Is fraud affected by investor beliefs about business conditions? How is that reflected in the data from IPOs?

A study by Tracy Wang and Andrew Winton from the University of Minnesota, and Xiaoyun Yu from Indiana University comes up with some interesting findings.

The study, Corporate fraud and business conditions: evidence from IPOs found that companies are more likely to commit fraud when investors are more optimistic about the firm's industry prospect. surveying the the SEC's Accounting and Auditing Enforcement releases filed from 1996 to 2005, and data from the Stanford Law School's Securities Class Action Clearinghouse, revealed that firms that commit fraud at their IPO stage are also underwritten by investment banks with significantly lower industry specific expertise. They also operate in an industry that is more likely to be sued, have worse stock returns, higher return volatilities, and larger share turnover.

But then, the probability of fraud decreases when investors are really optimistic about the company's prospects. That's because the company is able to obtain funding without misrepresenting information to outside investors.

This study sends a message to regulators and auditors. You can't expect investors to stop or monitor fraud. All they want are good returns. But because fraud seems to peak in relatively good times, regulators and auditors need to be especially vigilant during a boom.