Financial Fraud And Regulation Of Listed Companies

Since the 21st century, Chinese stock market prices have been falling. By the middle of the year 2005, Chinese securities markets had dropped below the Shanghai Stock Exchange (SSE) historical height of 2245 points for 4 years, and the drop was as great as 55%. Securities market investments have completely lost the"fortune effect". In 2001, the market value of circulation on stock market was 1.7 trillion yuan. Currently, it drops to 1.4 trillion yuan. Deducting financing factors like newly listed stocks, it dwindles by 800 billion yuan. Apparently, stock markets can no longer bear due returns to the investors.By contrast, China's GDP has been growing year by year, (China's GDP rose to the world's No.6 in 2004), its macroeconomic strength has been building up. If the stock markets are the weatherglass of a country, there are apparent defects in the Chinese stock market system. It is well known that equity division reform has been carried out on the Chinese stock markets like a raging fire since 2005. Though equity division reform is important, the key to the problem should be to restore the pricing function of the stock market. Stock markets need transparent and public information disclosure system and corresponding rigid government supervision. According to the research of LLSV and othersâ‘¡, it is the strengthening of the investor protection, especially the reinforcement of the external regulation of the listed companies, that is crucial to the stability and development of securities markets.Stock market is the place where the internal values of the listed companies are rationally priced, thus resources are effectively allocated. The dispersive pricing mechanism relies heavily upon the related value information disclosed by the listed companies, and demands that the information disclosed be true and fair. Among the information disclosed, financial reports are the core. Therefore, throngs of participants from various countries carry out keen competition over the rights of discourse of the financial information. As the LLSV research series indicate: as long as there are space or opportunities of gains through frauds like financial frauds, insider trading etc, executives, voting stock holders and ultimate controllers will lose the incentive to engage in proper management, thus securities frauds which jeopardize the fundamental interests of medium and small share holders will often occur.Among all the securities frauds, false statements mainly based on financialfrauds make the strongest impact on the market. According to Chinese financial corruption researchers Xie Ping and Lu Lei, hidden illegal cases of the listed companies far exceed disclosed or punished ones, which means that countless listed companies that have carried out or are carrying out frauds are like the greater part of an iceberg --- hidden under the water. This article holds that it is imperative to apply radical reforms to the stock markets, including reinforce the supervision, especially over the management and information disclosure of the listed companies, taking every necessary measure like government's active regulation and civil action; to establish a completely just, public and fair market, so that investors'interests will be effectively protected. The research focus of this article is the financial frauds of the listed companies. The seven parts in this article are listed as follows: Chapter I. Introduction. This chapter explains the background and incentive of my choosing the topic; the research methods; relating concepts like the differentiation, analysis and identification of financial frauds, financial malpractices, earnings management; the research flow chart and the arrangement of the contents. Chapter II. Discussion on why investors need protection and the intrinsic logical connection between the investor protection and financial frauds. The author maintains that the key to the investor protection lies in the prevention of financial frauds of the information disclosure of the listed company, rather than other perspectives like prevention of insider trading and stock price manipulation. Chapter III Based on the principals of Economics of Information, this chapter expounds on the function of financial information on the investors'decision-making in the capital markets. Then, from the perspective of dynamic game of incomplete information, it goes on to research the formative mechanism of financial frauds in the capital markets and the effectiveness of signal function of accounting information. Finally, through the analysis of dynamic game deduction results, it expound on the reason why external regulation is needed against the financial frauds of the listed companies. Chapter IV Demonstrate the necessity of legal regulation over the stock markets, with reference to the Theory of Incompleteness of Law (Pistor, Xu Chenggang, 2002) and Public Constrain Theory(Shleifer,2004). Concerning the financial frauds in the share offers and exchanges on the stock markets, this chapter elaborates on severalsocial control and problem solving strategies introduced by the above-mentioned theories, which include four strategies: market competition mechanism, government supervision, legal litigation and state ownership. Chapter V Discuss the selection of effective approaches of investor protection and legal supervision. Firstly, it introduced different countries'experiences and lessons in this respect; secondly, it emphasizes the features of accounting rules and their functions and limitations in the prevention of financial frauds, the direction of their future consummation, the investor protection functions and feasibilities of supervising measures such as active law enforcement and information disclosure; finally, from the perspective of improving legislation and government regulation, it discusses