RFS Advance Access originally published online on March 17, 2007
Review of Financial Studies 2009 22(6):2169-2199; doi:10.1093/rfs/hhm016
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The Economics of Fraudulent Accounting
Rutgers University
New York University, CEPR and NBER
Address correspondence to Thomas Philippon, New York University, CEPR and NBER, or e-mail: tphilipp{at}stern.nyu.edu
JEL Classification: G30, G34, M41
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Abstract |
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We argue that earnings management and fraudulent accounting have important economic consequences. In a model where the costs of earnings management are endogenous, 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 before and after the market crash of 2000. In the aggregate, our model provides a novel explanation for periods of jobless and investment-less growth.
We are grateful to Michael Weisbach, the editor, as well as two anonymous referees for their suggestions and their insights. We thank Franklin Allen, Chris Hennessy, Yishay Yafeh and Steve Slezak for their discussions, and Darren Roulstone for his detailed comments. We also thank Natasha Burns, Greg Mankiw and the seminar participants at NYU, USC, UCLA, Chicago GSB, and NBER CF and EFG, AFA and 17th FEA meeting. Kedia thanks the Whitcomb center for financial support.