Earnings Management to Tunnel: Evidence from China s Listed Companies*

Transcription

1 Earnings Management to Tunnel: Evidence from China s Listed Companies* Qiao Liu McKinsey & Company / University of Hong Kong and Zhou (Joe) Lu University of Hong Kong First draft: October 2002 This draft: December 2002 * Liu is affiliated with McKinsey & Company, Inc. and the School of Economics and Finance at the University of Hong Kong. Lu is from the School of Business, Faculty of Business and Economics, the University of Hong Kong. We thank Chuntao Li for his excellent research assistance. The views expressed here are those of the authors and do not necessarily reflect those of their respective institutions. Both authors acknowledge financial supports from the HKU Research Initiation Grant and the Center for China Financial Research. Liu also thanks the Hong Kong Research Grants Council for their support (Competitive Earmarked Research Grant No. HKU7201/01H). We are responsible for all remaining errors. Send correspondence to: Dr. Qiao Liu, School of Economics and Finance, the University of Hong Kong, Pokfulam Road, Hong Kong SAR, P.R.China. Tel: (852) , qiao_liu@mckinsey.com or qliu@hku.hk or Dr. Joe Lu, School of Business, University of Hong Kong, Pokfulam Road, joelu@business.hku.hk.

2 Earnings management to tunnel: evidence from China s listed companies Abstract This paper examines whether earnings management in China s publicly traded companies is related to tunneling of resources from firms by controlling shareholders for their own benefits. We hypothesize that the incentives to manage earnings are greater in firms with poorer governance practices and more urgent needs to exceed regulatory thresholds; they become weaker where tunneling is more difficult. Our empirical evidence shows that total accruals and industry median adjusted accruals are positively correlated with the largest shareholder s interest in a company, top executives interests in the company, and whether the board of directors is chaired by the CEO and are negatively related to a H/B share dummy. Our results suggest that tunneling is more of a problem in companies with powerful controlling shareholders, with CEOs that have a great personal interest in the company, and with boards that are less independent and that it is less severe for firms that have shares traded by foreign investors. Moreover, anecdotal evidence from several specific incidents in the context of China s capital market also provides support to our hypothesis. Key words: earnings management, tunneling, corporate governance, and Chinese listed companies JEL classification: G34, G32, M41, M43

3 1. Introduction The Asian financial crisis has spawned a vast body of research on corporate governance issues in emerging markets. In contrast with traditional literature such as Berle and Means (1932) and Jensen and Meckling (1976) 1, recent research focuses more on a different form of agency problem: controlling shareholders expropriating a firm s minority shareholders. As La Porta, Lopez-de-Silanes, and Schleifer (1999) conclude, the central agency problem in large corporations around the world is that of restricting expropriation of minority shareholders by controlling shareholders Expropriation of minority shareholders may occur wherever there is a conflict of interest between controlling shareholders and minority shareholders. However, this type of agency problem can be particularly serious in emerging markets, where fewer corporate governance mechanisms, such as dispersed ownership structures, independent boards, active external takeover markets, and high-quality disclosure, exist to protect minority shareholders. Expropriation from minority shareholders by controlling shareholders can take a variety of forms, such as excessive executive compensation, loan guarantees, dilutive share issues, etc. Johnson, La Porta, Lopez-de-Silanes, and Shleifer (2000) use the term tunneling to describe the transfer of resources away from firms to benefit their controlling shareholders. It has been argued that conglomerate style of corporate structure facilitates the tunneling activities of controlling shareholders. Through cross-holding or pyramidal ownership structures, controlling shareholders are able to obtain greater control of firms with a minimal amount of capital, which exacerbates the conflicts of interest between controlling shareholders and other shareholders. For example, Bertrand, Mehta, and Mullainathan (2000) use data on Indian business groups to examine the extent of tunneling activity in companies with cross-holding or pyramidal ownership 1 Both argue that when ownership and control of corporations are not fully coincident, there is potential for conflicts of interest between owners and controllers. Managers, by controlling the daily operating activities of a firm, may extract private benefits at the expense of the firm s ultimate owners - shareholders. 1

