Skip to main content
SpringerLink
Log in

Equity Incentives and Corporate Fraud in China

  • Published:
Journal of Business Ethics Aims and scope Submit manuscript

Abstract

This paper explores how managers’ and supervisors’ equity incentives impact the likelihood of committing corporate fraud in Chinese-listed firms. Previous research has shown that corporate fraud in China is a widespread phenomenon and has severe consequences for affected firms and executives. However, our understanding of the reasons that fraud is committed in a Chinese setting has been very limited thus far. This is an increasingly important topic, because corporate governance is rapidly changing in China, and it is unclear whether adopting the executive compensation practices of the West is appropriate for Chinese firms. We show that managers’ equity incentives increase their propensity to commit corporate fraud. We also find that this effect is more pronounced for state-owned firms. However, we find a negative but not significant relationship between the equity incentives of the supervisory board and the incidence of fraud.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Similar content being viewed by others

Notes

  1. U.S. evidence shows negative abnormal returns on the announcement day of an enforcement action by the U.S. Securities and Exchange Commission (SEC) (see Feroz et al. 1991; Dechow et al. 1996). Moreover, Karpoff et al. (2008) estimate that firms can lose, on average, 38 % of their market value as a result of SEC enforcement actions.

  2. www.economist.com. Accessed on 21 December 2013.

  3. For a discussion on the regulatory framework and institutional setting please see Chen et al. (2006).

  4. In 2006, the State-owned Assets Supervision and Administration Commission (SASAC) and the Ministry of Finance (MOF) published the Trial Procedures for the implementation of stock-based incentives in SOEs (Li et al. 2013). In 2007, the CSRC updated their regulations and required the disclosure of compensation committee duties, and the implementation of stock-based incentive plans (Li et al. 2013).

  5. See Firth et al. 2006 for a review of executive pay history in China.

  6. It is interesting to note that recent empirical evidence suggests external governance mechanisms are important in China. Chen et al. (2014) find that analyst coverage can mitigate instances of fraud in Chinese-listed companies. This effect is particularly important for non-SOEs because they are more dependent, with respect to financing needs, on capital markets than SOEs. Moreover, Chen et al. (2013) report that the presence of auditors can serve as an external governance mechanism that also mitigates the fraudulent behavior of executives.

  7. We present the results based on the sample matched by industry and size. However, we also matched the sample based on the propensity score method used by Armstrong et al. (2010), and found very similar results.

References

  • Aggarwal, R. K. (2007). Chapter 17—Executive compensation and incentives. In B. E. Eckbo (Ed.), Handbook of empirical corporate finance (pp. 497–538). North-Holland: Elsevier.

    Google Scholar 

  • Allen, F., Qian, J., & Qian, M. J. (2005). Law, finance, and economic growth in China. Journal of Financial Economics, 77(1), 57–116.

    Article  Google Scholar 

  • Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. Journal of Finance, 23(4), 589–609.

    Article  Google Scholar 

  • Armstrong, C. S., Jagolinzer, A. D., & Larcker, D. F. (2010). Chief executive officer equity incentives and accounting irregularities. Journal of Accounting Research, 48(2), 225–271.

    Article  Google Scholar 

  • Armstrong, C. S., Larcker, D. F., Ormazabal, G., & Taylor, D. J. (2013). The relation between equity incentives and misreporting: The role of risk-taking incentives. Journal of Financial Economics, 109(2), 327–350.

    Article  Google Scholar 

  • Ball, R. (2009). Market and political/regulatory perspectives on the recent accounting scandals. Journal of Accounting Research, 47(2), 277–323.

    Article  Google Scholar 

  • Bar-Gill, O., & Bebchuk, L. (2003). Misreporting corporate performance. Harvard Law and Economics Discussion Paper No. 400.

  • Beasley, M. S. (1996). An empirical analysis of the relation between the board of director composition and financial statement fraud. The Accounting Review, 71(4), 443–465.

    Google Scholar 

  • Becker, G. (1968). Crime and punishment: an economic approach. Journal of Political Economy, 76, 169–217.

    Article  Google Scholar 

  • Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management. Journal of Financial Economics, 80(3), 511–529.

