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Abstract

This paper examines the deterrence effect of whistleblowing threats on the probability of accounting fraud. I predict that firms’ exposure to whistleblowing laws can create ex ante incentives for managers to deter fraud. If a state has adopted a False Claims Act (FCA), whistleblowers who report fraud involving that state's pension fund investments are eligible for monetary rewards. Using staggered adoption of FCAs by states between 1987 and 2010, and comparing firms that are now exposed to a state FCA due to state pension fund ownership in the firm with other control firms, I find firms' exposure to the threat of whistleblowing under the FCA reduces the probability of accounting fraud by 7%. Also, when the Securities and Exchange Commission (SEC) introduced the Dodd-Frank whistleblower provision in 2011, the probability of accounting fraud declined more pronouncedly among firms that had not been affected previously by state FCAs. I also find firms’ exposure to whistleblowing threats reduces audit fees by 5%, consistent with concerned managers tightening internal controls to detect fraud, which can substitute for external audits and/or reduce the control risk auditors face. Overall, this paper sheds light on the policy debate over the effectiveness of whistleblower provisions in preventing fraud.

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