4 structures and find evidence for tunneling of resources by the largest shareholder within one Indian business group. Bae, Kang, and Kim (2002) study Korean merger activities between 1981 and 1997 to explore the nature of business groups in emerging markets. They find that the business group type structure allows owner-managers to receive private benefits that do not accrue to other shareholders through M&As. However, this is not to say that tunneling is a phenomenon specific to business groups. In the absence of effective governance mechanisms to protect shareholders rights, any controlling shareholder can find opportunities or create opportunities to tunnel. For example, cross-holding and pyramidal ownership structures are not common in China. Nevertheless, controlling shareholders in Chinese listed companies still manage to take advantage of regulatory loopholes, the lack of effective shareholder protection, and concentrated ownership structures to make decisions solely to benefit themselves. In this paper, we explore Chinese controlling shareholders incentives to manage earnings and link earnings management to Chinese listed companies poor governance practices. Traditionally, the literature on earnings management has mainly presented American or European evidence. Recently, some researchers have started to focus on earnings management in emerging markets. For example, Aharony, Lee, and Wong (2000) examine the earnings management behavior of Chinese companies around initial public offerings (IPOs). They find that Chinese state-owned enterprises (SOEs) manage earnings upwards before IPOs, and that the pattern of earnings management depends on a company s relationship with the government, and on whether a company issues shares to foreign investors. In this paper, we hypothesize that the unique institutional background in China actually connects earnings management with the 2

5 incentives to tunnel. There are two reasons why earnings management is a crucial step for a Chinese controlling shareholder attempting to expropriate minority shareholders: First, until recently, access to listing in China s stock market was strictly administrated by the central government. The listing quota was allocated to each province or ministry based on certain criteria (e.g., economic development level, location, national industrial policies, ties to the central government, etc.). Listing status is a privilege that few companies are able to enjoy. The controlling shareholders of those lucky draws often exploit this privilege at the expense of minority shareholders. Hence, maintaining this listing status and gaining access to secondary or right issues provide management with the strongest incentives to manage earnings. Second, earnings management is crucial in enabling controlling shareholders to tunnel because Chinese investors and regulators are unsophisticated: they are usually fixated on reported earnings. For example, the most important criterion for IPOs and right offerings used by the China Securities Regulatory Commission (CSRC) is the reported ROE; the most important criterion for designating a listed company as a special treatment firm (a pre-step for de-listing) is a reported net loss for two straight years 2. Using a single accounting variable to make policy decision is bound to affect the way managers report earnings. Due to poor corporate governance practices, Chinese executives are able to exercise much greater discretion in the financial reporting process than their Western counterparts. Most institutional mechanisms, such as internal audit committees, independent and skillful auditors, and sufficient investor protection, typically found in well-established markets that restrain managers discretion over financial reporting do not exist in China. Earnings management, 2 The Shanghai and Shenzhen Stock Exchanges introduced the ST designation in 1998 as a mechanism to alert investors, to force listed companies to improve their performance, and to discipline executives. If an ST company cannot improve its performance in next year, it is labeled a particular transfer (PT) firm, which entails virtual suspension of trading in its shares and a significant danger of de-listing. 3

6 therefore, is the listed companies rational response to their incentive to tunnel: to manage earnings above certain thresholds so as to earn the right to issue new shares or to avoid the likelihood of de-listing. Earnings management appears to be dependent on several factors, including: the level of governance standards imposed, the resources the controlling shareholders are able to tunnel from the listed firms, the urgency to manage earnings above regulatory thresholds, etc. A firm with higher governance standards may be less likely to tunnel, and therefore has fewer incentives to manage earnings. We, therefore, test whether earnings management is related to a series of corporate governance measures. We find evidence that genuinely supports our hypothesis. We then study several corporate incidents that are unique in the context of the Chinese stock market and find that: firms tend to manage their earnings when the tunneling incentives and earnings management urgency are high; they tend to hold back when monitoring is strict. Our study contributes to the literature in several ways. China provides a unique experimental setting for investigating links between earnings management and the incentives of controlling shareholder to expropriate minority shareholders. Typical incentives to manipulate earnings, found in more market-oriented economies, do not exist in China. For example, Chinese managers do not face the pressure of debt covenant constraints. Incentive-based compensation plans are rare in Chinese listed companies. Incentives to meet market expectation are minimal, since the demand for equity investment is huge. Therefore, we can minimize control variables to focus on the factors we are interested in. We also argue and provide evidence to show that the fundamental reason Chinese listed companies manage earnings is to tunnel. Thus, our paper presents itself as an interesting case study of how tunneling occurs and the form it takes in the context of emerging markets. 4

