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Abstract
The Enron scandal offers the opportunity to assess the degree to which misleading accounting can affect connected firms and industry rivals. While the market was inept at detecting the inaccuracy of Enron's financial statements, it swiftly punished many connected firms once Enron's faulty accounting was publicized. A cross-sectional analysis documents that the market punished connected firms that had greater exposure to Enron's business, whose financial statements were viewed as more complex, and that had greater financial leverage. Most of the negative news indicating concern with Enron's accounting corresponded with a significant decline in the stock prices affirms in the energy and natural gas (ENG) industry, regardless of an explicit connection to Enron. Furthermore, rival firms with direct exposure to Enron and more aggressive earnings-reporting methods also experienced more detrimental effects. (JEL G39, G14)
Introduction
The ability of financial markets to revalue stocks based on financial statements and other related information has received much attention in the financial literature. Because firms commonly possess asymmetric information, investors may rely on information about one firm as indirect signals for the valuation of others. While the sluggish market recognition of Enron's problems because of misleading financial statements is well documented, less is known about how these problems triggered accounting concerns about the industry and other firms that had relationships with Enron. The damage caused by Enron's misleading accounting statements is not limited to the shareholders and employees of Enron but can affect firms with linkages to Enron. The losses may extend to adverse effects on connected firms that have business relationships with Enron and also on rival firms in the same industry whose financial condition may have been overstated if they had used similar methods as Enron to report financial information.
Since Enron's collapse is attributed to its accounting irregularities, the adverse effects of Enron's collapse on firms with linkages to Enron can be viewed as a form of accounting contagion. To the extent that misleading financial statements cause erroneous valuations of a reporting firm, they can cause erroneous valuations of firms with linkages to that firm.
Our goal is to measure the extent and breadth of corrected valuations following news of Enron's misleading financial statements.2 We document negative valuation effects for connected firms that have...