Abstract: This paper documents the extent of fraudulent reporting in a sample of 148 Chinese SMEs. We compare the financial statements of companies that simultaneously apply for grants from the Chinese Ministry of Science and Technology (MOST) and that file statements with the local Bureau of Industry and Commerce (BIC), which is a municipal authority. MOST grants, for which the submission of audited financial statements is a requirement, are similar to Small Business Innovation Research (SBIR) awards in the US. We document a systematic gap in profitability in the two sets of financial statements. We find: (i) only 25% of the companies in the sample report the same level of profitability across the two sets of books; the remaining 75% of companies misrepresent their profitability, most likely by over-reporting their profits in their MOST grant applications; (ii) there is strong evidence of an insider effect in fraudulent reporting: companies led by individuals with close ties to the government are far more likely to commit fraud, and (iii) it pays to cheat; net of ties to the government, we estimate that companies which file discrepant books because they (most likely) exaggerate their profitability in the MOST grant applications have at least 50% higher odds of being awarded a MOST grant. Presented by: Assistant Professor Yanbo Wang at Boston University School of Management’s 2nd Annual Faculty Research Day held on May 14, 2012.

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