Managerial compensation, product market competition and fraud

•Managers have private information about profits and can exert cost-cutting effort.•Stock based compensation is employed to align manager's and shareholders' incentives.•We study shareholders' trade-off between fraud and effort as the degree of PMC varies.•We find a positive relationship between PMC and fraudulent reporting.

We study a model in which a manager can engage in unobservable cost-cutting effort, possesses private information about firm profits and where shareholders employ stock and stock option-based compensation packages to align the manager's interests with theirs. Stock-based incentives may induce the manager to misrepresent profits with the aim to increase the firm's stock price and hence her compensation. Common wisdom holds that competition disciplines the manager. We investigate how product market competition affects the shareholders' trade-off between fraud and effort and hence incentive provision.