Accounting Fraud and the Pricing of Corporate Liabilities: Structural models with garbling

by Angelo Baglioni of the Catholic University of the Sacred Heart, and
Umberto Cherubini of the University of Bologna

February 2005

Abstract: We provide a method for modelling accounting distortions and their impact on the value of corporate liabilities. Our model is able to account for both small noise (estimate errors) and large mis-representations (deliberate fraud). Such a methodology is then applied to structural pricing models, in the spirit of Merton (1974). It turns out that accounting distortions may be a relevant factor in the pricing of corporate securities: indeed, they are able to explain why credit spreads are actually larger than implied by traditional structural models, particularly on short maturities. Simulations show that such an effect is stronger for safer firms, namely those with lower leverage and asset volatility.

JEL Classification: D82, G12, G30, M41.

Keywords: Accounting, Information, Asset pricing, Credit spreads.

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