Does the Capital Market Recognize Financial Misrepresentations? – Fundamental Value and Market Analysis
The efficiency of a (capital) market is a key element in economics (e.g. Marshall 2009; Mankiw 2014). This paper attempts to shed more light on the market efficiency hypothesis in cases of the rare event of a deliberate violation of the GAAP (misrepresentation). The aim of the paper is twofold. The first aim is to determine the amount by which misrepresented firms are overvalued due to the misrepresentation. I therefore compare the actual firm value with a hypothetical firm value based on the fundamental value of the firm without the misrepresentation. The latter is calculated with conventional valuation methods. The second aim is to compare the value difference with the market reaction once the misrepresentation emerges to test market efficiency. The firm’s value difference is then compared with the market reaction around the date when the misrepresentation was revealed to the public e.g. with a restatement announcement. The method is thereby an OLS-regression. The analysis is based on a dataset of misrepresenting firms detected by the US Securities and Exchange Commission (AAER cases). The results indicate a substantially higher market value due to the misrepresentation depending on the method of an average value of up to 29.6% and median values ranging from 1.6% to 17.6%. Moreover, the results indicate that the market reaction once the misrepresentation is revealed is independent of the value difference. The results are robust for the valuation method and market reaction horizon. My interpretation is that the results provide statistical and economical evidence of an anomaly for the market efficiency hypothesis.
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