Earnings quality and earnings management in Chinese-listed companies

Transcription

1 University of Wollongong Research Online University of Wollongong Thesis Collection University of Wollongong Thesis Collections 2011 Earnings quality and earnings management in Chinese-listed companies Feng Li University of Wollongong Recommended Citation Li, Feng, Earnings quality and earnings management in Chinese-listed companies, Doctor of Philosophy thesis, School of Accounting and Finance, University of Wollongong, Research Online is the open access institutional repository for the University of Wollongong. For further information contact the UOW Library:

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3 Earnings Quality and Earnings Management in Chinese-listed Companies A thesis submitted in fulfillment of the requirements for the award of the degree of Doctor of Philosophy From University of Wollongong By Feng Li School of Accounting and Finance 2011

4 Thesis Certification I, Feng Li, declare that this thesis, submitted in fulfilment of the requirement for the Doctor of Philosophy, in the School of Accounting and Finance, University of Wollongong, is wholly my own work unless otherwise referenced or acknowledged. The document has not been submitted for qualifications at any other academic institution. Feng Li 04 May 2011 I

5 TABLE OF CONTENTS CHAPTER ONE... 1 Introduction and Overview Introduction Relation between Earnings Quality and Earnings Management Motivation for the Research Research Objectives and Contributions Structure of the Theses... 9 CHAPTER TWO Literature Review Introduction Defining Earnings Management and Earnings Quality Defining Earnings Management Defining Earnings Quality Literature Review of Earnings Management Opportunistic Earnings Management Capital Market Motivations Initial Public Offerings (IPOs) Seasoned Equity Offerings (SEOs) Income Increasing Income Decreasing Efficient Earnings Management Earnings Management in China Incentives Percent Rule Initial Public Offerings (IPOs) Literature Review of Earnings Quality Earnings Quality and Market Outcomes Earnings Quality in China Concluding Remarks CHAPTER THREE Research Methods and Classification of Firms Introduction Earnings Attributes Measures Accruals Quality Earnings Persistence Earnings Predictability Earnings Smoothness Earnings Management Measures Non-discretionary Accruals Discretionary Accruals Specific Accruals Discontinuities in the Distribution of Earnings MMH Firm-Year Model The Emerging Market Score Model (EMS Model) II

6 3.6 Concluding Remarks CHAPTER FOUR Theoretical Framework Introduction Agency Theory Overview of Agency Theory Contributions of Agency Theory Application of Agency Theory in Earnings Management Application of Agency Theory in Earnings Quality Research Questions Concluding Remarks CHAPTER FIVE Earnings Quality - Hypotheses Development, Research Method and Empirical Results Introduction Hypotheses Development Research Methodology and Data Research Methodology Data and Sample Results Results for Accruals Quality (H 5.1) Results for Earnings Persistence (H 5.2) Results for Earnings Predictability (H 5.3) Results for Earnings Smoothness (H 5.4) Concluding Remarks CHAPTER SIX Earnings Quality - Sensitivity Analysis Introduction Changes in EMS Default Equivalent Rating Using the Z-Score Model (1993 Altman Model) Changes in Scaling the Accounting Variables by Average Changes in Accruals Quality Model Using CFO Persistence Model Earnings Predictability based on CFO Persistence Concluding Remarks CHAPTER SEVEN Earnings Management - Hypotheses Development, Research Method and Empirical Results Introduction Hypothesis Development Research Methodology Research Model Sample Selection Results Results for Accruals Quality (H7.1) Results for Earnings Persistence (H7.2) Results for Earnings Predictability (H7.3) III

7 Results for Earnings Smoothness (H7.4) Concluding Remarks CHAPTER EIGHT Earnings Management - Sensitivity Analysis Introduction Changes in EMS Default Equivalent Rating (D) Using Z Score Model (1993 Altman Model) Changes in Scaling the Accounting Variables by Average Changes in Accruals Quality Model Using ROA Persistence Model Concluding Remarks CHAPTER NINE Conclusion Introduction Purposes, Findings and Implications Limitations and Future Research References Appendices IV

