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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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11573.

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Date of creation: Aug 2005
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Publication status: published as Kedia, Simi and Thomas Philippon. "The Economics of Fraudulent Accounting." Review of Financial Studies 22, 6 (2009): 2169-2199.
Handle: RePEc:nbr:nberwo:11573

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  1. Paul A. Gompers & Joy L. Ishii & Andrew Metrick, 2002. "Corporate Governance and Equity Prices," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 02-32, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Philippon, Thomas, 2006. "Corporate governance over the business cycle," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 30(11), pages 2117-2141, November.
  3. Dechow, Patricia M. & Kothari, S. P. & L. Watts, Ross, 1998. "The relation between earnings and cash flows," Journal of Accounting and Economics, Elsevier, Elsevier, vol. 25(2), pages 133-168, May.
  4. Daniel Bergstresser & Thomas Philippon, 2003. "CEO incentives and earnings management," Proceedings, Federal Reserve Bank of Chicago 862, Federal Reserve Bank of Chicago.
  5. Ilan Guttman & Ohad Kadan & Eugene Kandel, 2003. "Adding the Noise: A Theory of Compensation-Driven Earnings Management," Discussion Paper Series, The Center for the Study of Rationality, Hebrew University, Jerusalem dp355, The Center for the Study of Rationality, Hebrew University, Jerusalem.
  6. Eli Ofek & David Yermack, 2000. "Taking Stock: Equity-Based Compensation and the Evolution of Managerial Ownership," Journal of Finance, American Finance Association, American Finance Association, vol. 55(3), pages 1367-1384, 06.
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