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The Economics of Fraudulent Accounting

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  • Simi Kedia
  • Thomas Philippon

Abstract

We argue that earnings management and fraudulent accounting have important economic consequences. In a model where the costs of earnings management are endogenous, we show that in equilibrium, bad managers hire and invest too much in order to pool with the good managers. This behavior distorts the allocation of economic resources among firms. We test the predictions of the model using new historical and firm-level data. First, we show that periods of high stock market valuations are systematically followed by large increases in reported frauds. We then show that during periods of suspicious accounting, firms hire and invest excessively, while insiders exercise options and sell stocks. When the misreporting is detected, firms shed labor and capital and productivity improves. In the aggregate, our model seems able to account for periods of jobless and investment-less growth.

Suggested Citation

  • Simi Kedia & Thomas Philippon, 2005. "The Economics of Fraudulent Accounting," NBER Working Papers 11573, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:11573
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    References listed on IDEAS

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    1. Philippon, Thomas, 2006. "Corporate governance over the business cycle," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2117-2141, November.
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    6. Bergstresser, Daniel & Philippon, Thomas, 2006. "CEO incentives and earnings management," Journal of Financial Economics, Elsevier, vol. 80(3), pages 511-529, June.
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    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • G3 - Financial Economics - - Corporate Finance and Governance

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