Keeping up with the Joneses: A Model and a Test of Collective Accounting Fraud

Abstract:     
This paper explains the variations in incidence of accounting fraud across economic settings by putting the behavior and motivation of managers under the microscope. To safeguard their reputation in the managerial labor market, managers of firms that perform poorly are prone to fraudulently inflate earnings if they expect the economy to be strong, since that raises the likelihood of peers reporting high performance. A realized level of economic activity, on the other hand, counteracts this tendency on the part of managers to manage earnings, by reducing the number of firms that actually perform poorly. We term these two effects the incentive effect and the need effect, respectively. The existing literature on the incidence of accounting fraud has not considered the distinct influences of the expected and the realized levels of economic activity on the behavior of managers seeking to protect their reputation. Although the health of the aggregate economy affects the performance of all firms, this desire of managers to keep up with their peers entails a characteristic relationship between the incidence of accounting fraud and macroeconomic conditions. Specifically, the fraction of firms fraudulently overreporting earnings is positively related to expected economic performance and negatively related to realized economic performance.

These two macro effects on collective fraud are examined empirically by relating proxies of the aggregate incidence of accounting fraud to expected and realized GDP growth rates. The results unambiguously support the predicted influence of macroeconomic performance.

Number of Pages in PDF File: 33

Keywords: earnings manipulation, fraud, corporate governance

JEL Classification: G34, G38, F36, M41, M43, H25, E44

working papers series