Abstract
The primary objective of this paper is to examine the associations among managerial ability, political connections and enforcement actions for financial reporting misrepresentation (hereafter financial reporting fraud) in China. Using a sample of listed firms in China during 2007–2012, we first find that increased managerial ability leads to less financial reporting fraud. Second, political connections of firms can weaken or limit the effect of managerial ability on the likelihood of financial statement fraud. Further analyses indicate that the results are primarily driven by non-state-owned firms, rather than state-owned firms. Finally, we further find that firms with capable managers face less severe penalties by the regulatory agencies relative to those without capable managers.
1. Introduction
China is the largest transitional economy, and plays an increasingly critical role in the global economy.1 However, because of high-level political corruption and lax legal enforcement in China (Allen et al., 2005; La Porta et al., 2008), the incidence of financial and accounting scandals has increased dramatically over the past two decades. The resulting decline in investor confidence in the capital market and firm financial reporting has received increasing attention from academics, practitioners and regulators. In this paper, we explore two potentially crucial determinants of financial statement fraud in China: managerial ability and political connections. More specifically, we first examine the relation between managerial ability and the likelihood of fraudulent financial reporting. Next, because political connections play a major role in business activities in China, we further examine whether the association between managerial ability and fraud probability varies systematically across the degree of managerial political ties.
6. Conclusions
Despite China’s weak legal and institutional environment, it has become the second largest economy in the world. The primary objective of this paper is to examine whether there are associations among managerial ability, political connections and financial reporting fraud in China.
Using a sample of listed firms in China during 2007–2012, we find that increased managerial ability results in less financial reporting fraud even in a relationship-based economy like China. Second, we find that the effect of managerial ability in reducing fraudulent financial reporting is stronger for non-connected firms than for connected firms.
