When do corporate penalties for financial misreporting enhance long-term firm value?

Securities regulators frequently punish firms for their managers’ misreporting. They argue that this would enhance firms’ long-term value by mitigating underinvestment in compliance mechanisms, such as internal controls over financial reporting. Opponents of corporate penalties argue that the penalties would harm the very same investors already harmed by misreporting. We evaluate these arguments in a model with a capital market-oriented misreporting manager and a board of directors that invests in internal control quality. We identify governance transparency and board dependence as key factors that moderate the firm-value effects of corporate penalties. Internal control underinvestment occurs only if the board is severely dependent and if its choice of internal controls is opaque. Then corporate penalties curb internal control underinvestment, but they only improve long-term firm value if, additionally, internal control costs are sufficiently small (e.g., in small and less complex firms). Overall, our differentiated results have implications for regulatory enforcement policies and empirical studies on the firm-value effects of public enforcement.