Working Paper: CEPR ID: DP7104
Authors: Marco Pagano; Giovanni Immordino
Abstract: We analyze corporate fraud in a model in which managers have superior information but are biased against liquidation, because of their private benefits from empire building. This may induce them to misreport information and even bribe auditors when liquidation would be value-increasing. To curb fraud, shareholders optimally choose auditing quality and the performance sensitivity of managerial pay, taking external corporate governance and auditing regulation into account. For given managerial pay, it is optimal to rely on auditing when external governance is in an intermediate range. When both auditing and incentive pay are used, worse external governance must be balanced by heavier reliance on both of those incentive mechanisms. In designing managerial pay, equity can improve managerial incentives while stock options worsen them.
Keywords: accounting fraud; auditing; corporate governance; managerial compensation; regulation
JEL Codes: G28; K22; M42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Poor external governance (G38) | Increased managers' biases against liquidation (G33) |
| Increased managers' biases against liquidation (G33) | Misreporting and bribery of auditors (M48) |
| Poor external governance (G38) | Increased reliance on auditing and performance-based pay (J33) |
| External governance quality (G38) | Effectiveness of auditing (M42) |
| Increasing performance sensitivity of managerial pay (J33) | Mitigation of effects of poor external governance (G38) |
| Equity-based compensation (M52) | Improved managerial incentives (M52) |
| Stock options (G13) | Exacerbated tendency for fraud (K42) |