What Drives Corporate Fraud — and How Much It Costs

Why It Matters 

Financial fraud continues to erode trust in capital markets, but not all misreporting is alike. This study shows that the motive behind the fraud — whether it’s personal gain, external pressure, or internal failure — affects not only why it happens, but how damaging it is. 

 

Key Takeaways 

• Companies misreport for different reasons: executive greed, pressure to meet financial targets, or weak internal controls. 

• The study introduces a new system that classifies fraud by motive and assigns each case a severity score. 

• This motive-based severity score more accurately predicts how the stock market reacts to fraud disclosures.

 

Breaking Down Corporate Misreporting 

When companies commit financial fraud, the reasons behind it matter. Most research treats fraud as a single phenomenon, but this study is the first to separate it into three distinct categories based on underlying motives:

• Wealth-Pursuing Misreporting: Fraud driven by executives seeking personal financial gain.
• Market-Induced Misreporting: Fraud committed to meet market expectations or secure financing.
• Subordinate-Driven Misreporting: Fraud that occurs due to inadequate oversight, typically by lower-level employees.

The researchers analysed 258 enforcement cases from the U.S. Securities and Exchange Commission (SEC) between 2004 and 2021. These detailed case records allowed the team to identify the main motive behind each fraud incident. 

Following the Money and the Market

Each motive reveals a different pattern of behaviour and consequence. In wealth-pursuing cases, for instance, executives often benefit directly from inflated stock prices. The study finds that CEOs and CFOs in this category sell 43.5% more of their company stock for every 1% rise in share price while the fraud remains hidden, reaping over $4 million on average in personal gains. That’s five times more than what executives in other fraud categories pocket.

Meanwhile, companies that misreport due to market pressure tend to raise more money through financing activities after the fraud, suggesting that the goal was to appear stronger to external investors. Because this type of fraud is typically seen as a team effort to boost the firm’s image, the executives involved are less likely to be removed.

For subordinate-driven fraud, the key issue is weak oversight. These companies tend to have less competent management and face greater challenges in monitoring daily operations, making them more vulnerable to internal wrongdoing. 

A Smarter Way to Measure Fraud Severity

To better understand the impact of each fraud case, the researchers developed a new severity score that incorporates the motive behind the misconduct. They combined five indicators — such as the amount of overstated earnings, penalties imposed, and number of people involved — into a composite score tailored to each misreporting motive.

This motive-based severity score proves far more effective at predicting stock market reactions than a traditional, one-size-fits-all approach. The more severe the fraud (as measured by this score), the greater the decline in the company’s stock price when the fraud is revealed.

Business Implications 

This research offers practical tools for regulators, investors, and companies: 

• For Regulators: Regulators can better target enforcement efforts and set penalties that reflect the motive behind the misconduct. 
• For Investors: By understanding the motives behind financial misreporting, investors can better assess the true risks hidden in a company’s financial statements. 
• For Companies: Companies can tailor internal controls to their specific vulnerabilities — whether that means curbing executive opportunism, easing pressure to meet short-term targets, or strengthening oversight of junior staff. This research also provides a roadmap for misreporting firms trying to recover from scandals. By addressing the root cause of the fraud, instead of just the surface-level symptoms, firms can rebuild credibility with the market and stakeholders.

 

Authors & Sources 

Authors: Wenjiao Cao (Erasmus University of Rotterdam), Yuping Jia (Frankfurt School of Finance and Management), and Yachang Zeng (Nanyang Technological University). 

Original Article: Management Science

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