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In the case of China, the regulations pertinent to the practice of independent directors were not issued until August 2001. Prior to that date most listed firms did not have independent directors on the board. As the study uses data prior to that date and following Daily et al.’s (1999) advice, this study avoids using the proportion of outside directors to measure the board composition in the Chinese context. Instead, the board directors are divided into two groups with one group of directors receiving financial income from the firm and the other group not receiving income from the firm. Directors who are in receipt of income from the firm may be less likely to resist the fraudulent behaviour of management. On the other hand, a board that comprises a greater proportion of directors who do not receive income from the firm is deemed to be stronger in monitoring the management. The proportion of directors without remuneration from the firm is used as a surrogate for measuring the independence of BOD, which is a variable examined in other studies, for example, Beasley (1996) and Sharma (2001). As this study is of an exploratory nature, the following hypothesis is stated in a null form.
Hypothesis 4: There is no relation between the proportion of the board directors without remuneration from the firm and the likelihood of corporate fraud in Chinese listed firms.
Board leadership structure (CEO/chair positions held jointly or separately) is another important governance mechanism. It is argued that the separate leadership structure leads to a more independent and effective board. The Cadbury Code of Best Practice recommends, “there should be a clearly accepted division of responsibilities at the head of the company, which will ensure a balance of power and authority, such that no individual has unfettered powers of decision” (Cadbury Report, 1992, p. 42). The role of the board chair is to run board meetings and oversee the process of hiring, firing, evaluating, and compensating the CEO. Clearly the CEO cannot perform this role independently of his or her personal interest. Without an independent chair, it is much difficult for the board to conduct its critical functions. Agency theory therefore suggests that the chair/CEO duality reduces the monitoring effectiveness of the board over management, and supports separation of the chair and CEO roles.
However, empirical research in the West regarding the effect of separating the chair and CEO on corporate governance has produced inconclusive results. While Kesner and Johnson (1990) and Rechner and Dalton (1991) find that the separation of the two roles leads to better company performance, studies by Daily and Dalton (1997), Dalton et al. (1998) and Coles et al. (2001) find no effect of this factor on performance. According to Sharma (2004), the chair/CEO duality increases the likelihood of fraud. In a Chinese context, Tian and Lau’s (2001) study shows that the better-performing companies tend to have a CEO-chairman leader. As whether and how the chair/CEO duality would affect the occurrence of fraud in Chinese firms is unclear, a null hypothesis is formulated.
Hypothesis 5: Whether or not the chair of the board is also the CEO of the firm has no relation to the likelihood of fraud in Chinese listed firms.
Audit Committee is a sub-committee of BOD and is responsible for overseeing the financial reporting process and ensuring the objectivity of the external audit. The Cadbury Committee Report on corporate governance (1992) asserts that audit committee can play an effective role in monitoring management actions. Empirical studies have confirmed the usefulness of audit committee in reducing the likelihood of financial statement fraud (e.g., Abbott et al., 2000; McMullen, 1996).
In the Chinese context, companies do not have audit committee; instead, there is a special committee in the governance system, namely, the Board of Supervisors (BOS). The Company Law stipulates that JSCs must have a BOS consisting of shareholder and employee representatives. The primary duties of BOS, which is placed at the same level as BOD, are to perform oversight functions over the BOD and senior management to ensure their compliance with legal requirements, firm’s policies and procedures and to review the company's financial matters (CSRC, 2003, articles 54 and 126).
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