    Article  Google Scholar 

  • Bryson, A., Forth, J., & Zhou, M. (2014). Same or different? The CEO labour market in China’s public listed companies. The Economic Journal, 124, F90–F108.

    Article  Google Scholar 

  • Burns, N., & Kedia, S. (2006). The impact of performance-based compensation on misreporting. Journal of Financial Economics, 79(1), 35–67.

    Article  Google Scholar 

  • Chen, J., Cumming, D., Hou, W., & Lee, E. (2013). Executive integrity, audit opinion, and fraud in Chinese listed firms. Emerging Markets Review, 15, 72–91.

    Article  Google Scholar 

  • Chen, J., Cumming, D., Hou, W., & Lee, E. (2014). Does the external monitoring effect of financial analysts deter corporate fraud in China? Journal of Business Ethics. doi:10.1007/s10551-014-2393-3.

  • Chen, G., Firth, M., Gao, D. N., & Rui, O. M. (2005). Is China’s securities regulatory agency a toothless tiger? Evidence from enforcement actions. Journal of Accounting and Public Policy, 24(6), 451–488.

    Article  Google Scholar 

  • Chen, G., Firth, M., Gao, D. N., & Rui, O. M. (2006). Ownership structure, corporate governance, and fraud: Evidence from China. Journal of Corporate Finance, 12(3), 424–448.

    Article  Google Scholar 

  • Chen, D., Jiang, D., Liang, S., & Wang, F. (2011). Selective enforcement of regulation. China Journal of Accounting Research, 4(1), 9–27.

    Article  Google Scholar 

  • Cheng, Q., & Warfield, T. D. (2005). Equity incentives and earnings management. The Accounting Review, 80(2), 441–476.

    Article  Google Scholar 

  • Cho, S., & Rui, O. M. (2009). Exploring the effects of China’s two-tier board system and ownership structure on firm performance and earnings informativeness. Asia-Pacific Journal of Accounting & Economics, 16(1), 95–117.

    Article  Google Scholar 

  • Conyon, M. J., & He, L. (2011). Executive compensation and corporate governance in China. Journal of Corporate Finance, 17(4), 1158–1175.

    Article  Google Scholar 

  • Conyon, M. J., & He, L. (2014). Executive compensation and corporate fraud in China. Journal of Business Ethics. doi:10.1007/s10551-014-2390-6.

  • Core, J., & Guay, W. (2002). Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. Journal of Accounting Research, 40(3), 613–630.

    Article  Google Scholar 

  • Cornett, M. M., Marcus, A. J., & Tehranian, H. (2008). Corporate governance and pay-for-performance: The impact of earnings management. Journal of Financial Economics, 87(2), 357–373.

    Article  Google Scholar 

  • Cressey, D. R. (1950). The criminal violation of financial trust. American Sociological Review, 15(6), 738–743.

    Article  Google Scholar 

  • Cumming, D. J., Hou, W., & Lee, E. (2012). Impact of split share structure reform in China on CEO accountability to corporate fraud. Journal of Business Ethics. doi:10.2139/ssrn.2015287.

  • Dahya, J., Karbhari, Y., Xiao, J. Z., & Yang, M. (2003). The usefulness of the supervisory board report in China. Corporate Governance: An International Review, 11(4), 308–321.

    Article  Google Scholar 

  • Dechow, P. M., Sloan, R. G., & Sweeney, A. P. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13(1), 1–36.

    Article  Google Scholar 

  • Denis, D. J., Hanouna, P., & Sarin, A. (2006). Is there a dark side to incentive compensation? Journal of Corporate Finance, 12(3), 467–488.

    Article  Google Scholar 

  • Du, F., Tang, G., & Young, S. M. (2012). Influence activities and favoritism in subjective performance evaluation: evidence from Chinese state-owned enterprises. The Accounting Review, 87(5), 1555–1588.

    Article  Google Scholar 

  • Efendi, J., Srivastava, A., & Swanson, E. P. (2007). Why do corporate managers misstate financial statements? The role of option compensation and other factors. Journal of Financial Economics, 85(3), 667–708.

