DP7104 Corporate Fraud, Governance and Auditing

Author(s): Giovanni Immordino, Marco Pagano
Publication Date: December 2008
Keyword(s): accounting fraud, auditing, corporate governance, managerial compensation, regulation
JEL(s): G28, K22, M42
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7104

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.