Keeping Up with the Joneses: A Model and a Test of Collective Accounting Fraud

This paper explains the variations in incidence of accounting fraud across economic settings by putting the behaviour and motivation of managers under the microscope. To safeguard their reputation in the managerial labour market, managers of firms that perform poorly are prone to fraudulently inflate earnings if they expect the economy to be strong, since that raises the likelihood of peers reporting high performance. A realised level of economic activity, on the other hand, counteracts this tendency on the part of managers to overstate earnings, by reducing the number of firms that actually perform poorly. We term these two effects the incentive effect and the need effect, respectively. The two effects yield a distinctive relationship between the incidence of accounting fraud and macroeconomic conditions. Specifically, the fraction of firms fraudulently over-reporting earnings is positively related to expected economic performance and negatively related to realised economic performance.
The incentive and need effects on collective fraud are examined empirically by relating proxies of the aggregate incidence of accounting fraud to expected and realised GDP growth rates. The results unambiguously support the predicted influence of macroeconomic performance.