8 LIST OF TABLES Table 5.1:The Classification of Firms in the Sample Table 5.2: Descriptive Statistics for Variables of SB SNB and NSNB Table 5.3: Pearson Correlation Coefficients (SB)...84 Table 5.4: Pearson Correlation Coefficients (SNB)..85 Table 5.5: Pearson Correlation Coefficients (NSNB)...86 Table 5.6: Earnings Quality Metrics (Accruals Quality)...88 Table 5.7: Earnings Quality Metrics (Earnings Persistence)...90 Table 5.8: Implications of Earnings Volatility for Long Term Earnings Table 5.9: Earnings Quality Metrics (Earnings Predictability) 95 Table 5.10: Earnings Quality Metrics (Earnings Smoothness)...97 Appendix 6.1: Sensitivity Test 1 - Sample Composition.173 Appendix 6.2: Sensitivity Test 1 - Earnings Quality Metrics (Accruals Quality) Appendix 6.3: Sensitivity Test 1 - Earnings Quality Metrics (Earnings Persistence and Earnings Predictability) Appendix 6.4: Sensitivity Test 1 - Earnings Quality Metrics (Earnings Smoothness).178 Appendix 6.5: Sensitivity Test 2 Sample Composition 179 Appendix 6.6: Sensitivity Test 2 - Earnings Quality Metrics (Accruals Quality) Appendix 6.7: Sensitivity Test 2 - Earnings Quality Metrics (Earnings Persistence and Earnings Predictability) Appendix 6.8: Sensitivity Test 2 - Earnings Quality Metrics (Earnings Smoothness).184 Appendix 6.9: Sensitivity Test 3 - Earnings Quality Metrics (Accruals Quality)..185 Appendix 6.10: Sensitivity Test 3 - Earnings Quality Metrics (Earnings Persistence and Earnings Predictability) Appendix 6.11: Sensitivity Test 3 - Earnings Quality Metrics (Earnings Smoothness).189 Appendix 6.12: Sensitivity Test 4 - Earnings Quality Metrics (Accruals Quality).190 Appendix 6.13: Sensitivity Test 5 and 6 CFO Quality Metrics (CFO Persistence and CFO Predictability).193 Table 7.1: Statistics of Relevant Accounting Variables and Earnings Attributes..121 Table 7.2: Pearson Correlation Coefficients Table 7.3: Earnings Attribute Variables (Raw and Rank Data) Used in This Study Table 7.4: Regression on Future Profitability with Accruals Quality (Decile Ranking).127 Table7.5: Regression on Future Profitability with Earnings Persistence (Decile Ranking) Table7.6: Regression on Future Profitability with Earnings Predictability (Decile Ranking) Table7.7: Regression on Future Profitability with Earnings Smoothness (Decile Ranking) Appendix 8.1: Sensitivity Test 1 - Earnings Attribute Variables (Raw and Rank Data) Used in This Study Appendix 8.2: Sensitivity Test 1 - Regression on Future Profitability with Accruals Quality (Decile Ranking) V

9 Appendix 8.3: Sensitivity Test 1 - Regression on Future Profitability with Earnings Persistence (Decile Ranking).197 Appendix 8.4: Sensitivity Test 1- Regression on Future Profitability with Earnings Predictability (Decile Ranking)..198 Appendix 8.5: Sensitivity Test 1- Regression on Future Profitability with Earnings Smoothness (Decile Ranking) 199 Appendix 8.6: Sensitivity Test 2 - Earnings Attribute Variables (Raw and Rank Data) Used in This Study 200 Appendix 8.7: Sensitivity Test 2 - Regression on Future Profitability with Accruals Quality (Decile Ranking) Appendix 8.8: Sensitivity Test 2 - Regression on Future Profitability with Earnings Persistence (Decile Ranking).202 Appendix 8.9: Sensitivity Test 2- Regression on Future Profitability with Earnings Predictability (Decile Ranking)..203 Appendix 8.10: Sensitivity Test 2- Regression on Future Profitability with Earnings Smoothness (Decile Ranking) 204 Appendix 8.11: Sensitivity Test 3 - Earnings Attribute Variables (Raw and Rank Data) Used in This Study 205 Appendix 8.12: Sensitivity Test 3 - Regression on Future Profitability with Accruals Quality (Decile Ranking) Appendix 8.13: Sensitivity Test 3 - Regression on Future Profitability with Earnings Persistence (Decile Ranking).207 Appendix 8.14: Sensitivity Test 3 - Regression on Future Profitability with Earnings Predictability (Decile Ranking).208 Appendix 8.15: Sensitivity Test 3 - Regression on Future Profitability with Earnings Smoothness (Decile Ranking) 209 Appendix 8.16: Sensitivity Test 4 - Earnings Attribute Variables (Raw and Rank Data) Used in This Study 210 Appendix 8.17: Sensitivity Test 4 - Regression on Future Profitability with Total Accruals (Decile Ranking).211 Appendix 8.18: Sensitivity Test 5 - Earnings Attribute Variables (Raw and Rank Data) Used in This Study Appendix 8.19: Sensitivity Test 5 - Regression on Future Profitability with ROA Persistence (Decile Ranking) VI

10 LIST OF ABBREVIATIONS ACCR CA CFO CL CSMAR CSRC DAC DD Model Dep EARN EBITA EMS EPS FASB GAAP IPO MMH NDAC NDNI ΔNI NSB NSNB Total Accruals Current Assets Cash Flow from Operations Current Liabilities China Stock Market and Accounting Research Chinese Securities Regulatory Commission Discretionary Accruals Dechow and Dichev Model Depreciation and Amortization Income before Extraordinary Items Earnings before Interest, Taxes and Amortization Emerging Market Score Model Earnings Per Share Financial Accounting Standards Board Generally Accepted Accounting Principles Initial Public Offering McKeown, Mutchler, and Hopwood Non-Discretionary Accruals Non-Discretionary Net Income Change in Earnings Not Financially Stressed but Bankrupt Not Financially Stressed and not Bankrupt VII

