The Economics of Fraudulent Accounting

Abstract

We argue that earnings management and fraudulent accounting have important eco- nomic consequences. In a model where the costs of earnings management are endoge- nous, we show that in equilibrium, low productivity firms hire and invest too much in order to pool with high productivity firms. This behavior distorts the allocation of economic resources in the economy. We test the predictions of the model using firm- level data. We show that during periods of suspicious accounting, firms hire and invest excessively, while managers exercise options. When the misreporting is detected, firms shed labor and capital and productivity improves. Our firm-level results hold both be-fore and after the market crash of 2000. In the aggregate, our model provides a novel explanation for periods of jobless and investment-less growth.