7 The rest of the paper is organized as follows. In Section 2, we present some institutional background about China s infant stock markets and explain how earnings management and tunneling are connected. Data collection and sample summary statistics are discussed in Section 3, Section 4 discusses the empirical results and Section 5 concludes. 2. The Institutional Background 2.1. Overview of the Chinese stock market The government organized the Chinese stock market as a vehicle for its state-owned enterprises (SOEs) to raise capital and improve operating performance. In a period of a bit more than a decade, China s stock markets have grown into the eighth largest in the world with market capitalization of around US$500 billion. Chinese companies, especially state-owned enterprises (SOEs), have benefited greatly from rapid equity issuance growth and public enthusiasm for the equity market due to the lack of other attractive investment vehicles 3. Over the past decade, regulation has been evolving to address problems typically found in emerging markets. The CSRC, in particular, has been managing the tradeoff between growth and control: balancing a liberal approach, which would lead to fast expansion with a more controlled approach, which would lead to slow, but hopefully orderly growth. Even though issuance approval, pricing and placement systems have all been significantly liberalized, they are still relatively controlled compared to other Asian and international markets. Since the primary objective of developing equity markets in China is to facilitate external financing for SOEs, regulations have been asymmetrically in favor of SOEs or companies with close ties to central or local government. Specifically, until recently, access to listing in China s 3 The first public companies went public in By 2001, there were already 1,200 public companies listed on China s two stock exchanges: the Shanghai and Shenzhen Stock Exchanges. One figure demonstrates the general public s enthusiasm towards China s fledgling stock market: the average subscription ratios have been over 200 times throughout the past decade, with retail investors dominating domestic issuances. 5

8 stock market was strictly administrated by the government 4. For example, the listing quota was allocated to provinces or ministries according to certain criteria. Firms in protected industries or with close ties to government had a great advantage over other companies in winning the right to go public. Because of policy constraints, competition for the rights to go IPO and for listing is fierce. As a result, the listing status of a public company carries significant value 5. Another consequence of such policy practice is that the ownership of Chinese listed companies is highly concentrated in the hands of the government. On average, state-owned shares and legal person shares (indirectly owned by governments) account for 70% of the total number of shares in China s listed companies. Furthermore, the largest shareholder (in 80% of cases, the government) controls 48% of listed companies shares, while the second largest shareholder owns less than 10% of these shares Poor Corporate Governance Practice by Listed Companies Concentrated ownership structures, executive-dominant boards and the lack of an effective corporate control market have long been argued as causes of Chinese listed companies poor governance practices. In China, most listed companies are spin-offs from large SOEs, and in most cases, they still share human resource functions, capital and assets with the parent companies, who often are, by far, the largest shareholder. Local or central governments, instead of shareholders, often appoint the management of listed companies. As a result, the management constantly takes actions in favor of the largest shareholder, and seldom considers the interests of minority shareholders. 4 Even though a new IPO mechanism was introduced in 2001, which is intended to liberalize the IPO decisions of firms, the CSRC still tightly controls the number and pace at which new firms go public. Going public is still inaccessible for most non-soes. 5 Based on Bai, Liu and Song (2002), the value of Chinese listed companies listing status amounts to 29% of their market capitalization. 6