11 OLS Persist PPE Pred ROA ROE SB SEO Smooth SNB SOE Stdresid T A TCA Ordinary Least Squares Earnings Persistence Property, Plant and Equipment Earnings Predictability Return on Asset Return on Equity Financially Stressed and Bankrupt Seasoned Equity Offerings Earnings Smoothness Financially Stressed and not Bankrupt State Owned Enterprise Standard Deviation of the Residuals Total Assets Total Current Accruals VIII

12 Abstract Earnings management is a universal phenomenon in firms financial reporting. The purpose of earnings management is to demonstrate reasonable earnings quality that meets either the shareholders expectation, or the requirement of obtaining relevant authorization from regulators (Francis et al., 2005). Thus, earnings management has much in common with earnings quality (represented by accruals quality, earnings persistence, earnings predictability, and earnings smoothness in this research). Highly managed earnings can yield low-quality earnings (Lo, 2008), as the artificial information may lead to an incorrect decision. However, the absence of earnings management is insufficient to guarantee high-quality earnings, because other factors can (such as capital market and management compensation) contribute to the quality of earnings (Lo, 2008). McKeown, Mutchler, and Hopwood (1991, hereafter MMH) create a model to classify firms as financially stressed and non-stressed. Altman (2006) develops an Emerging Market Score model (EMS, hereafter) to group firms as bankrupt and non-bankrupt firms which is conceptually different from the MMH model. This study did not assume that a bankrupt or near-bankrupt firm has a positive relationship with financial distress. Therefore, in this study financial distress and bankruptcy are two different constructs. The firms listed on the new emerging market of China can be described by combining both MMH and EMS models. Due to the imperfect delisting system in the Chinese stock exchange, some firms are in financial distress and should be bankrupt in terms of the IX

13 criteria used in developed countries. However, they are still being listed on the stock exchanges flagging their near-bankruptcy status to investors. This study adopts the two models (MMH and EMS) to examine the significant differences in earnings quality and the efficiency of earnings management in relation to the firms financial status of being stressed and non-stressed as per the MMH model, the near bankruptcy status of being bankrupt and non-bankrupt as per the EMS model; classifying firms into four quadrants: (1) financially stressed and bankrupt (SB), (2) not financially stressed but bankrupt (NSB), (3) financially stressed and not bankrupt (SNB), and (4) not financially stressed and not bankrupt (NSNB). However, due to the zero sample firms in the quadrant of NSB, this study focuses on firms in the quadrants of SB, SNB, and NSNB by disregarding the firms in the quadrant of NSB. To the author s best knowledge, no research until now has been published on the different four earnings attributes (accruals quality, earnings persistence, earnings predictability, and earnings smoothness) of firms in China classified into three quadrants - SB, SNB, and NSNB and whether there are efficient or opportunistic earnings management in related to the four earnings attributes in Chinese-listed firms. Using the discretionary accruals as a proxy for earnings management, this study empirically investigates significant differences in the four earnings attributes and how the four earnings attributes affect future profitability, examining the efficiency of earnings management in each firm classification (SB, SNB and NSNB), and thus filling a void in the literature. X

14 One purpose of this study therefore, is to investigate earnings quality of Chinese companies listed in the Shanghai and Shenzhen stock exchanges from 2003 to 2007 by classifying them as SB, SNB, and NSNB firms. This study measures earnings quality by the four earnings attributes: accruals quality, earnings persistence, earnings predictability, and earnings smoothness. Since the computation of MMH firm-year model and accruals quality require past and future year s data, this study covers the analysis period from 2000 to To mitigate concern that differences in sample composition might drive comparisons for each kind of firm, this study further requires that data on all variables are available for each year for the sample period. The data are collected from the database (China Stock Market and Accounting Research) that offered financial data of Chinese companies. Since determining the MMH firm-year model requires past three years of relevant data as a variable, and therefore the beginning firm-year is The regression model of accruals quality also requires one-year-ahead cash flow from operations as a variable, and therefore the end firm-year is The usable firms representing as samples in the three quadrants varied from 2003 to The final sample consists of 987 firms with a total of 4935 firm-year observations for the period In determining earnings quality of firms in China, this study finds that SB firms have the lowest earnings quality measured by each of the four earnings attributes. SNB firms have higher earnings quality compared with SB firms. NSNB firms have the highest earnings quality. This study also finds that earnings quality deteriorated over the study period, the XI

15 number of SB firms with the lowest earnings quality increased, and the number of NSNB firms with the highest earnings quality decreased for the fiscal years 2003 to The other purpose of this study is to examine the relation between earnings management and each earnings attribute among the Chinese firms classified into the three quadrants - SB, SNB, and NSNB. This study using a regression model, measures the four earnings attributes on a firm-and year-specific basis, in a rolling five-year windows, t-4, t. In preparing data for the regression model that measures whether earnings are managed efficiently or opportunistically, this study ranks each earnings attribute in each year to form deciles. The results reveal that SB firms are more inclined to choose opportunistic earnings management and SNB firms are more inclined to choose efficient earnings management. NSNB firms choose more efficient earnings management than SNB firms. The results also reveal that earnings management is a better measure than earnings quality in predicting future profitability, because the indicators of earnings management (proxy by discretionary accruals) have more positive significant coefficients than earnings quality in predicting future profitability. Additionally, the results reveal that NSNB firms provide a better indication than both SNB and SB firms in predicting future profitability in relation to each earnings attribute. The findings of this study can have positive implications for the development of accounting standards and practices in China. The findings provide useful input to a XII

