Inflating profits and industry competitiveness

• Date: 01 September 2019
• Author: Sugata Marjit,Hamid Beladi,Reza Oladi
• Published date: 01 September 2019
• DOI: http://doi.org/10.1111/ijet.12185

doi: 10.1111/ijet.12185

Inflating profits and industry competitiveness

Hamid Beladi,∗Sugata Marjit†and Reza Oladi‡

We provide a theoretical model in which managers inflate actual profits to attract capital and

shareholders cannot monitor such actions. We focus on the role of market competition in

cross-industry difference in financial performance overstatement. We show that the degree of

competition negatively affects the extent of overstatement.

Key wor ds inflating profit, competition, corporate governance

JEL classification G30, L1

Accepted 31 May2017

1 Introduction

The agency problem has been extensively modeled and utilized in analyzing the behavior of agents.

The literature has addressed various aspects of this problem – see, for example, Hart (1995) on cor-

porate governance and more recently Batabyal (2012) and Chau and Kanbur(2013) on contracting.

At the heart of the problem are the separation of ownership and control, and the lack of monitoring

(see Batabyal 2012; Hu and Yang 2014). These may result in the undesirable outcome that managers

of a public company pursue their own interests at the expense of those of their shareholders. This is

also corroborated by the fact that firms lose value once the announcement of restatements is made

(see Agrawal and Chadha 2005; Hu et al. 2014). Given that the enforced policy of restatement causes

an immediate decline in firm value, it is reasonable to assume that shareholders, specifically small

stakeholders, tend to believe disclosures announced by the managers.

Todeal with the agency problem, various corporate governance mechanisms have been discussed

in the literature such as monitoring, voting by shareholders or their representatives on the board

of directors, large shareholders or proxy fights. In addition, in the context of this classical agency

problem, some authors consider the role of competition as well as mergers and acquisition – see, for

example, Hart (1983) on the role of competition and Grossman and Hart (1980) on the effects of

the agency problem on takeover bids.

In this paper we consider a differentproblem in which managers may overstate their performance,

enticing shareholders to put in additional capital. An (overstated) increase in the announced profit

∗College of Business, University of Texas at San Antonio, USA.

†Centre for Studies in Social Sciences, Calcutta, India, and CES-Ifo, Munich,Germany.

‡Department of Applied Economics, Utah State University,Logan, Utah, USA. Email: reza.oladi@usu.edu

We are grateful to an anonymous referee and the editor for their suggestions. Hamid Beladi acknowledges generous

support from the Janey S. Briscoe endowment. Sugata Marjit acknowledges financial support from the RBI endowment

at CSSSC and is indebted to FerdinandGul for many fruitful discussions on the topic. He is also grateful for the academic

hospitality of the School of Economics at the University of Queensland. RezaOladi is gr atefulfor financial suppor t from

Utah Agricultural Experiment Station.

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