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We use BOS as a surrogate for audit committee and examine the effectiveness of BOS in monitoring the company directors and management. Similar to the investigation on the BOD, members of the BOS are divided into two groups with one group of supervisors receiving remuneration from the firm and the other group without remuneration from the firm. Supervisors who do not receive remuneration are seen to be more capable of resisting the fraudulent behaviour of the directors and management. However, in practice, according to Lin (2001), there is hardly any evidence of BOS performing substantive oversight functions; instead, members of BOS are often captured: they become part of the group of insiders and identify with their interests. As it is unclear as to the effectiveness of BOS on corporate governance, a null hypothesis is formulated.
Hypothesis 6: There is no relation between the proportion of supervisors without remuneration from the firm and the likelihood of corporate fraud in Chinese listed firms.
Debt Provider
Debt providers are an external governance mechanism acting as a monitoring device on the actions of management. Debt contracts normally include a number of debt constraints and leverage covenants (such as, debt to asset ratio, interest coverage, etc.) for management to abide by. Debt providers have inherent incentives to monitor management in accordance with the contracts. On the part of management, the existence of debt contracts (constraints) gives management incentives to manipulate financial results, especially in situations where the debt constraints are approaching violation of the contracts. Empirical evidence shows that managers would manipulate accounting accruals in the year before and the year after violation of the debt contract (DeFond and Jiambalvo, 1994) and engage in income-increasing strategies as a firm approaches violation of the contract (Sweeney, 1994). Therefore, it is reasonable to assume that there is a relation between leverage covenants and the likelihood of financial statement fraud.
In China, companies obtain loans from state banks and state-owned non-bank financial institutions as their main source of external financing for there do not exist private banks. China’s banking system, although considerably reformed in a number of respects, is still not a real commercial banking system and nor does it constitute an efficient debt market. As a result, the debt market is weak in monitoring firms and disciplining managers. On the other hand, the lending process would be subject to the checks and procedures and meets the set lending criteria. Debt contracts would need to be signed and debt restrictions to be abided by. Borrowers, especially for listed firms whose shares are partially owned by private investors, would need to demonstrate a sound financial position and acceptable performance. As a consequence, management would have incentives to manipulate financial results to avoid violation of debt constraints. However, as the joint effect of the state-owned banking system and the commercial lending operation on the relation between the level of leverage and financial statement fraud is unclear, a null hypothesis is formulated.
Hypothesis 7: There is no relation between the level of leverage and the likelihood of corporate fraud in Chinese listed firms.
Managerial Remuneration
Agency theory suggests that there is a necessity to tie management remuneration, at least in part, to the performance of the firm in order to mitigate the agency problem and to reduce the potential agency costs (Jensen and Meckling, 1976). In practice, management bonus plans tied to the performance of the firm are often used to align the interests of the owners and the managers. As management bonus plans are commonly drawn based on performance measures derived from the accounting system (e.g., profit, return on assets, etc.), there exists a possibility that managers may be induced to manipulate the related accounting numbers to improve their performance and their related rewards. Numerous prior studies have documented this opportunistic behaviour of managers, e.g., manipulation of earnings (see, for example, Healey, 1985; Holthausen et al., 1995). This opportunistic behaviour of management clearly indicates a relation between managerial remuneration and the likelihood of management committing financial statement fraud. While higher managerial remuneration leads to better performance (Murphy, 1985), a negative correlation between managerial remuneration and fraud is a more likely scenario.
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