16 review of the relevant regulations, as well as insights for regulators who are attempting to improve the efficiency of China s capital markets and implement corporate governance provisions to prevent opportunistic behaviour by managers. It may prove useful for auditors to have a better understanding of how managers exercise the discretion inherent in accounting standards to mask poor performance in financially troubled firms, and to enhance the quality of financial reports and thus increase the efficient allocation of capital in the emerging market. The findings are also useful to other parties (such as analysts, creditors, and researchers) who use accounting numbers to assess failure probability, default risk, and the liquidation value of the firm, since these individuals need to be aware of regulation-related earnings quality when analysing the financial statement of listed Chinese firms. A limitation that needs to be considered when interpreting the results is possible that earnings attributes and earnings management variables are all impacted by variables not included in this study. XIII

17 Acknowledgements First of all, I would like to sincerely express my appreciation and gratitude to my principal supervisor, Associate Professor Indra Abeysekera, for giving me the opportunity to carry out this research project under his supervision. I thank him for always providing appropriate direction, advice and assistance in my research work. I am indebted to his knowledge, inspiration and have learned so much from him. I am also deeply indebted to my co-supervisor Dr Shiguang Ma for his guidance, stimulating discussions, encouragement, friendship, and constant valuable support during the completion of this thesis. I would like to thank all members of the research group and staff in the department of accounting and finance for their help and support. I sincerely thank my PhD fellow mates, Shirley Xu, Melisa Lu; and my friends, Cong Zhao, FangLu Peng, SiZhou Yan and XiaFang Xue, for helpful discussions about sampling, methodology, and data analysis. Finally, my special thanks go to my parents and my wife, who are an essential part of my life and who have always supported me in my pursuits. This thesis is dedicated to them. XIV

18 CHAPTER ONE Introduction and Overview 1

19 1.1 Introduction One purpose of this study is to investigate earnings quality of Chinese companies listed on the Shanghai and Shenzhen stock exchanges from 2003 to 2007 by classifying them as financially stressed and bankrupt (SB), financially stressed and not bankrupt (SNB), and not financially stressed and not bankrupt (NSNB) firms. This study measures earnings quality by four separate attributes: accruals quality, earnings persistence, earnings predictability, and earnings smoothness. The other purpose of this study is to examine whether firms classified thus, manage earnings efficiently or opportunistically and their relation to each of the four earnings attributes among the Chinese firms. 1.2 Relation between Earnings Quality and Earnings Management Generally accepted accounting principles (GAAP) offer financial managers to prepare financial statements with some flexibility by selecting accounting policies and alternative measurement methods of assets, liabilities, revenue, and expenses. Earnings management is the use this flexibility in financial reporting to alter the financial results of the firm (Ortega and Grant, 2003). It is a purposeful intervention in the process of external reporting to communicate firm s private information to obtain some private gain (Schipper, 1989). The measurement of earnings management plays a central role in a wide body of accounting research (Healy and Wahlen, 1999). Typically, studies that investigate earnings management use discretionary accruals as its proxy which is measured as the residual or prediction error from an accrual - expectation mode (Healy and Wahlen, 2

20 1999). There are two types of earnings management: efficient earnings management (i.e., to improve information about earnings to better communicate private information) and opportunistic earnings management (i.e., reporting earnings to gain the most personal benefit) (Scott, 2000). Ronen and Yaari (2008) explain different definitions of earnings management. Efficient earnings management is taking advantage of the flexibility in the choice of accounting treatment to signal the manager s private information on future cash flow (Ronen and Yaari, 2008, p.25). Opportunistic earnings management is choosing an accounting treatment that is opportunistic (maximizing the utility of management only) (Ronen and Yaari, 2008, p.25). Earnings quality has a close relationship with earnings management in evaluating an entity s financial health. For instance, highly managed earnings can yield low-quality earnings (Lo, 2008). However, the lack of earnings management is not sufficient to guarantee high-quality earnings, because other factors (such as capital market and management compensation) contribute to the increased quality of earnings (Lo, 2008). In addition, earnings management may affect the quality of accounting earnings. As explained by Schipper and Vincent (2003), reported earnings faithfully represent Hicksian income, where representational faithfulness means correspondence or agreement between a measure or description and the phenomenon that it purports to represent. Hicksian income corresponds to the amount that can be consumed (that is, paid out as dividends) during a period, while leaving the firm equally well off at the beginning 3