the specific legal process against financial frauds such as legal liability, shift of burden of proof, corporate government etc. Chapter VI Summarize the main research results of this article, indicate the limitations of the research and future research directions. Appendix is the empirical research section. This article insists that it is imperative to establish a mechanism to detect financial frauds, because it is very important to discover the omens of financial frauds as far as active regulation is concerned. It also discusses the establishment of earl-warning mechanism against financial frauds from the perspective of financial index of the listed companies. Firstly, it carries out case studies and experience analysis over the listed companies that were identified as having financial frauds by the China Securities Regulatory Commission during 1996-2005 in order to find out financial indexes that can be used in the empirical research; secondly, it carries out the empirical analysis and make statistical in section to find out whether there is salient correlation between listed companies and financial fraud indexes. This article probes into the sphere of financial frauds. The major research results and discovery are as follows: 1. Based on the Economics of Information and analysis in the light of Game Theory, this article reaches a preliminary conclusion: under the conditions of information asymmetry, relative low bargaining power of investors and low costs of financial frauds, financial frauds are inevitable. Thus financial information's signal function as indicator of excellent or poor performance will be weakened. What is worse, it could even become a tool of frauds and play a negative role. Up to now,China's securities markets are in such a situation: distorted accounting information of listed companies often occurs due to financial frauds. Therefore, it is imperative to have rigid external regulation against financial frauds, especially the kind of legal regulation that all participants can reasonably anticipate on the basis of law. 2. Based on the Theory of Incompleteness of Law and Public Constraint Theory, this article further explains the necessity of active regulation against financial frauds. It goes on to point out that market autonomy, legal intervention, government regulation and intervention, and possible complete state take-over reflect the different system choices of the society against financial frauds in the course of securities offering under specific social and historical circumstances. Indispensable to the course of systematic transition (compulsory transitions like governmental administrative regulation, or inductive transitions) is the practical circumstances of a country or region, especially the scales of the securities markets and the level of specialization. Divorced from the social and historical circumstances, it is impractical to graft in or introduce by force an administrative system. Currently, China's governmental supervising departments particularly need to strengthen system construction and intensify active law enforcement, so that it can play a leading role in the special field against financial frauds. 3. In the light of SOX Act of the US and the anti-fraud reform guideline of the International Organization of Securities Commissions (IOSCO), this article insists that to prevent financial frauds, it is imperative to strengthen the authorities'active regulation (mainly through effective law enforcement), improve the related legislation, accounting rules and information disclosure system. As far as accounting is concerned, to carry out the accounting regulation against financial frauds, the first measure to take is to allocate the surplus legislation and law enforcement among different government institutions, especially rational allocation of accounting administration and regulation between the Ministry of Finance and the China Securities Regulatory Commission; secondly, as far as standardized accounting is concerned, it is imperative to solve the problem of how to rationally, promptly and pertinently establish accounting guidelines and systems; as far as legislation is concerned, on the basis of stepping up the administrative, criminal and civil liabilities against financial frauds, it is imperative to reinforce the civil action legislation and law enforcement among the choices of litigations against financial frauds, the corporate government prevalentaboard can be China's major litigation methods in the securities markets. Though the current Chinese law about securities concerning false statement has partially adopts inverse onus probandi system, the author maintains that precautions must be taken in applying the shift of burden of proof in financial frauds. In view of the harmfulness of the financial frauds, the author recommends a civil action mechanism with corporate government as the mainstay, and derivative government as supplement in order to effectively protect the very interest of the investors. 4. Based on the China Securities Regulatory Commission's public penalty announcement against listed companies with false information disclosure or serious misleading statement over the years, this article derives 22 financial indexes from both horizontal dimension analysis (comparison with the average level of the same trade) and vertical dimension analysis (comparison with the previous year performance of the same enterprise). After the Regression Analyses of LMP modal and logit modal, 6 financial indexes are statistically significant, which can be adopted as early warning indexes. The indexes include: period expense-industry index, gross profit index, depreciation-industry index, non-recurring profit and loss index, current profit and loss-industry index, accounts receivable-trade index. As far as differentiation effect is concerned, logit modal is superior to LMP model.