    Article  Google Scholar 

  • Erickson, M., Hanlon, M., & Maydew, E. L. (2006). Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research, 44(1), 113–143.

    Article  Google Scholar 

  • Feng, M., Ge, W., Luo, S., & Shevlin, T. (2011). Why do CFOs become involved in material accounting manipulations? Journal of Accounting and Economics, 51(1), 21–36.

    Article  Google Scholar 

  • Feroz, E. H., Park, K. J., & Pastena, V. (1991). The financial and market effects of the SEC’s accounting and auditing enforcement releases. Journal of Accounting Research, 29(Supplement), 107–142.

    Article  Google Scholar 

  • Firth, M., Fung, P. M., & Rui, O. M. (2006). Corporate performance and CEO compensation in China. Journal of Corporate Finance, 12(4), 693–714.

    Article  Google Scholar 

  • Firth, M., Fung, P. M., & Rui, O. M. (2007a). How ownership and corporate governance influence chief executive pay in China’s listed firms. Journal of Business Research, 60(7), 776–785.

    Article  Google Scholar 

  • Firth, M., Fung, P. M., & Rui, O. M. (2007b). Ownership, two-tier board structure, and the informativeness of earnings–Evidence from China. Journal of Accounting and Public Policy, 26(4), 463–496.

    Article  Google Scholar 

  • Firth, M., Rui, O. M., & Wu, W. (2011). Cooking the books: Recipes and costs of falsified financial statements in China. Journal of Corporate Finance, 17(2), 371–390.

    Article  Google Scholar 

  • Fischer, P. E., & Verrecchia, R. E. (2000). Reporting bias. The Accounting Review, 75(2), 229–245.

    Article  Google Scholar 

  • Giroud, X., & Mueller, H. M. (2010). Does corporate governance matter in competitive industries? Journal of Financial Economics, 95(3), 312–331.

    Article  Google Scholar 

  • Giroud, X., & Mueller, H. M. (2011). Corporate governance, product market competition, and equity prices. Journal of Finance, 66(2), 563–600.

    Article  Google Scholar 

  • Goldman, E., & Slezak, S. L. (2006). An equilibrium model of incentive contracts in the presence of information manipulation. Journal of Financial Economics, 80(3), 603–626.

    Article  Google Scholar 

  • Graham, J. R., Li, S., & Qiu, J. (2008). Corporate misreporting and bank loan contracting. Journal of Financial Economics, 89(1), 44–61.

    Article  Google Scholar 

  • Gul, F. A., Kim, J. B., & Qiu, A. A. (2010). Ownership concentration, foreign shareholding, audit quality, and stock price synchronicity: Evidence from China. Journal of Financial Economics, 95(3), 425–442.

    Article  Google Scholar 

  • Harris, J., & Bromiley, P. (2007). Incentives to cheat: The influence of executive compensation and firm performance on financial misrepresentation. Organization Science, 18(3), 350–367.

    Article  Google Scholar 

  • Hass, L. H., Johan, S., & Mueller, M. (2014). The effectiveness of public enforcement: Evidence from the resolution of tunneling in China. Journal of Business Ethics. doi:10.1007/s10551-014-2389-z.

  • Hou, W., Lee, E., Stathopoulos, K., & Tong, Z. (2013). Executive compensation and the split share structure reform in China. European Journal of Finance. doi:10.1080/1351847X.2013.802250.

  • Hou, W., & Moore, G. (2010). Player and referee roles held jointly: The effect of state ownership on China’s regulatory enforcement against fraud. Journal of Business Ethics, 95(2), 317–335.

    Article  Google Scholar 

  • Huang, F., & Rice, J. (2012). Firm networking and bribery in China: Assessing some potential negative consequences of firm openness. Journal of Business Ethics, 107(4), 533–545.

    Article  Google Scholar 

  • Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance, 48(3), 831–880.

    Article  Google Scholar 

  • Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3(4), 305–360.

    Article  Google Scholar 

  • Jia, C., Ding, S., Li, Y., & Wu, Z. (2009). Fraud, enforcement action, and the role of corporate governance: Evidence from China. Journal of Business Ethics, 90(4), 561–576.