21 and the end of the period. This measure of income corresponds to the change in net economic assets other than from transactions with owners. 1.3 Motivation for the Research Earnings quality and earnings management are important issues because the reliability of capital markets is based on credible financial reporting (Teets, 2002). Many studies of reporting transparency examine its effects on users ability to detect earnings management (Hunton et al., 2006). Academics need to pay more attention to earnings management and earnings quality in developing countries, especially in China because of its fast-growing economy and its undeniable role as a global economic powerhouse (Ding et al., 2007). Along with this rapid economic growth, a sound framework of corporate governance has become a top priority in the Chinese government s agenda (Noronha et al., 2008). Recently, a number of efforts have led China s business environment toward higher levels of transparency and accountability (Noronha et al., 2008). Earnings management and earnings quality are widespread in China s listed companies (Wu, 2004). One important reason is due to the administrative governance approach adopted in China, regulators often rely on accounting numbers to govern the listed firms (Lu and Liu, 2007). For example, the China Securities Regulatory Commission (CSRC) requires listed firms to meet certain level of return on equity (ROE) before they can apply for a permission to issue additional shares to existing shareholders (rights issues); and the most important criterion for de-listing a listed company is a reported net loss for three consecutive years (Qi et al., 2005). A peculiar feature of Chinese-listed firms is that some 4

22 of them that should be declared as financial distress and/or should be declared as bankrupt in terms of the criteria used in developed countries are still being listed on the stock markets in China in contrast with that in mature stock markets in developed countries. Academic literature has long been interested in earnings management and earnings quality in China. Wu (2004) points out that the deficiencies of accounting standards have seriously influenced the quality of accounting information in the Chinese market. This suggests that earnings management is common on the Chinese mainland. Chen and Wang (2007) explain earnings management for a stock-rights offering in China. For example, the benefit of earnings management for a stock-rights offering is high for Chinese-listed firms because of the limited alternative sources of raising capital, while its cost is expected to be low because the users of accounting information are less sophisticated. Ortega and Grant (2003) classify most of the Chinese earnings management techniques into four categories: revenue recognition, operating expense timing, unrealistic assumptions to estimate liabilities, and real operating actions. McKeown, Mutchler, and Hopwood (1991, hereafter MMH) provide a model to divide the firms into financially stressed and non-stressed. They find that the financially stressed and non-stressed firms employ contrasting earnings management techniques and differing earning quality. Altman (2006) on the other hand, develops an Emerging Market Score model (EMS, hereafter) to group firms as bankrupt and non-bankrupt firms which is 5

23 conceptually different from the MMH model, and states that the bankrupt and nonbankrupt firms can be identified to some extent by earnings management approaches. The firms listed on the new emerging market of China can be described by both MMH and EMS models. Thus, this study borrows the two models to conduct an analysis on earnings management and earnings quality in relation to the firms financial status of being stressed and non-stressed, the near bankruptcy status of being bankrupt and nonbankrupt; classifying firms into four quadrants: (1) financially stressed and bankrupt (SB), (2) not financially stressed but bankrupt (NSB), (3) financially stressed and not bankrupt (SNB), and (4) not financially stressed and not bankrupt (NSNB). However, due to the zero sample firms in the quadrant of NSB, this thesis focuses on firms in the quadrants of SB, SNB, and NSNB by disregarding the firms in the class of NSB. To the author s best knowledge, no evidence is available at present on whether the four earnings attributes (accruals quality, earnings persistence, earnings predictability, and earnings smoothness) are different among the three types of firms (SB, SNB, and NSNB), and whether there are efficient or opportunistic earnings management in relation to the four earnings attributes in Chinese-listed firms. This study empirically investigates significant differences in the four earnings attributes and how the four earnings attributes affect future profitability, examining the efficiency of earnings management in each firm classification (SB, SNB and NSNB), and thus filling a void in the literature. 6

24 1.4 Research Objectives and Contributions The following four objectives are formulated to meet the two purposes of the study: 1) To present a review of the literature that describes and frames earnings quality and earnings management, which can be used to understand the importance of earnings quality and earnings management. 2) To collect sample firms that issued A-shares and were listed on the Shanghai and Shenzhen stock exchanges for the fiscal years 2003 to The data are collected from the CSMAR (China Stock Market and Accounting Research) Financial Database developed by the Shenzhen GTA Information Technology Co. 3) To apply the MMH firms-year model and EMS model employed in developed countries to classify Chinese-listed firms into three quadrants as financially stressed and bankrupt (SB), financially stressed and not bankrupt (SNB), and not financially stressed and not bankrupt (NSNB). 4) To indicate data analysis of significant differences in earnings quality and the type of earnings management and the effect of earnings quality in each firm classification (SB, SNB, and NSNB). This thesis provides contributions to the existing body of knowledge in the following ways: 7

25 1) This study investigates the overall breadth and scope of earnings quality and earnings management in a broad context by a comprehensive analysis of reported earnings across Chinese-listed firms. This may be of interest to investors and regulators. The significant differences of earnings quality and efficiency of earnings management by classifying them as SB, SNB and NSNB firms may help investors assess the different firms types of financial reporting quality in China. 2) It is the first study to classify Chinese-listed firms along two dimensions: financially stressed versus not financially stressed, and bankrupt versus not bankrupt. Sample firms are then divided into three groups: financially stressed and bankrupt, financially stressed and not bankrupt, and not financially stressed and not bankrupt, due to zero observations in the not financially stressed but bankrupt category. Prior research creates models to divide the western countries firms into financially stressed and bankrupt (SB), not financially stressed but bankrupt (NSB), financially stressed but not bankrupt (SNB), and not financially stressed and not bankrupt (NSNB) (Kida,1980; Mutchler,1985; McKeown et al., 1991; Hopwood et al., 1994; Mutchler, et al., 1997; and Rosner, 2003). But there are no literatures until now have been shown on the three types of firms (SB, SNB, and NSNB) in China. 3) Previous research related to measurement of both earnings quality and the tests on its capital market effects is still a paucity of academic research. For example, Francis et al. (2004) examine the relation between earnings quality and cost of equity; Francis, Nanda and Olsson (2008) investigate the relations among voluntary disclosure, 8

