Finance faculty members explore the links between financial reporting fraud and business conditions in award-winning paper

A paper written by Andrew Winton, professor of finance and insurance and Minnesota Chair in Banking and Finance, Carlson School; Tracy Yue Wang, assistant professor of finance and insurance, Carlson School; and Xiaoyun Yu, associate professor, Indiana University, recently won the Best Paper Award at the 2008 China International Conference on Finance in Dalian, China.

In the paper, “Corporate Fraud and Business Conditions: Evidence from IPOs,” the authors examine the links between financial reporting fraud and business conditions in an industry. The authors find that, while fraud tends to increase as investor beliefs about business conditions improve; eventually, when investor beliefs are very optimistic, fraud actually begins to decrease.

The research also revealed that the presence of investors with superior monitoring ability, such as venture capitalists, has mixed effects on fraud. “Venture capitalists are most helpful at decreasing fraud when investor beliefs are pessimistic; when beliefs are optimistic, there is actually more fraud when venture capitalists are active in the firm,” says Winton. “By contrast, as underwriter skills increase, fraud always decreases, but it decreases most when beliefs about business conditions are pessimistic.”

These results are consistent with a theoretical paper that Winton; Paul Povel, associate professor of finance and insurance; and Rajdeep Singh, Minnesota Banking and Finance Term Professor (all Carlson School faculty members), published in 2007 in the Review of Financial Studies. The theory is based on investors’ incentives and their skills at monitoring firms. For example, when investors are pessimistic, they scrutinize even strong reports, making fraud hard to get away with. As they grow more optimistic, they take strong reports at face value, and fraud increases. However, for very optimistic beliefs, investors are willing to fund firms with weak results, and the incentive to commit fraud is weakened. (Note: This paper was recently cited in an 11-4-08 VentureBeat column by Justin Hibbard called,"Due diligence, recession style." http://venturebeat.com/2008/11/04/due-diligence-recession-style/)

«BACK