On Fraudulent Financial Practice and Competitive Discipline

Following the huge Enron scandal that rocked the financial system of the United States, many firms were asked to restate their accounts by the regulatory authorities. We provide a theoretical model of overstatement in which managers inflate actual profits to attract share capital and shareholders find it too costly to monitor such action. We completely characterize such equilibrium and argue that more competitive industries are likely to discourage such earning manipulations. We also show that in case only some firms in an industry engage in such malpractice, the margin of manipulation will be greater. However, greater entry will reduce the extent of overstatement