How Pervasive Is Corporate Fraud?

We estimate what percentage of firms engage in fraud and the economic cost of fraud. Our estimates are based on detected frauds, and frauds that we infer are started but are not caught. To identify the ‘iceberg’ of undetected fraud we take advantage of an exogenous shock to the incentives for fraud detection: Arthur Andersen’s demise, which forces companies to change auditors. By assuming that the new auditor will clean house, and examining the change in fraud detection by new auditors, we infer that the probability of a company engaging in a fraud in any given year is 14.5%. We validate the magnitude of this estimate using alternative methods. We estimate that on average corporate fraud costs investors 22 percent of enterprise value in fraudcommitting firms and 3 percent of enterprise value across all firms. _____________________________ * We thank Patricia Dechow, Katherine Guthrie, Phil McCollough, Joseph P. Weber, Michael Weisbach as well as participants at the University of Illinois Symposium on Auditing Research, the European Finance Association, the University of Chicago, the Rotman School at the University of Toronto, Berkeley-Haas Accounting, and Queens University. Alexander Dyck thanks the Connaught Fund of the University of Toronto, and Adair Morse and Luigi Zingales, the Center for Research on Security Prices, the Stigler Center, and the Initiative on Global Financial Markets at the University of Chicago for financial support.