The Determinants Of Financial Fraud And The Selection Of Signaling Strategy Among U.S.-listed Chinese Companies

Financial scandal involving more than one third of the U.S.-listed Chinese companies up to February,2012has attracted extensive attention around the world. In this scandal, not only fraudulent firms but also firms that have not been accused of wrongdoing experienced similar steep stock price decline. Apparently, investors have thrown out the baby with the bathwater. The first purpose of this paper is to find whether there are some factors that could help regulators and investors to detect the likelihood of financial fraud among Chinese cross-listed firms. The other purpose is to test whether non-fraudulent firms could, after the outbreak of the scandal, differentiate themselves from fraudulent firms via signaling.Based on a sample of262U.S.-listed Chinese companies, this paper first provides an empirical study of the determinants of financial fraud among overseas listing companies. I examine the role of not only familiar fraud detection variables such as financial ratios, corporate governance, and the reputation of financial intermediaries, but also several novel variables, including mode of listing, home-country social trust, and CEO’s political connection. The result shows that companies that gain listing via reverse mergers are more likely to commit financial fraud; and the possibility of fraud among these firms is higher when the corporate governance is poor or when the auditor is less-prestigious. Also, companies that are headquartered in provinces with lower social trust and that have politically connected CEOs are associated with higher probability of committing fraud.In addition, this paper investigates signals sent by U.S.-listed Chinese companies after the outbreak of the scandal and their short-term market reactions. The results show that non-fraudulent firms could indeed differentiate themselves from fraudulent firms by sending costly signals such as insiders purchasing shares, increasing dividends, and going private.These findings not only contribute to the studies in the fields of cross-listing, financial fraud, and signaling, but are also of practical use. First, investors could use fraud detection factors tested in this paper to identify fraudulent Chinese companies, and thus lower investment risk; Second, Chinese regulators could also use these factors to detect pre-listing companies with high risk of committing fraud, so as to avoid low-quality firms from going public in foreign markets and restore the reputation of Chinese companies in the international community; Third, companies intending to list in foreign markets could also learn from this paper the importance of choosing proper listing method and hiring prestigious financial intermediaries. Besides, the study of signaling strategy in this paper also provides some practical guidance for cross-listed companies that need to reverse the sharp stock price decline during the crisis.