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May 6, 2010
Abstract
The paper studies corporate financial fraud and detection using an empirical framework that models the strategic interdependence between fraud and detection and accounts for the possibility that some fraud remains undetected (incomplete detection). The framework first models fraud as a discrete choice and is then extended to model the magnitude of fraud. The paper shows that failure to account for incomplete detection can lead to significant downward biases in estimating the effects of various factors on the likelihood of fraud. By modeling fraud and detection in two separate equations, the model allows one to study the impact of the regulator’s budget on fraud detection and the strategic interdependence between fraud and detection. Furthermore, the empirical model in the paper has a number of potential applications.
implicitly treats detected fraud as all fraud and understates the true extent of fraud. The
understatement may cause biases in model estimates, and the bias may be severe when the
JEL Classification: G34, G39, C35, M41, K22, K42 Keywords: Fraud, detection, corporate misreporting, monitoring, detection controlled estimation, incomplete detection, partial observability, probit models, Tobit models, simultaneous equation models
is, the manager’s fraud decision depends on his/her assessment of the likelihood of being caught
and the monitor’s decision to investigate a firm depends on the likelihood that the firm has committed fraud. 2 Nevertheless, none of the prior work on corporate fraud has empirically
Feinstein (1990) names as detection controlled estimation (DCE). Using an extended DCE model,
the paper empirically examines the determinHale Waihona Puke Baidunts of corporate fraud and detection and the
interdependence between the two.
1 The Antifraud Rule 10b-5 of Securities Exchange Act of 1934 defines corporate financial fraud as the intent to deceive or manipulate with misstatements or omissions of material information relating to financial condition, solvency, and profitability (see SEC Administrative Proceeding 3-9588, April 27, 1998). McLucas et al. (1997) state that financial fraud is accomplished through the use of false financial information or the failure to disclose material facts relating to a public company’s financial condition. 2 The interdependent property between firms and monitors is well recognized in the theoretical literature. Baron and Besanko (1984), Laffont and Tirole (1986), Graetz, Reinganum, and Wilde (1986), and Reinganum and Wilde (1985) model the strategic interdependence between a potential violator and its regulator in a game-theoretic framework and derive the optimal reporting policy for the potential violator and the optimal monitoring rule for the regulator in equilibrium. The theoretical work on corporate fraud, such as Bar-Gill and Bebchuk (2003), Goldman and Slezak (2006), Noe (2008), Povel, Singh, and Winton (2007), Stein (1989), and Subrahmanyam (2003), models the interdependence between firm managers and shareholders and investigates such issues as the optimal design of executive compensation, causes and consequences of corporate fraud, etc.
1
1. Introduction
A series of high-profile corporate fraud scandals like Enron and Worldcom have drawn the attention of the public, regulators, and academics.1 It is widely recognized that some fraud cases
models the strategic interdependence between fraud and detection and accounts for the possibility that some fraud remains undetected (incomplete detection). The framework first models fraud as a discrete choice and is then extended to model the magnitude of fraud. The paper shows that failure to account for incomplete detection can lead to significant downward biases in estimating the effects of various factors on the likelihood of fraud. By modeling fraud and detection in two separate equations, the model allows one to study the impact of the regulator’s budget on fraud detection and the strategic interdependence between fraud and detection. Furthermore, the empirical model in the paper has a number of potential applications. JEL Classification: G34, G39, C35, M41, K22, K42 Keywords: Fraud, detection, corporate misreporting, monitoring, detection controlled estimation, incomplete detection, partial observability, probit models, Tobit models, simultaneous equation models
remain undetected (this is referred to as incomplete detection in Feinstein [1990]). The empirical
literature on fraud, however, has largely ignored the incomplete detection problem. This literature
modeled such interdependence. This paper sets up a model that explicitly accounts for incomplete
detection as well as the interdependence between fraud and detection. The model is built on what
Corporate Financial Fraud: An Application of Detection Controlled Estimation
Abstract The paper studies corporate financial fraud and detection using an empirical framework that
Corporate Financial Fraud: An Application of Detection Controlled Estimation
Si Li∗
School of Business and Economics, Wilfrid Laurier University, Waterloo, ON, N2L 3C5, Canada
*Please address correspondence to Si Li (sli@wlu.ca), School of Business and Economics, Wilfrid Laurier University, 75 University Avenue West, Waterloo, Ontario N2L 3C5, Canada. I owe special thanks to Alon Brav, John Graham, Han Hong, David Hsieh, and Hui Ou-Yang for their invaluable insights. I thank Ben Amoako-Adu, Tim Bollerslev, Michael Bradley, Michael Brandt, Bruce Carlin, Jim Cox, Bjorn Eraker, Ronald Gallant, Simon Gervais, Itay Goldstein, Hyoung Kang, Ron Kaniel, Pete Kyle, Mark Leary, Richmond Mathews, Manju Puri, Michael Roberts, David Robinson, Brian Smith, Matthew Spiegel, George Tauchen, Stephen Wallenstein, Mike Weisbach, Julia Wu, Rebecca Zarutskie, the 2005 Western Finance Association Meetings, the 2005 Econometric Society World Congress, and seminar participants at Charles River Associates, Duke University, University of Minnesota-Twin Cities, University of Oklahoma, and Wilfrid Laurier University for helpful discussions and comments.
