39 Pages Posted: 20 Mar 2005
This paper analyzes a firm's propensity to commit securities fraud and the real consequences of fraud. The theory shows that fraud has real economic cost, as investment distortions can arise from fraud-induced market misvaluation and management's ability to influence the firm's litigation risk through investment. The cost of inefficiency is borne by not only shareholders of fraudulent firms but also those of honest firms. The theory also characterizes a firm's equilibrium supply of fraud. A firm's fraud propensity and the magnitude of fraud are shown to depend on the nature of the firm's assets, growth potential, and the quality of corporate governance. The theory provides testable implications for cross-sectional variations in firms' fraud propensities and for firms' investment incentives in the presence of fraud. It also sheds light on he potential effectiveness of legislative initiatives and regulatory changes that deal with fraud.
Keywords: securities fraud, financial misreporting, corporate governance, investment
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