When the Going Gets Tough, the Books Get Cooked:Product Market Competition and Financial Misconduct

Abstract

This paper extends the research on financial misconduct by developing a new perspective based on general strain theory, and more specifically on the strain effect of product market competition. Previous literature suggests that product market competition can provide incentives for managers, but we argue that it can also lead to financial misconduct. In so doing, we take a strain perspective in making the argument that product market competition should be positively associated with the occurrence of misconduct, as it magnifies the threat arising from the possibility of firm liquidation and executive dismissal. We also examine the effect of internal governance mechanisms that are commonly deployed to minimize the agency problem. We argue that CEO option pay will negatively moderate the relationship between product market competition and the occurrence of financial misconduct, in line with the prevailing wisdom of corporate governance research. By contrast, while board independence has often been proposed as an effective governance mechanism to reduce the number of undesirable managerial behaviors, we argue it can exacerbate the threat of executive dismissal resulting from competition, creating incentives for fraudulent behavior. An empirical study of U.S. manufacturing firms provides broad support for our arguments.