The Strategic Interaction between Committing and Detecting Fraudulent Misreporting

The paper considers an agency model of fraudulent misreporting which implies a rich set of relationships between the commission of fraud, the observation or detection of fraud, economic performance, and the compensation policy of the firm. The paper develops a number of testable empirical implications and highlights several interesting phenomena, including implications on exogenous variables that can cause an increase in the amount of fraud committed but a decrease in the amount of fraud being observed (and visa versa). Thus, empirical studies that seek to identify the firm or managerial characteristics associated with the commission of fraud cannot infer a relationship by simply examining how the amount of observed fraud varies with these characteristics. In addition, the paper also shows that an increase in an industry’s growth potential can cause that industry to fall from a high-productivity pooling equilibrium (with high levels of incentive compensation and effort and, as a result, many high-productivity firms) to the lower-productivity mixed-strategy equilibrium (with lower levels of incentive compensation and effort and, as a result, fewer high-productivity firms), resulting in a drop in economic performance.

Myra Lissenberg