9 Due to the fact that only around 30% of listed companies shares are publicly tradable, and that the controlling shareholders normally hold more than 40% of total shares, controlling shareholders are rarely challenged by other shareholders on important issues. Minority shareholders cannot take listed companies to court, due to limitations in the civil law, and a lack of punishment spectrum in the current securities laws 6. Listed companies, therefore, are the nexus of a series of related party transactions carried out for the benefit of the controlling shareholder. Anecdotal evidence suggests that controlling shareholders treat listed companies as cash machines, from which they can withdraw money whenever they wish. 7 Compared to their counterparts in the U.S., Chinese listed companies rely more heavily on equity financing for two reasons. First, the banking sector in China is not well developed, nor efficient, which increases the external financing constraints. Second, equity financing carries relatively low costs, and leaves the listed companies with more flexibility. Listed companies are not placed under a great deal of pressure to report to minority shareholders how they have used the raised capital unless they are involved in serious civil litigation or criminal charges. Listed companies constantly misuse raised capital, usually favoring the controlling shareholder. Examples of poor corporate governance practice are abundant. In 2001, the largest shareholder of Meierya a then profitable company, colluded with other insiders to embezzle US$44.6 million, 41% of the company s total equity. In the same year, Sanjiu Pharma s largest shareholder extracted US$301.9 million, 96% of the listed company s total equity Incentives to Manage Earnings 6 For example, current Chinese securities laws do not allow stringent legal enforcement. Regulators can only take extreme actions, i.e., prison sentences or warnings, but are unable to punish intermediate wrongdoings. 7 A recent study conducted by Shanghai s Shenying and Wangguo Securities Co., Ltd. Surveyed 130 listed companies and found that the companies largest shareholders on average owed listed companies US$ 40 million in the form of account receivable or parent borrowings. (See the article in Caijin (Finance and Economics) Magazine, June 5 Issue, 2002). 7

10 Listing status carries special value for controlling shareholders in China for a very important reason: through secondary and right issues, listed companies are able to tap the everincreasing capital base in China. 8 There is a huge demand from domestic investors for new equity issues. In 2000, 47% of equity issuance was in the form of secondary and right issues: through which listed companies raised US$ 9 billion capital. The amount could have been much larger if more listed companies had earned the right to secondary or right issues. To be eligible for secondary or right issues, a listed company has to satisfy several requirements. For example, a listed company has to maintain at minimum, a reported return on equity (ROE) of 6% for three consecutive years, and the average ROE over these three years must be no less than 10%. This is not an easy task for most Chinese listed companies considering that the average ROE for all listed companies was just 6.9% in Nevertheless, a reasonable amount of listed companies manage to achieve the requirements. Market observers and public investors attribute this to earnings manipulation, which has been ubiquitous throughout Chinese listed companies. The requirement to obtain an ROE of 6% or greater provides the management of companies with a strong incentive to manipulate reported earnings. An example may illustrate the point. On March 17, 1999, one and a half months before the deadline for releasing 1998 annual reports, the CSRC revised the requirements for secondary and rights issues from an annual ROE greater than 10% for three consecutive years to an average ROE greater than 10% over a three-year period with no annual ROEs below 6%; the average reported ROE dropped abruptly to 7.4% in 1998 from 9.5% in A simple t-test shows that 8 China s total savings amounted to 8 trillion Yuan (around US$ 1 trillion) in The majority of the savings are held in the form of bank deposits. However, an inefficient banking sector and the increasing non-performing loans have shifted investor s attention to the equity market. The number of stock investors reached 80 million in More and more, policy makers have started to promote the equity market as a way of absorbing savings and transferring them into equity capital. 8

