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 into the market efficiency in case of the rare event of a deliberate violation of 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 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 value difference is then compared with the market reaction around the date when the misrepresentation gets revealed to the public e.g. with a restatement announcement. The method is thereby an OLS-regression. The analysis bases on a dataset of misrepresenting firms detected by the US Securities and Exchange Commission (AAER cases). 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, 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 of the market efficiency hypothesis.