Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting

Abstract

AbstractUsing samples of restating and nonrestating U.S. firms, the study empirically investigates the relationship between the incidence of fraudulent financial reporting and accounting‐based performance outcomes. The outcomes are framed as gains and losses relative to a reference point, defined as the mean performance of industry peers. Consistent with cumulative prospect theory (CPT), the findings show that fraud incidence is positively (negatively) related to the probability of a loss (gain); more (less) sensitive to the probability of a loss (gain) (i.e., loss‐aversion); and more (less) sensitive to an extra unit of the probability at a high‐ or low‐ (medium‐) probability level (i.e., nonlinear probability weighting function). The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual‐level behavioral implications on firm‐level archival data, the study reconceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real‐world setting of fraudulent financial reporting.