26 earnings quality, and cost of capital; and Boonlert-U-Thai et al. (2006) explore the effects of investor-protection on reported earnings quality. However, no empirical research examines the association between earnings quality attributes and earnings management. This study empirically examines the relation between earnings quality attributes and earnings management in the three classes of Chinese-listed firms, thus it extends the existing knowledge to gain greater understanding in the context of Chinese capital market. 4) The findings of this study related to efficient or opportunistic earnings management among the three classes of Chinese-listed firms (SB, SNB, and NSNB) may be of interest to investors. Dechow et al. (1996) report substantial corporate costs due to opportunistic earnings management: firms which have committed accounting fraud experienced average 9% of losses in shareholder wealth. Burgstahler and Dichev (1997) show that engaging in earnings management is a way to avoid reporting losses or decline in earnings. The findings of this thesis will contribute rational investors to make investment decision primarily based on the prediction of firms future performance and such prediction is largely influenced by current reported earnings. 1.5 Structure of the Thesis This thesis is organized into eight chapters following this introduction. Chapter 2 presents a review of the literature that explains and frames the characteristics of earnings quality and earnings management. The purpose of the literature review is to present a theoretical 9

27 background and context for this study, which can be used to explain or understand the importance of earnings quality and earnings management in accounting research fields. Chapter 3 reviews the four earnings attributes and earnings management measures and the MMH firm-year model as well as the Emerging Market Score model (EMS model). Chapter 4 describes overview of agency theory and discusses application of agency theory in the fields of earnings management and earnings quality. Chapter 5 performs the empirical analysis in relation to earnings quality assessed on the four earnings attributes. This chapter examines the effect of each earnings attribute on each type of the firms to identify higher or lower earnings quality for SB, SNB and NSNB firms of Chinese-listed companies. Chapter 6 reports the six sensitivity tests for earnings quality to ensure the robustness results. Chapter 7 investigates the type of earnings management and the effect of earnings quality in Chinese-listed firms. Chapter 8 examines five sensitivity tests for earnings management to ensure the robustness of the main results. Chapter 9 reviews summary conclusions for this study. Further, it outlines the implications, limitations and future research. 10

28 CHAPTER TWO Literature Review 11

29 2.1 Introduction This chapter reviews the literature which explains the existing studies on earnings management and earnings quality. The aim of this literature is to provide a conceptual background and context for this study: earnings management and earnings quality in accounting research fields. This literature review is organized into five sections as follows. The next section provides different definitions of earnings management and earnings quality. Section 2.3 and section 2.4 demonstrate existing knowledge of earnings management and earnings quality, respectively. These sections are followed by section 2.5, providing concluding remarks. 2.2 Defining Earnings Management and Earnings Quality Defining Earnings Management In the literature, academics have not reached a consensus on is the definition of earnings management (Beneish, 2001). There are two definitions of earnings management. (1) Earnings management is taking advantage of the flexibility in the choice of accounting treatment to signal the manager s private information on future cash flow (Ronen and Yaari, 2008, p.25). (2) Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence 12

30 contractual outcomes that depend on reported accounting number (Healy and Wahlen, 1999, p.368). A lack of consensus on the definition of earnings management implies differing interpretations of empirical evidence in studies that seek to detect earnings management, or to provide evidence of earnings management incentives (Beneish, 2001). All two definitions deal with actions that managers undertake within the context of financial reporting including the structuring of transactions so that a desired accounting treatment applies. The first definition is beneficial to investors; earnings management is beneficial if managers use their discretion to communicate private information about firm profitability, which is yet to be reflected in the historical cost-based earnings. The second definition is pernicious to investors, as managers are likely to use accounting policy discretion to maximize their personal utility (Subramanyam, 1996) Defining Earnings Quality Earnings quality is a multidimensional concept and there is no agreed-upon definition in the literature and as a result means different things to different financial statement users (Boonlert-U-Thai et al., 2006; Dechow and Schrand, 2004). Regulators generally view earnings to be of high quality when they conform to the spirit and the rules identified in generally accepted accounting principles (GAAP) (Dechow and Schrand, 2004). In contrast, creditors are likely to view earnings to be of high quality when they are easily convertible into cash flows. Compensation committees are likely to view earnings to be 13

