The political effects on corporate financial fraud: Evidence from China

Abstract

Why does corporate financial fraud in China remain prevalent after the aggressive anti-corruption campaign that began in 2012? To explore this phenomenon, this study examines how the political factors embedded in China’s Regionally Decentralized Authoritarian system affect the commission and detection of financial fraud. Synthesizing the political mechanisms behind regulators’ selective enforcement behavior and managers’ financial fraud activity, I demonstrate that four critical political factors--provincial officials’ factional affiliation and retirement, social unrest, and an industry’s national prominence--affect fraud commission and fraud detection in opposing directions. I employ a bivariate probit model to separately test the political effects on fraud commission and fraud detection. The findings show that regulators reduce enforcement while managers commit more fraud when provincial leaders have a factional affiliation with the national president. On the contrary, regulators strengthen enforcement, and managers commit less fraud when provincial leaders are close to retiring, local social unrest becomes intense, and when firms are in state-supported industries. This study contributes to understanding the political drivers of corruption by offering a framework that combines the mechanisms behind regulators’ enforcement behavior and managers’ misconduct. It also extends the knowledge of the government’s influence on managerial behavior, facilitates the application of the bivariate probit approach in management studies, and provides practical insights for policymakers, investors, and due diligence-based equity research firms in combating financial fraud.