Who cooks the books in China, and does it pay? Evidence from private, high‐technology firms
| DOI | http://doi.org/10.1002/smj.2466 |
| Date | 01 December 2016 |
| Author | Yanbo Wang,Toby Stuart |
| Published date | 01 December 2016 |
Strategic Management Journal
Strat. Mgmt. J.,37: 2658–2676 (2016)
Published online EarlyView 12 January 2016 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2466
Received 4 February 2014;Finalrevision received 10 May 2015
WHO COOKS THE BOOKS IN CHINA, AND DOES IT
PAY? EVIDENCE FROM PRIVATE, HIGH-TECHNOLOGY
FIRMS
TOBY STUART1and YANBO WANG2*
1Hass School of Business, UC, Berkeley, Berkeley, California, U.S.A.
2Cheung Kong Graduate School of Business (CKGSB), Beijing, China
Research summary: We document the extent of fraudulentreporting among 467 private Chinese
technology companies. Comparing the nancial statements concurrentlysubmitted to two different
state agencies, we demonstrate a systematic gap in reported prot gures in the two sets
of books. We nd: (1) more than half the sampled companies report incentive-compatible,
materially discrepant prot numbers to the two agencies;(2) politically connected companies are
approximately 18percent more likely to commit fraud and those with venture capital backing are
19 percentmore likely to do so; and (3) it pays to cheat. We estimate that companies who “cook”
their books have considerably higher odds of receiving an innovation grant. Especially given
its prevalence, we conclude that fraud can be a source of performance differential for emerging
market companies.
Managerial summary: We document that more than half of a sample of 467 private, Chinese
technology companies engage in fraudulent nancial reporting. By comparing the nancial
statements companies concurrently submitted to two different state agencies, we demonstrate a
systematic gap in reported protgures in the two sets of books. Relative to the companies without
these attributes, we nd that politically connected companies are approximately 18percent more
likely to commit fraud and those with venture capital backing are19 percent more likely to do so.
Furthermore, we show that it pays to cheat. We estimate that companies who “cook” their books
have considerably higher odds of receiving a government-sponsored innovation grant.Therefore,
fraud can be a source of performance differential for emerging market companies. Copyright ©
2015 John Wiley & Sons, Ltd.
INTRODUCTION
A burgeoning literature nds that connections to
government ofcials convey advantages to com-
panies. The link between political connections and
corporate performance exists in industrialized coun-
tries (e.g., Hillman, Zardkoohi, and Bierman, 1999;
Keywords: nancial fraud; political connection; venture
capital; emerging market economies
*Correspondence to: Yanbo Wang. Cheung Kong Graduate
School of Business, 1 East Chang An Avenue, Beijing, China
100006. E-mail: yanbo.wang@ckgsb.edu.cn
JEL Classications: H25, K33, K42, M48 and P16.
Copyright © 2015 John Wiley & Sons, Ltd.
Schuler, Rehbein and Cramer, 2002; Lester et al.,
2008), but it is especially pronounced in emerging
economies (Li and Zhang, 2007; Malesky and
Taussig, 2009; Peng and Luo, 2000; Siegel, 2007).
One regrettable channel through which political
connections may contribute to corporate perfor-
mance is to facilitate prot-enhancing fraud. This
occurs because high-level ties to the state may
deect regulatory scrutiny from dubious forms
of corporate conduct. Even in business environ-
ments characterized by strong market-supporting
institutions such as the United States, evidence
suggests that law enforcement is not universally
applied in instances of suspected fraud, which
Who Cooks the Books in China, and Does It Pay? 2659
creates asymmetric payoffs for rms to engage
in fraudulent conduct (Correia, 2009; Fulmer and
Knill, 2012; Yu and Yu, 2011).
In this article, we ask a set of related ques-
tions: How prevalent is fraud among private,
technology-based companies in China? Do polit-
ical connections and other entrepreneur- and
rm-level characteristics correlate with fraudulent
conduct in this sector of the Chinese economy?
Under what conditions is fraud rewarded?