31 of high quality when they reflect managers real performance and are little influenced by factors beyond management control (Dechow and Schrand, 2004). Schipper and Vincent (2003) consider earnings quality both from a decision usefulness perspective, following the Financial Accounting Standards Board s (FASB) conceptual framework, and from a Hicksian income 1 perspective, following the idea that reported earnings faithfully represent Hicksian income, where representational faithfulness means correspondence or agreement between a measure or description, and the phenomenon that it purports to represent (FASB Concepts Statement No. 2, para. 63). Focusing on decision usefulness is appropriate because the FASB s Conceptual Framework states that the purpose of financial reporting is to provide information that is useful for business decisions (Schipper and Vincent, 2003). Focusing on Hicksian income is appropriate because Hicksian income abstracts from user-decision contexts; from accounting recognition rules, which preclude the recording of many economic assets and liabilities; from difficulties in reliably measuring assets and liabilities at their economic values; from the effects of management s judgments and estimates; and from the influence of auditors (Schipper and Vincent, 2003). In contrast, Dechow and Schrand (2004) analyse earnings quality from a financial analysis perspective. They take the view that a high-quality earnings number is one that accurately reflects the company s current operating performance, is a good indicator of future operating performance, and is a useful summary measure for assessing firm value. 1 Hicksian income corresponds to the amount that can be consumed (that is, paid out as dividends) during a period, while leaving the firm equally well off at the beginning and the end of the period (Hicks, 1939, p.176). 14

32 Another way to think about this concept is that earnings are of high quality when return on equity is a good measure of the internal rate of return on the company s current portfolio of projects. Francis, Nanda and Olsson (2008) focus on capital markets setting to lay out a research perspective on earnings quality. They associate earnings quality with precision, in the sense that higher quality earnings are more precise with respect to an underlying valuation-relevant construct that earnings is intended to describe. In addition, Francis, Olsson and Schipper (2008) state earnings quality is influenced by two factors: those that reflect innate features of business models and operating environments, and those that reflect the financial reporting process. 2.3 Literature Review of Earnings Management Opportunistic Earnings Management Several researchers find evidence that the opportunistic perspective is a common motivation for earnings management. The following discusses the reviews of opportunistic earnings management: capital market motivations, initial public offerings, seasoned equity offerings, income increasing and income decreasing Capital Market Motivations The widespread use of accounting information by investors and financial analysts to help value stock can create an incentive for managers to manipulate earnings in an attempt to influence short-term stock price performance. Recent studies on stock market incentives 15

33 to manage earnings have focused on unexpected accrual behavior during periods when capital market incentives to manage earnings are likely to be high (Healy and Wahlen, 1999). These include studies of earnings management in periods surrounding capital market transactions and when there is a gap between firm performance, and analysts or investors expectations (Healy and Wahlen, 1999). Several studies examine earnings management prior to management buyouts. A management buyout is a leveraged buyout in which a public firm becomes a private firm where managers also become equity investors (Depamphilis, 2003, p. 23). DeAngelo (1988) reports that earnings information is important for valuations in management buyouts and hypothesizes that managers buyout firms have an incentive to understate earnings. However, DeAngelo finds little evidence of earnings management (measured as change in accrual level) to support it. Several studies explore that earnings management affect stock prices, and with it, the managers wealth (Cornett et al., 2009; Beatty et al., 2002; Cheng and Warfield, 2005). Option and restricted stock compensation are the particularly direct routes by which management can increase its wealth by inflating stock prices. Indeed, evidence that such compensation is associated with higher degrees of earnings management is prevalent. Gao and Shrieves (2002), Adams and Santos (2006), Bergstresser and Philippon (2006), Cohen et al. (2004), and Cheng and Warfield (2005) all find that the use of discretionary accruals and earnings management is more common with firms where top management 16

34 compensation is more closely tied to the value of stock in general and options more particularly. Specifically, as earnings management applies to banking, previous studies have found that banks use loan loss provisions and securities gains and losses to manage earnings and capital levels. However, results on the direction of earnings management are mixed. For example, Cornett et al. (2009) examines whether corporate governance mechanisms affect earnings and earnings management at the largest publicly traded bank holding companies in the United States. They find that CEO pay-for-performance sensitivity (PPS), board independence, and capital are positively related to earnings and that earnings, board independence, and capital are negatively related to earnings management. Wahlen (1994) shows that managers increase discretionary loan loss provisions when they expect future cash flows to increase. Finally, Beatty et al. (2002) find that relative to private banks, public banks are more likely to use loan loss provisions and realized securities gains and losses to eliminate small earnings decreases. Recent studies have also examined whether managers overstate earnings in periods prior to equity offers. The findings indicate that firms report positive (income-increasing) unexpected accruals prior to seasoned equity offers (Teoh et al., 1998b), initial public offers (Teoh et al., 1998a; Teoh et al., 1998b), and stock-financed acquisitions (Erickson and Wang, 1999). There is also evidence of a reversal of unexpected accruals following initial public offers (Teoh et al., 1998a) and stock financed acquisitions (Erickson and Wang, 1999). 17

