Economic Fraud
Table of Contents
Introduction
Economic stability is based on multiple factors in the financial market. Economic growth and predictability attract investors, while uncertainty deters them. Vices, such as fraud and accounting scandals among notable firms in the US, have put the stock market at risk. Fraud in the stock market is detrimental. It leads to eroded confidence in stock and bond market, as well as decreases demand for stock and bonds. The current paper seeks to analyze the impact of fraud and recent accounting scandals on the stock exchange. It will also discuss the differences between stock and bonds, as well as the reasons as to why the price of stocks and bonds vary.
Impact of Fraud and Recent Accounting Scandals on Stock Market
Fraud and accounting scandals, which stem from collusion made by unscrupulous auditors and firms to conceal the actual standings of companies, have been revealed among the US Firms in the recent past. Since the discovery of such damning evidence, investors have incurred million-dollar losses, as well as eroded confidence in the capital markets. A large stock price decline for such firms is the result of such kind of revelations (Rahman, Burkel, & Mustafa, 2009).
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Investors lose confidence in the stock market leading to a sharp fall in turnover as many investors leave the market due to the fear of incurring multiple losses. Among companies that have used dubious methods, such as fraud and accounting fraud to rise to prominence, are Enron, WorldCom, Tyco, and HealthSouth (Rahman, Burkel, & Mustafa, 2009). Firms engaged in accounting scandals portray themselves as the most efficient and are characterized with high profits and low operating costs.
Consequently, unhealthy competition arises leading to the inefficient pricing of debt and equity due to the unrealistic expectations generated by such accounting fraud. Overpriced securities and over borrowing by firms result from accounting fraud. Though the concerned company can avoid bankruptcy in the short perspective, consistent frauds have an extensive impact on the entire market. The non-optimal operation of fraudulent firms coupled with the interdependence of companies in the stock market translates to non-equilibrium in the stock exchange.
In the long perspective, fraudulent companies together with other businesses are susceptible to bankruptcy (Sadka, 2006). A case under consideration involves Enron, WorldCom, and HealthSouth among others. The firms misstated their operational costs and bloated profit margins attracting unnoticing investors. However, their falsified successes were short-lived. Lawsuits filed by investors, suppliers, customers, and employees against Enron and WorldCom after losses lead the firms to bankruptcy (Agrawal & Cooper, 2016).
Differences between Stock and Bonds
Stock and bonds are correlated and, therefore, differentiating them is important. Generally, stocks help own a part of a company. Investors who opt to buy shares of stock become shareholders and own a part of stock issuer company. It enables investors to choose the leadership of the enterprise, share profits, if the business wishes to distribute dividends, as well as gain or lose investments, if the value of the stock increases or decreases respectively (The USAA Educational Foundation, 2010). Bonds, on the other hand, are a way for investors to loan money to a company, government or other organization. Once a person (Investors) purchases a bond, it means that he/she is making a loan to the bond’s issuer. Governments, companies, state and local governments hold the bonds issuing status. Bondholders are entitled to interest payments from the issuer of the bond, receive the face value of the bond on its maturity date, as well as gain or loss profit, if the value of the bond increases or decreases. Considering risks and rewards, stocks are riskier but the rewarding is compared to bonds. The constant fluctuation of stock market, which translates to varying value of assets, makes investment in inventories a dangerous affair (The USAA Educational Foundation, 2010).
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Stock owners are entitled to dividends once a corporation declares a dividend. However, equity investments are dependent on market trends or events that affect the market as a whole. Though stock market is a conglomerate of thousands of individual companies, the investment environment is critical as it can cause most or all of the companies fall in value simultaneously regardless of prior sales and profit records. For instance, fraud and accounting scandals of notable firms, Enron and WorldCom, which were listed in the US stock market, led to the instability of the market. As a result, many investors left in fear of incurring losses. When other firms restored their financial statements in an attempt to restore investor’s trust, their action exacerbated the incidence leading to a crisis, which resulted in the passing of Sarbanes-Oxley Act of 2002 that focuses on improving accuracy and integrity of the financial reporting system (Rahman, Burkel, & Mustafa, 2009). Bondholders, on the other hand, may incur losses when a bond issuer fails to make promised interest or principal payments. In addition, the rise and fall of interest rates cause an appreciation and depreciation of bond value respectively.
Reasons Why the Price of Stocks and Bonds Vary
The interrelationships between stocks and bonds make their co-variation crucial for investors who seek to diversify their investment. Price variation is caused by inflation rate and uncertainty, changes in monetary policy, and stock market risk.
Stock value for any firm is determined by expectations of future appreciation of companies’ shares. A projection of growth in dividend payment based on present value of a firm motivates investors to hold riskier stocks. It increases demand for stocks regardless of the risks connected to them. Risk-free rate and the equity risk premium are crucial in determination of whether to retain stocks and bonds (Johnson, 2014). A projection of a steady economic growth and higher inflation rate translates to increased interest rates, which raise dividends due to increased corporate profits. Uncertainty in such variables influences stock prices and bond yields. Growth change raises equity risk premium, whereas inflation raises equity risk and a term premium. In respect to bond and stock prices, inflation rate and uncertainty increases interest rates resulting in limited borrowing. It reduces economic growth rate making potential investors in stocks leave the stock market (Rankin & Idil, 2014).
Monetary policy, on the other hand, leads to a decline in stock-bond correlation due to the interest rates raise bond yields with a reduction in future earnings. For instance, in the 1980s, attempts by the US Federal Reserve to lower the level of inflation lead to a significant decline in stock-bond correlation (Rankin & Idil, 2014). Moreover, the incidence in 2011 where the US Federal Reserve implemented an asset purchase program in an attempt to raise equity prices led to a fall in shock-bond yield. In general, increased stock uncertainty coupled with inflation tends to increase treasury bonds.
Conclusion
In conclusion, accounting fraud is detrimental to the entire economy. Once firms that are listed in stock market engage in accounting frauds to maintain their existence, the impact is far-reaching in the long perspective. Detection of such frauds erodes investors’ trust and confidence in the stock market. They also lead to fall of stock values of the high-tech firms, as well as other interrelated enterprises in the industry. The decreased stock turnover lowers economic growth rate and profits among investors. Such uncertainty has made investors exercise due diligence in choosing whether to invest in stock or bonds, which attracts various advantages and risks. Purchasing of inventory, which enables an individual to own a part of a firm is profitable and riskier compared to bonds, which enables investors to loan money to companies, governments, etc. Nevertheless, its dependence on interest rates is also dangerous. Stocks and bonds frauds influence prices due to market uncertainty and inflation, shifts in monetary policies, as well as stock market risk.