We emphasize three ndings. First, we quantify
the effect of political connections on the extent
of fraud and the ability of rms to access state
resources. We present a clear illustration of how
political ties translate to a rm-level nancial
advantage because they enable rms to gain priv-
ileged access to scarce, state-allocated resources.
Second, we demonstrate a link between com-
pany ownership structure and the propensity to
commit fraud. Specically, we (unexpectedly)
nd that venture capital-backed companies are
more likely to perpetrate fraud and to benet
from government-dispensed resources. Finally, we
demonstrate the base rate of fraud in an as-yet
unexamined segment of the Chinese economy:
the vast sector of young, private, entrepreneurial
companies.
On the latter point, a sizable literature examines
cases of large, public company fraud. In conse-
quence of their economic scale, the actions of these
organizations affect many thousands of employees,
investors,suppliers, and customers. Therefore, large
companies are subject to a more focused regula-
tory lens. But because media and regulatory atten-
tion concentrates on large companies, we know
much less about the incidence of fraud at small,
private companies. We believe that understanding
this population is vital. First, in emerging mar-
kets, private rms are primary catalysts of economic
growth (McMillan and Woodruff, 2002).1Second,
major decisions in young companies set in motion
path-dependent dynamics in which organizational
practices and values are transmitted from one group
1For instance, in China between 1998 and 2010, industrial output
by large-rm-dominated state-owned enterprises increased from
2.22 to 6.67 trillion RMB. This compares to an astonishing
increase from 0.32 to 25.23 trillion RMB for the private-company
sector, which is dominated by small- and medium-sized rms
(National Bureau of Statistics, 1998, 2010). The exchange rate
between the Chinese RMB and the U.S. dollar was 0.121 (1 U.S.
dollar =8.27 RMB yuan) in 1998, and appreciated to 0.148 (1 U.S.
dollar =6.77 RMB yuan) in 2010.
of employees to the next (Baron, Burton, and Han-
nan, 1999; Harrison and Carroll, 2006). Identifying
the precursors of fraud in early-stage companies is
likely to illuminate the set of companies in which
unethical behaviors become cultural inheritances.
This article uses a unique approach to iden-
tify cases of fraud among entrepreneurial rms in
China. Our analysis does not rely on the actions
of regulatory agencies; rather, we directly observe
instances of nancial data manipulation by collect-
ing and comparing two sets of nancial books that
are required to be identical under Chinese law. We
consider incentive-compatible, discrepant reporting
across the two sets of books to be evidence of nan-
cial fraud.
One set of books comes from corporate appli-
cations for a state-funded innovation grant. To
apply for this grant applicants must submit
audited nancial statements to China’s Ministry
of Science and Technology (MOST). The MOST
decision-makers exhibit a publicly stated preference
for strong-performing companies, which creates
an incentive for applicants to exaggerate prot
levels and to over-state technical achievements. We
study companies that applied for the MOST grants
because, for the same set of companies at the same
points in time, we were able to retrieve a second set
of nancial statements. These statements, which
were required of all companies in China, were
submitted to the local State Administration of
Industry and Commerce (SAIC). The SAIC is one
of China’s primary regulatory bodies with broad
jurisdiction. Although not directly responsible for
detecting tax evasion, the SAIC does coordinate
with taxation agencies in investigating so-called
“irregular behaviors” (Tian, 2012).
Chinese law clearly states that companies must
submit the same nancial information in these two
sets of books, but many rms may benet from
misrepresenting the numbers. In the typical case in
our data, companies appear to fall within a range of
nancial performance in which they have incentive
to overstate their protability to the MOST, and
possibly to understate it to the SAIC. To be up front
about one limitation of the data: We neverknow the
true numbers for the rms in our sample; we simply
know whether these companies illegally report dis-
crepant results across their two sets of books. As we
show, however, in all but a handful of cases, report-
ing discrepancies are incentive-compatible: Finan-
cial performance is almost always stronger in the
MOST books, relative to that disclosed to the SAIC.
Copyright © 2015 John Wiley & Sons, Ltd. Strat. Mgmt. J.,37: 2658–2676 (2016)
DOI: 10.1002/smj
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