The Public Cost of Broken Confidence : Spillover Effects of Financial Reporting Irregularities

A common justification for new or more intensified regulation of accounting firms and financial reporting is to restore and enhance public confidence. In this paper we examine whether confidence is indeed significantly damaged by financial reporting irregularities (‘irregularities' hereafter) and, if so, the magnitude of the resulting costs. In particular, using an event study approach we analyze whether, for firms listed in the Netherlands, domestic and foreign irregularities over the February 2003 to March 2004 period have a significant impact on the stock prices of other firms. We distinguish effects due to reduced expected cash flows (direct exposure) and effects due to broken confidence (no direct exposure). We find that irregularities at domestic firms are associated with significantly negative abnormal trust-related returns at other firms. Overreactions to the news only partially offset these negative trust-related abnormal returns and hence irregularities among domestic firms may significantly damage trust. Irregularities of foreign firms, however, do not appear to have a long-term effect on other firms' stock prices. This study sheds light on spillover costs in general and on the costs related to broken public confidence more specifically