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Authors:

• Xiaoyun YU
  Indiana University

• Tracy Y. WANG
  University of Minnesota

• Andrew WINTON
  University of Minnesota

Using a sample of firms that went public between 1995 and 2002, we examine whether a firm's incentive to commit fraud when raising external capital varies with investor beliefs about industry business conditions as predicted by Povel, Singh and Winton (2007). We document a concave relationship between fraud propensity and optimism in investor beliefs. A firm is more likely to commit fraud when investors are more optimistic about the firm's industry prospect. Nevertheless, the probability of fraud decreases in the presence of extreme investor optimism, as the firm is able to obtain funding without misrepresenting information to outside investors. We also find evidence that venture capitalists and underwriters have different monitoring incentives. When venture capitalists are present, fraud is less likely for low investor beliefs but more likely for high investor beliefs; this suggests that venture capitalists primarily monitor to seek good returns for their investment and thus take investor beliefs into account. By contrast, underwriters' monitoring choices appear to be more concerned with preventing fraud per se so as to protect their reputations. These findings are consistent with the predictions from Povel, Singh and Winton (2007).