The causes and consequences of accounting fraud

One of the fundamental purposes of corporate accounting is to facilitate the monitoring of managers. Since managers are instrumental in the production of accounting numbers, and since it is costly to monitor their behavior in this regard, firms sometimes report fraudulent accounting numbers. This paper tests several hypotheses concerning why some firms, and not others, commit accounting fraud. This is accomplished through examination of a sample of 62 firms charged with disclosure violations by the Securities and Exchange Commission (SEC) during the period 1981–1987. We also examine whether directors of companies that commit accounting fraud are disciplined in the managerial labor market. We adopt the perspective that the decision to commit fraud is governed by the expected costs and benefits of this behavior (This approach to the study of fraud has been used elsewhere, e.g. Darby and Karni (1973); Michael R. Darby and Edi Karni, “Free Competition and the Optimal Amount of Fraud”, Journal of Law and Economics 16 (April 1973), 68–88. For a brief discussion of the economics of fraud, see Edi Karni (1989) “Fraud” in The New Palgrave: Allocation, Information, and Markets, edited by John Earwell, Murray Milgate, and Peter Newman, New York: W.W. Norton, 117–119). Accordingly, a theory of accounting fraud requires an understanding of how these costs and benefits vary across firms. Those costs and benefits can be varied by external forces, through institutions such as equity markets and independent auditors, or internally through the design of monitoring and reward systems. We will divide our attention between the external and internal forces that change the costs and benefits of accounting fraud. © 1997 John Wiley & Sons, Ltd.