We examine firm managers' incentives to commit fraud in a model where firms seek funding from investors and investors can monitor firms at a cost in order to get more precise information about firm prospects. We show that fraud incentives are highest when business conditions are good, but not too good: in exceptionally good times, even weaker firms can get funded without committing fraud, whereas in bad times investors are more vigilant and it is harder to commit fraud successfully. As investors' monitoring costs decrease, the region in which fraud occurs shifts towards better business conditions. It follows that if business conditions are sufficiently strong, a decrease in monitoring costs actually increases the prevalence of fraud. If investors can only observe current business conditions with noise, then the incidence of fraud will be highest when investors begin with positive expectations that are disappointed ex post. Finally, increased disclosure requirements can exacerbate fraud. Our results shed light on the incidence of fraud across the business cycle and across different sectors.
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Paper provided by EconWPA in its series Finance with number
0312007.
Paul Povel & Rajdeep Singh & Andrew Winton, 2007.
"Booms, Busts, and Fraud,"
Review of Financial Studies,
Oxford University Press for Society for Financial Studies, vol. 20(4), pages 1219-1254.
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Find related papers by JEL classification: E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles G3 - Financial Economics - - Corporate Finance and Governance G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
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