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In the Chinese context, the way the top management is remunerated is unique and differs significantly from the West. The top management of most listed firms are either appointed by government or have government background and they are mainly representing the state’s dominant shareholdings in the firms. There still does not exist a managerial labour market where the demand for and supply of managers would work out proper remunerations for managers. Furthermore, according to Lin (2001), there appears to be little or no correlation between the money incomes of management and firm performance, and between management incomes and firm size. Unlike in the West, managerial bonus schemes based on performance measures are not existent in China. Consequently, how the unique way of remunerating management in China affects managerial decision-making and, in particular, the likelihood of management committing fraud is unclear. A null hypothesis is formulated.
Hypothesis 8: There is no relation between the level of managerial remuneration and the likelihood of corporate fraud in Chinese listed firms.
5. Sample Selection and Research Design
This study uses a sample of 78 Chinese firms that are listed on Shanghai and Shenzhen Stock Exchanges. Half (39) of the firms represent the “fraud firms” because each of these firms had at least one occurrence of financial statement fraud publicly reported during the period 1997–2002. Each of the fraud firms is matched with a no-fraud firm, creating a choice-based sample of 39 fraud and 39 no-fraud firms.
Selection of Fraud Firms
The concept of corporate fraud used in this study is narrowly defined to be management perpetrated fraud that has financial statement effects, or financial statement fraud. In other words, it refers to the fraudulent action of management that has a material effect on firm’s financial results and has attracted actions of regulators. It may include misappropriation of assets by management, falsification of financial records, misrepresentation of firm’s financial condition, and other forms of dishonest actions that have adverse financial ramifications for stakeholders. This definition is consistent with the ones used by prior studies in similar context (e.g., Beasley, 1996; Sharma, 2004).
The CSRC (similar to SEC in the United States) that oversees the stock market in China has the authority to prosecute any listed firms that breach the laws and violate the regulations and rules. Firms that are detected to have committed any kind of fraud and the outcome of the disciplinary action are reported in the CSRC News Release. For this study the sample of fraud firms are identified in the News Release on the CSRC database. As the firms that are identified by the CSRC to have committed fraud are required to disclose the fraud in their annual report, the sample of fraud firms is confirmed in the annual reports. Hence, the data on fraud firms was collected from two sources, the CSRC News Release and annual reports.
An initial sample of 92 firms that committed fraud at least once was identified. However, due to unavailability of the required information, or the types of fraud not investigated in this study, the final example consists of 39 fraud firms.8 The fraud sample selection procedure is described in Table 1. The 39 fraud firms are dispersed across 24 industries but mostly in manufacturing industries, which are heavily represented in the Chinese market. The top four industries represented in the sample are pharmaceutic (5 firms), metal (3 firms), retail (3 firms) and tourism (3 firms).
(Insert Table 1 here)
Selection of No-Fraud Firms
To create a comparison group, no-fraud firms were identified that were similar to the fraud firms in size, industry and the reporting period. Taking Seamer and Psaros’ (2000) advice, the no-fraud sample was matched with the fraud firms on size because this variable could affect the size and composition of the board of directors and the firm’s susceptibility to fraud. Firms were considered similar in size if the value of total assets was within 20 percent of those of the fraud firm (Beasley, 1996 and Sharma, 2004 both used 30 percent). Industry was the second factor considered when no-fraud sample was selected. To minimise the industry effect, no-fraud firms were selected from the same industries as the fraud ones. The two groups of firms must be in the same period of time to make the comparison more reliable. Efforts were also made to ensure that the selected no-fraud firms were not reported for other types of fraud. The mean (median) total assets of the fraud and no-fraud firms were compared using a paired t-test and no significant differences were detected, indicating the fraud and no-fraud firms were similar in size.
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