35 Initial Public Offerings (IPOs) An initial public offering (IPO) occurs when the firm goes to public for the first time to obtain an infusion of capital and changes its ownership structure (Ronen and Yaari, 2008). Ronen and Yaari note that one possible explanation for this finding is that entrepreneurs mislead investors by manipulating earnings. Ritter (1991) provides empirical evidence that IPO firms stock returns are significantly less than a matched sample of non-ipo firms. Jain and Kini (1994) examine accounting measures of operating performance of IPO firms. They find that firms exhibit a decline in operating performance after their IPOs suggesting that potential investors may initially have high expectations of future earnings growth that are not subsequently fulfilled. Teoh et al. (1998b) investigate earnings management during the year of IPO and subsequent stock returns. They find a significant negative association between abnormal accruals measured during the year of offer and stock returns over a three-year post-ipo period. Similarly, Teoh et al. (1998a) investigate abnormal accruals during the IPO year and subsequent earnings performance. They find that discretionary current accruals for the year of offer are negatively correlated with post-issue earnings. In addition, Teoh and Wong (1997) interpret abnormal accruals as a measure of earnings management, report evidence consistent with analysts being misled by opportunistic earnings management by new equity issuers (both IPOs and SEOs). One potential inefficiency explanation is discussed by Ritter (1991) and Loughran and Ritter (1995 and 2000). They suggest that managers take advantage of asymmetric 18

36 information by issuing equity when their firms equity specifically or equities in general are overvalued. Rangan (1998) and Teoh et al. (1998a and 1998b) extend this idea and suggest that some firms may manage earnings upwards to induce mispricing. Higher earnings produce higher share prices, and higher share prices produce greater proceeds from the share issue with less dilution of earnings and control. To counter the explanations based on inefficiency above, several studies discuss rational explanations. Eckbo et al. (2000) argue that the new issues puzzle can be explained by omitted risk factors. Eckbo et al provide evidence to this effect relating to seasoned equity offerings (SEOs). Brav and Gompers (1997) and Brav et al. (2000) show that underperformance is concentrated in small, low book-to-market firms and conclude that the return patterns seen following IPOs are not anomalous, but reflect the return pattern seen in the market as a whole Seasoned Equity Offerings (SEOs) In a seasoned equity offering (SEO), a firm seeks to recruit a new group of investors (Ronen and Yaari, 2008). Beginning with Rangan (1998) and Teoh et al. (1998a), researchers have been concerned with whether firms manage reported earnings during SEOs, and the accounting and stock market consequences associated with such activities. They have demonstrated that SEOs are followed by both poor stock returns and poor earnings performance (Rangan, 1998; Shivakumar, 2000; Ronen and Yaari, 2008; Teoh et al., 1998a; Kinnunen et al., 1999; Kim, 2002; Ching et al., 2002; Marquardt and Wiedman, 2004a, 2004b; Zhou and Elder, 2004; Pastor and Poveda, 2005). 19

37 Consistent with above literature, Rangan (1998) finds that, on average, SEOs firms have positive abnormal accruals (i.e., upwardly managed reported earnings) during the year around the SEOs. Rangan interprets the findings as the stock market is misled by the upwardly managed earnings, temporarily overvaluing issuing firms and then being disappointed by their predictable earnings declines. Teoh et al. (1998b) report similar evidence to Rangan, with the additional finding that SEOs issuers who upwardly manage earnings have lower post-event share returns. Both of these studies attribute the decline in post-seos operating performance primarily to accrual reversals Income Increasing Scott (2003) states that income-increasing earnings management is a strategy of inflating reported earnings, it either depletes past reserves of reported outcome or borrows from future reports. There is evidence that firms prefer to choose income-increasing earnings management rather than income-decreasing earnings management (Ronen and Yaari, 2008). For example, Kinney and Martin (1994) analyze nine sets of audit-related adjustments from more than 1500 audits across 15 years, and conclude that adjustments are overwhelmingly negative. In other words, audits correct a positive bias in pre-audit earnings and assets (Nelson et al., 2003). The management compensation hypothesis claims that managers have incentives to maximize their compensation by selecting alternative accounting procedures. Hence, under this hypothesis, managers will attempt to increase reported earnings when earnings affect their respective financial compensation (Yoon and Miller, 2002). Some studies provide evidence consistent with managers altering reported earnings to increase their 20

38 compensation (Healy, 1985; Gaver et al., 1995; Holthausen et al., 1995; and Adams et al., 2005). Darrough et al. (1998) examine choices of accounting accruals using a large sample of Japanese companies, which operate in an environment that is generally regarded as being rather different from the United States. The findings indicate that managers of Japanese companies chose income-increasing accounting accruals to increase their bonus and increase the amount of outside funding (Darrough et al., 1998). The ownership effect was also observed on the choice of accounting accruals. Those companies that have higher degrees of ownerships by trust companies and stock brokers have incentives to choose income-increasing accruals to provide a more positive picture of the firm. The managers of Japanese firms that have a lower degree of ownership prefer to choose incomeincreasing accruals to increase their wealth through accounting numbers (Darrough et al., 1998). In contrast, Yoon and Miller (2002) examine that the ownership control or management buyout hypothesis infers that managers will either increase or decrease reported earnings to protect the ownership control of firms. For example, if managers plan to increase their ownership percentage, then the managers might have incentives to decrease reported earnings. However, if managers are confronted with a threat by a third party s attempt to control their respective firm, managers will have incentives to increase reported earnings (Yoon and Miller, 2002). DeAngelo (1986) hypothesizes that managers of firms going 21