In this study, we examine the association between tournament incentives and financial restatements in China. Prior research documents that tournament incentives have a positive impact on firm performance. However, an alternative view suggests that tournament incentives can also have detrimental effects on firm performance. Using a sample of Chinese listed companies for the years 2008–2015, we find that tournament incentives, in the form of large pay disparities, reduce the occurrence of both core and non-core financial restatements. This negative association is more pronounced for SOEs as compared to non-SOEs. We further document that the negative association between tournament incentives and financial restatements is related to CEO turnover, and is stronger if the successor CEO is recruited from within the organization. This research contributes to a better understanding of tournament incentives, as a corporate governance mechanism, in constraining the occurrence of financial restatements in a unique institutional setting where state ownership is pronounced.
This paper examines the impact of tournament incentives on the occurrence of financial restatements in China. The separation of ownership and control gives rise to information asymmetries that managers may use to exploit outside individual shareholders (Berle & Means, 1991; Jensen & Meckling, 1976). To minimize such sub-optimal managerial actions, researchers have identified a number of pure market forces, such as product market competition (Alchian, 1950; Stigler, 1958), the market for corporate control (Manne, 1965), and labor market pressure (Fama, 1980). However, despite these market controls, there remains residual demand for additional governance measures, such as well-designed managerial compensation schemes: an explicit form of compensation. A substantial body of academic research has investigated the association between this form of compensation and firm performance in various countries (Aggarwal & Samwick, 2006; Baker, Jensen, & Murphy, 1988; Cheng & Firth, 2006; Conyon & He, 2011; Jensen & Murphy, 1990; Kaplan, 1994; Kato & Long, 2006; Mengistae & Colin Xu, 2004; Tang & Sun, 2014; Xin & Tan, 2009). However, an implicit compensation scheme in the form of rank-order tournaments also exists (Lazear & Rosen, 1981; Lin & Lu, 2009). Tournament theory views executives as competitors contesting for promotion, and the large pay gap between the CEO and other executives becomes the prize for the tournament (Bognanno, 2001; Eriksson, 1999; Kale, Reis, & Venkateswaran, 2009; Lazear & Rosen, 1981). A large pay disparity motivates non-CEO senior executives to work hard and to invest in firm-specific human capital and, thus, helps build a motivated pool of internal candidates for the CEO position. Such a pool of internal candidates increases the bargaining power of the board, thus fostering positive CEO actions. Therefore, this perspective predicts a positive association between pay disparity and firm performance (Kale etal., 2009), and a negative association between pay disparity and the cost of capital (Chen, Huang, & Wei, 2013).