understatement is large. In addition, the theoretical work on fraud has emphasized the strategic
interdependence between a firm manager’s fraud decision and a monitor’s detection effort. That
Abstract
The paper studies corporate financial fraud and detection using an empirical framework that models the strategic interdependence between fraud and detection and accounts for the possibility that some fraud remains undetected (incomplete detection). The framework first models fraud as a discrete choice and is then extended to model the magnitude of fraud. The paper shows that failure to account for incomplete detection can lead to significant downward biases in estimating the effects of various factors on the likelihood of fraud. By modeling fraud and detection in two separate equations, the model allows one to study the impact of the regulator’s budget on fraud detection and the strategic interdependence between fraud and detection. Furthermore, the empirical model in the paper has a number of potential applications.
implicitly treats detected fraud as all fraud and understates the true extent of fraud. The
understatement may cause biases in model estimates, and the bias may be severe when the
JEL Classification: G34, G39, C35, M41, K22, K42 Keywords: Fraud, detection, corporate misreporting, monitoring, detection controlled estimation, incomplete detection, partial observability, probit models, Tobit models, simultaneous equation models
is, the manager’s fraud decision depends on his/her assessment of the likelihood of being caught
and the monitor’s decision to investigate a firm depends on the likelihood that the firm has committed fraud. 2 Nevertheless, none of the prior work on corporate fraud has empirically
Feinstein (1990) names as detection controlled estimation (DCE). Using an extended DCE model,
the paper empirically examines the determinHale Waihona Puke Baidunts of corporate fraud and detection and the
interdependence between the two.
1 The Antifraud Rule 10b-5 of Securities Exchange Act of 1934 defines corporate financial fraud as the intent to deceive or manipulate with misstatements or omissions of material information relating to financial condition, solvency, and profitability (see SEC Administrative Proceeding 3-9588, April 27, 1998). McLucas et al. (1997) state that financial fraud is accomplished through the use of false financial information or the failure to disclose material facts relating to a public company’s financial condition. 2 The interdependent property between firms and monitors is well recognized in the theoretical literature. Baron and Besanko (1984), Laffont and Tirole (1986), Graetz, Reinganum, and Wilde (1986), and Reinganum and Wilde (1985) model the strategic interdependence between a potential violator and its regulator in a game-theoretic framework and derive the optimal reporting policy for the potential violator and the optimal monitoring rule for the regulator in equilibrium. The theoretical work on corporate fraud, such as Bar-Gill and Bebchuk (2003), Goldman and Slezak (2006), Noe (2008), Povel, Singh, and Winton (2007), Stein (1989), and Subrahmanyam (2003), models the interdependence between firm managers and shareholders and investigates such issues as the optimal design of executive compensation, causes and consequences of corporate fraud, etc.
1
1. Introduction
A series of high-profile corporate fraud scandals like Enron and Worldcom have drawn the attention of the public, regulators, and academics.1 It is widely recognized that some fraud cases
models the strategic interdependence between fraud and detection and accounts for the possibility that some fraud remains undetected (incomplete detection). The framework first models fraud as a discrete choice and is then extended to model the magnitude of fraud. The paper shows that failure to account for incomplete detection can lead to significant downward biases in estimating the effects of various factors on the likelihood of fraud. By modeling fraud and detection in two separate equations, the model allows one to study the impact of the regulator’s budget on fraud detection and the strategic interdependence between fraud and detection. Furthermore, the empirical model in the paper has a number of potential applications. JEL Classification: G34, G39, C35, M41, K22, K42 Keywords: Fraud, detection, corporate misreporting, monitoring, detection controlled estimation, incomplete detection, partial observability, probit models, Tobit models, simultaneous equation models
remain undetected (this is referred to as incomplete detection in Feinstein [1990]). The empirical
literature on fraud, however, has largely ignored the incomplete detection problem. This literature
modeled such interdependence. This paper sets up a model that explicitly accounts for incomplete
detection as well as the interdependence between fraud and detection. The model is built on what
Corporate Financial Fraud: An Application of Detection Controlled Estimation
Abstract The paper studies corporate financial fraud and detection using an empirical framework that
Corporate Financial Fraud: An Application of Detection Controlled Estimation
Si Li∗
School of Business and Economics, Wilfrid Laurier University, Waterloo, ON, N2L 3C5, Canada
*Please address correspondence to Si Li (sli@wlu.ca), School of Business and Economics, Wilfrid Laurier University, 75 University Avenue West, Waterloo, Ontario N2L 3C5, Canada. I owe special thanks to Alon Brav, John Graham, Han Hong, David Hsieh, and Hui Ou-Yang for their invaluable insights. I thank Ben Amoako-Adu, Tim Bollerslev, Michael Bradley, Michael Brandt, Bruce Carlin, Jim Cox, Bjorn Eraker, Ronald Gallant, Simon Gervais, Itay Goldstein, Hyoung Kang, Ron Kaniel, Pete Kyle, Mark Leary, Richmond Mathews, Manju Puri, Michael Roberts, David Robinson, Brian Smith, Matthew Spiegel, George Tauchen, Stephen Wallenstein, Mike Weisbach, Julia Wu, Rebecca Zarutskie, the 2005 Western Finance Association Meetings, the 2005 Econometric Society World Congress, and seminar participants at Charles River Associates, Duke University, University of Minnesota-Twin Cities, University of Oklahoma, and Wilfrid Laurier University for helpful discussions and comments.
understatement is large. In addition, the theoretical work on fraud has emphasized the strategic
interdependence between a firm manager’s fraud decision and a monitor’s detection effort. That