    Article  Google Scholar 

  • Jiang, J. X., Petroni, K. R., & Wang, I. Y. (2010). CFOs and CEOs: Who have the most influence on earnings management? Journal of Financial Economics, 96(3), 513–526.

    Article  Google Scholar 

  • Johnson, S. A., Ryan, H. E., & Tian, Y. S. (2009). Managerial incentives and corporate fraud: the sources of incentives matter. Review of Finance, 13(1), 115–145.

    Article  Google Scholar 

  • Karamanou, I., & Vafeas, N. (2005). The association between corporate boards, audit committees, and management earnings forecasts: An empirical analysis. Journal of Accounting Research, 43(3), 453–486.

    Article  Google Scholar 

  • Karpoff, J. M., Lee, D. S., & Martin, G. S. (2008). The cost to firms of cooking the books. Journal of Financial and Quantitative Analysis, 43(3), 581–611.

    Article  Google Scholar 

  • Kim, I., & Skinner, D. J. (2012). Measuring securities litigation risk. Journal of Accounting and Economics, 53(1), 290–310.

    Article  Google Scholar 

  • Li, Y., Lou, F., Wang, J., & Yuan, H. (2013). A survey of executive compensation contracts in China’s listed companies. China Journal of Accounting Research, 6(3), 211–231.

    Article  Google Scholar 

  • Ndofor, H. A., Wesley, C., & Priem, R. L. (2013). Providing CEOs with opportunities to cheat the effects of complexity-based information asymmetries on financial reporting fraud. Journal of Management. doi: 10.1177/0149206312471395.

  • Peng, L., & Röell, A. (2008a). Executive pay and shareholder litigation. Review of Finance, 12(1), 141–184.

    Article  Google Scholar 

  • Peng, L., & Röell, A. (2008b). Manipulation and equity-based compensation. American Economic Review, 98(2), 285–290.

    Article  Google Scholar 

  • Shleifer, A., & Vishny, R. W. (1994). Politicians and firms. Quarterly Journal of Economics, 109(4), 995–1025.

    Article  Google Scholar 

  • Tian, Q. (2008). Perception of business bribery in China: The impact of moral philosophy. Journal of Business Ethics, 80(3), 437–445.

    Article  Google Scholar 

  • Trompeter, G. M., Carpenter, T. D., Desai, N., Jones, K. L., & Riley, R. A, Jr. (2012). A synthesis of fraud-related research. Auditing: A Journal of Practice & Theory, 32(1), 287–321.

    Google Scholar 

  • Xi, C. (2006). In search of an effective monitoring board model: board reforms and the political economy of corporate law in China. Connecticut Journal of International Law, 22, 1–46.

    Google Scholar 

  • Yermack, D. (1996). Higher market valuation of companies with a small board of directors. Journal of Financial Economics, 40(2), 185–211.

    Article  Google Scholar 

Download references

Acknowledgments

The authors gratefully acknowledge valuable feedback from the guest editors, Douglas Cumming, Wenxuan Hou, Edward Lee, two anonymous referees, Oliver Rui (discussant), participants at the Conference on Business Ethics in Greater China: Past, Present, and Future, and seminar participants at the Warsaw School of Economics.

Author information

Authors and Affiliations

  1. Lancaster University Management School, Lancaster University, Lancaster, LA1 4YX, UK

    Lars Helge Hass

  2. University of Exeter Business School, Streatham Campus, Rennes Drive, Exeter, EX4 4ST, UK

    Monika Tarsalewska

  3. Boler School of Business, John Carroll University, 1 John Carroll Blvd, University Heights, OH, 44118-4581, USA

    Feng Zhan

Authors
  1. Lars Helge Hass
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Monika Tarsalewska
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Feng Zhan
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Lars Helge Hass.

Appendix

Appendix

See Table 8.

Table 8 Variable definitions
Full size table

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Hass, L.H., Tarsalewska, M. & Zhan, F. Equity Incentives and Corporate Fraud in China. J Bus Ethics 138, 723–742 (2016). https://doi.org/10.1007/s10551-015-2774-2

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10551-015-2774-2

Keywords

Search

Navigation