"I'm interested in the fallout, or the potential effects of SEC investigations — how it impacts these firms outside of just we know that they were bad, and we are slapping them on the hand."

Financial regulation and reporting is an endless game of cat-and-mouse. As the U.S. Securities and Exchange Commission passes laws and regulations to protect investors, companies find new loopholes. Take, for instance, the statements of cash flow that publicly traded firms are required to release quarterly. Among other information, the statements reveal how much cash a company brought in through the firm's main line of business, called operating activities, through investing activities, and through financing activities.

The size of the operating activities category reflects how well the company's core business is doing. "If you are a business reporting to the public, operating cash flows is a good place to have cash coming in, because you want to show that you are profitable," says Assistant Professor of Management Curtis Nicholls. A company that sells dump trucks, for instance, ought to make most of its money from selling dump trucks.

Exactly how firms should classify certain cash flows into those three pools, however, was not clear until recently. In 2006, the SEC acknowledged as much and issued new regulations. Uncharacteristically for the agency, it also gave firms a grace period to correct any past misstatements in their next regular filing. Nicholls and his colleagues examined the statements issued directly after the new ruling. They found that the vast majority of re-classifications involved moving money that had been reported as operating activities into one of the other two categories.

To Nicholls, this indicates the original misstatements were made deliberately to enhance the appearance of profitability. "Were they being fraudulent? No," Nicholls says, because the original guidance from the SEC was not clear. "Was it intentional misreporting? Probably."

Investors, however, seem unperturbed by the apparent deceit. Release of reclassified earnings had no significant effect on a firm's share price. "We are finding the market doesn't really care when they reclassify," Nicholls says. Whether that is because investors were savvy enough to realize how cash flows were being misstated before the reclassification, or because investors are simply uninterested in cash flow disclosures, is a question Nicholls hopes to look into.

For a different look at SEC regulation, Nicholls is studying the impact of investigations on a firm's cost of equity capital. Since the Sarbanes-Oxley Act set new reporting standards for publicly traded companies in 2002, the number of firms found guilty of fraudulent financial reporting has gone up dramatically, Nicholls says.

Approximately 70 firms are reprimanded by the SEC each year, with consequences ranging from a turnover in management to a drop in share price. Nicholls is specifically interested in whether a reprimand can also lead to difficulty raising funds for future projects. "I'm interested in the fallout, or the potential effects of SEC investigations — how it impacts these firms outside of just we know that they were bad, and we are slapping them on the hand," Nicholls says. "How else does it impact them?"

Posted Sept. 22, 2009

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