AN EXAMINATION OF OWNERSHIP STRUCTURE, THE NATURE OF FINANCIAL STATEMENT FRAUD, AND AUDIT EFFECTIVENESS: EVIDENCE FROM CHINA

Abstract

This paper examines two types of financial statement fraud (i.e., earnings manipulation fraud and tunneling fraud) and their association with ownership structure and audit effectiveness using a sample of Chinese listed companies. We find that more concentrated ownership tends to induce tunneling fraud and more dispersed ownership tends to induce earnings manipulation fraud. Controlling shareholders tend to over-reach minority shareholders when they become more powerful, but at the same time, they tend to curb earnings manipulation fraud. The second largest shareholder is able to curb earnings manipulation fraud by monitoring management. However, we do not find evidence that they are able to monitor the controlling shareholder and curb tunneling fraud. We also find that although Chinese auditors are generally effective in detecting earnings manipulation fraud, they are not so effective in detecting tunneling fraud. Moreover, Big-4 audit firms are not significantly different from non-Big-4 firms in terms of detecting financial statement fraud. These findings should further our understanding of the role of incentives and opportunities in financial statement fraud.