The Economic Consequences of Accounting Fraud in Product Markets: Theory and a Case from the U.S. Telecommunication Industry (WorldCom)

This paper studies the effects of accounting fraud on the product market. The model presented in this paper relies on the idea that a firm's financial statements and actions must be consistent with each other. If the firm is behaving fraudulently, insofar as its financial statements portray it as relatively efficient, the firm must act accordingly, i.e., increase its market share and/or reduce its prices. If the firm does not behave in keeping with its fraudulent financials, the market would be able to identify the fraud. As such, the manager will take actions and make pricing decisions which are not optimal. These actions can have a significant adverse effect on social welfare. This paper utilizes the WorldCom case to illustrate the implications of such fraudulent behavior and its economic significance in product markets.