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Using a sample of 137 financial fraud companies that were subject to CSRC enforcement action and a matched sample of control firms that were not subject to such action in year 2002 through 2004, this paper employ logistic regression model to empirically tests the effects of manager compensation and market competition on the likelihood of listed companies financial fraud in China. The main findings are as follows: first, the relationship between manager market competition and the probability of firm financial fraud is negative, which means that competitive manager market can help to prevent corporate financial fraud. Second, though manager compensation is negatively related to the probability of financial fraud, it is not statistically significant when we consider manager market competition. These results suggest that underdeveloped manager market can't discipline Chinese top managers efficiently. Hence the mechanisms of reputation and efficiency-wages, which tend to reduce the incidence of fraud, do not function properly in China. They do not provide an incentive for managers to prevent fraud in the firms. Introduction In recent years, the many financial frauds about prominent companies such as Enron, HealthSouth, Tyco and Worldcom have shaken the investors' confidence on stock market and bring substantial losses to investors. Investors' worrying about accounting problems may be the main reason for the stock market slump that followed these financial frauds. In China, the frequency of listed companies' financial fraud is higher than that in U.S. and almost all virtual headers of listed companies' significant financial fraud cases are top managers. China's weak corporate governance and moral hazard of top managers may be the leading reasons for those widespread failures in financial report fraud. Some wide-ranging legislative and regulatory changes relating to corporate governance are issued or proposed in response to the appeal for faithful disclosure. China securities Regulatory Commission (CSRC) is set up to take charge of enforcing securities laws, investigate allegations of corporate and securities frauds, and make enforcement actions when frauds and malpractices are proved. Boards of directors (BOD) are required to have outside directors although, only recently, have they been required to be independent. CSRC issue statement 102 'Guidelines for establishing an independent directors System for listed companies' in August 2001 and it stipulate that by June 2003, one-third of the directors should be independent and non-executive. And at least one independent director with a background in finance or accounting is demanded in independent directors. Appointment committees, compensation committees, and other committees are now becoming common in Chinese listed firms. The governance of listed firms above, in many respects, practices after the patterns of companies in U.K. and U.S. Although western corporate governance practices are seemingly widespread adopted, the poor effectiveness is proved by more and more financial frauds. What are the differences between determinants of financial frauds between China and developed countries, such as U.S.? China is a transition economy country, and its market economy environment, such as labors market, is quite different from that of developed countries. As we know, market competition has an important effect on corporate performance and managers' behavior. We thus deduce that manager market in China is a crucial factor that affected the likelihood of corporate financial fraud and the effect of manager compensation. The purpose of this paper is to empirically investigate the relationship between manager market competition, manager compensation and the likelihood of a company financial fraud. To our knowledge, our paper is the first empirical study to analyze the relationship between manager market competition, manager compensation, and the incidence of financial fraud in China. …
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