The Effect of the Possibility of Fraud on Misvaluation: The Role of Government Ownership

Objective: Correctly asset valuation leads to optimal allocation of capital resources, and lack of accuracy and precision in stock valuation can harm company performance and jeopardize shareholders' interests. So, mispricing, as a financial anomaly, undermines the efficient market hypothesis. The occurrence of fraud reduces confidence and causes negative reactions in the market. In this regard, the publication of fraud news damages the company's reputation and shareholders' wealth. Under these circumstances, the stock price fails to accurately represent the true state of the company, thus exposing fraudulent activities within the company lays the groundwork for the misvaluation. Today, governmental ownership has become a rescue strategy in developed and developing countries. The restricted information environment of governmental companies leads to a decrease in the liquidity of these companies' shares. On the other hand, managers of government companies focus on achieving short-term social and political goals. State-owned enterprises play a crucial role in assisting the government in enhancing societal welfare. How does the presence of state-owned companies influence the current circumstances? This study examines the relation between the likelihood of fraud and misvaluation, emphasizing the role of state ownership.
Method: This research was carried out utilizing actual stock market data and the financial statements of firms. The statistical population for this study comprises companies that were listed on the Tehran Stock Exchange during the eight-year span from 2015 to 2022. After applying regular screening conditions, 129 companies, 1032 observations have been selected. Misvaluation was measured following the study of Rhodes–Kropf et al. (2005) and Chang et al. (2013) and the probability of fraud was measured following Benish (1999) and Erdoğan and Erdoğan (2020). After examining the assumptions of multivariate regression, the hypotheses were tested using a panel data model with fixed effects.
Findings: The findings show that the probability of fraud significantly increases the misvaluation of companies. In state-owned companies, the effect of the probability of fraud on misvaluation is significantly intensified.
Conclusion: The issuance of fraudulent financial statements results in the propagation of misleading information, thereby diminishing investor trust in the market. Furthermore, numerous instances of fraud and misconduct go undetected for extended periods, and not all detected cases are subsequently reported. As a result, the publication of corporate fraud reports triggers a negative response within the capital market, resulting in heightened costs associated with resource provision. This escalation in costs ultimately results in a mispricing of the company's securities. Alternatively, in the context of state-owned firms, the probability of fraudulent activities significantly amplifies the misvaluation of stock prices. The support from the government, along with the closed nature of state-owned companies, contributes to diminished transparency in financial reporting. This situation exacerbates information asymmetry and heightens the likelihood of fraudulent financial activities. Moreover, the erosion of internal control mechanisms within these companies facilitates opportunities for fraudulent activities and conflicts of interest involving management. Hence, in state-controlled companies, the likelihood of stock misvaluation is heightened.