The public cost of broken trust: Spillover effects of financial reporting irregularities

Abstract

A common justification for new or more intensified regulation of accounting firms and financial reporting is to restore and enhance public trust. In this paper I explore whether trust 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 I analyse 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. I distinguish effects due to reduced expected cash flows (direct exposure) and effects due to broken trust (no direct exposure). I 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 domestic firms' stock prices. This study sheds light on spillover costs in general and on the costs related to broken public trust more specifically.