Working Paper: NBER ID: w11573
Authors: Simi Kedia; Thomas Philippon
Abstract: 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, bad managers hire and invest too much in order to pool with the good managers. This behavior distorts the allocation of economic resources among firms. We test the predictions of the model using new historical and firm-level data. First, we show that periods of high stock market valuations are systematically followed by large increases in reported frauds. We then show that during periods of suspicious accounting, firms hire and invest excessively, while insiders exercise options and sell stocks. When the misreporting is detected, firms shed labor and capital and productivity improves. In the aggregate, our model seems able to account for periods of jobless and investment-less growth.
Keywords: Earnings management; Fraudulent accounting; Employment dynamics; Investment dynamics
JEL Codes: E0; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| earnings management (M52) | hiring decisions (M51) |
| earnings management (M52) | investment decisions (G11) |
| bad managers (M54) | excessive hiring (J23) |
| bad managers (M54) | excessive investment (E22) |
| high P/E ratios (G12) | increased SEC actions for fraud (G18) |
| firms engaging in earnings management (M48) | higher hiring during misreporting (J68) |
| firms engaging in earnings management (M48) | higher investment during misreporting (G31) |
| earnings management (M52) | decline in hiring post-restatement (J63) |
| earnings management (M52) | decline in investment post-restatement (G31) |
| earnings manipulation (M52) | jobless growth (F66) |
| earnings manipulation (M52) | misallocation of resources (D61) |