OPICS
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SSUES
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ONTROVERSIES IN
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ORPORATE
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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
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ANIPULATION
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ORDS
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ON
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IE
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NTEGRITY OF
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INANCIAL
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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.
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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.
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