Competition and Corporate Fraud Waves

Abstract

Our paper examines the effect of product market competition on firms’ incentives to misreport financial information to investors. We examine three specific channels through which product market competition can affect the information environment in an industry and individual firms’ incentives to misreport information. We show that the lack of product market sensitivity to individual firm information tends to encourage fraud commission. The use of relative performance evaluation (i.e., industry benchmarking) in managerial retention decisions also encourages fraud. The lack of information collection about individual firms tends to decrease the probability of fraud detection and increase the probability of fraud commission. All three channels are more likely to be present in more competitive industries, implying that fraud propensity is on average higher in those industries. We show that fraud can help explain the predictable busts in competitive industries. Post-boom poor performance in competitive industries is largely concentrated in firms that are likely to have committed fraud during the booms. The underlying reason is twofold. First, fraud propensity is more cyclical in more competitive industries. Second, the consequence of fraud in competitive industries is particularly bad following booms. Our results suggest that the dynamic of fraud can amplify the cyclical fluctuations in the real economy, particularly in competitive industries.

Keywords: corporate securities fraud, misreporting, product market competition, boom, bust, investment, relative performance evaluation

JEL Classification: G30, G31, G32, G34