11 the difference between ROEs for these two years is statistically significant (t-statistic = -3.57). Obviously, managing earnings above certain thresholds is key to the ability to tunnel Figure In an attempt to protect minority shareholders and to encourage better corporate governance, the CSRC has stipulated that a publicly traded company may be de-listed if it reports net losses for two consecutive fiscal years. To the controlling shareholders and other insiders, delisting suggests the loss of further rent-seeking opportunities through secondary or right issues, or through related part transactions; it is an end game every listed company will take steps to avoid. Avoiding de-listing provides Chinese listed companies with another incentive to manage earnings: to report a profit. 9 Figure 2 presents two histograms. Figure 2a shows a histogram of net income scaled by beginning total assets for China's listed companies from 1991 to It is not surprising that very few companies reported have reported losses throughout the history of China s equity markets Figure 2a An infamous scandal recently highlighted disclosed that the management of Yinguangxia, with the assistance of its auditing firm, fabricated US$ 90million in earnings over the period 1999 to The company was able to earn the right to hold right issues. Before the scam was exposed, the listed company raised a tremendous amount of capital through several right issues, the majority of which was later transferred to the listed company s controlling shareholder. CSRC later discovered that a small group of corrupt executives, with the help of the company s auditing firm, had been manipulating Yinguanxia s financial statements all along. Its listing status, consequently, was suspended. 9

12 Figure 2b presents a histogram of ROE for China's listed companies from 1999 to It is apparent that a disproportionately high number of companies reported ROEs just slightly over 6% and 10% Figure 2b Obviously, in China s stock market, earnings management is closely connected to the tunneling activities of controlling shareholders, among which secondary and right issues are the most conspicuous. 3. Data and Empirical Design 3.1. The Sample Our empirical analyses require both financial information and corporate governance data. The corporate governance data used in our tests are manually collected from annual reports. Not until the year 2000 did Chinese listed companies annual reports contain relevant information about aspects of a listed company s corporate governance, such as ownership structure, executives shareholding, board structure, etc. Therefore, our analyses only focus on the year 2000 and thereafter. Listed companies financial data are collected from the CSMAR Financial Databases developed by Shenzhen GTA Information Technology Co., and the China Accounting and Finance Research Center at the Hong Kong Polytechnic University. There were 1,088 companies listed on the Shanghai and Shenzhen stock exchanges by the end of However, in our analysis, we use listed companies historical financial data. Thus, we are only able to focus on 10

13 companies listed prior to Our sample therefore consists of 894 companies that provide all the necessary financial and governance data Variables and Hypothesis Development Measure of earnings management As we have argued previously, earnings management is a crucial step for a listed firm to tunnel. To carry out our analysis, finding an appropriate measure of Chinese management s discretion over reported earnings is key. We use two variables, total accruals (ACC), and industry-median-adjusted accruals (IAACC), to proxy for earnings management. ACC is defined as the difference between net income (NI) and cash flows from operating activities (CFO) divided by average total assets (TA) in : ACC i = NI i CFO ( TA + TA ) / i, 2000 i, i (1) Most earnings management literature uses abnormal accruals estimated from a specific model to measure earnings management. We select the total accruals as a measure of earnings management for two reasons. First, we do not have a reliable model for estimating abnormal accruals in Chinese companies. Given the unique nature of China s stock market and accounting regulations, it is difficult to argue that any model well received in the developed markets can easily be applied without major adjustments. Second, our study examines the relationship between managers earnings management and corporate governance. Our independent variables are proxies for various corporate governance mechanisms. It is unlikely that these variables correlate with the non-discretionary component of the total accruals. To the extent that our independent variables are uncorrelated with the non-discretionary component of the total 10 The average of total assets at the start and the end of the year. 11

14 accruals, the empirical relations detected in our analyses can be attributed to the correlation between the discretionary component of the total accruals and the independent variables. Most studies using U.S. data define total accruals as the difference between earnings before extraordinary items and operating cash flows. Under Chinese GAAP, so-called onetime items, such as extraordinary items and discontinued operations, are not reported separately. On China s standardized income statement, profit from operations is sales revenue less cost of goods sold and operating expenses, plus profits (losses) from non-major operations; total profit includes profit from operations, gains (losses) from disposal of assets and investments, and other revenues and expenses; net income is total profit less income taxes 11. The main results reported in the paper are based on accruals calculated from net income. We also conduct relevant empirical tests using accruals calculated from profit from operations and total profit. All results are qualitatively similar. Our industry median adjusted accruals is defined as the difference between a firm s ACC and the median ACC of the industry the firm belongs to: IAACC i = ACC i - Industry median ACC (2) We adjust total accruals by the industry median to control for common determinants of accruals among firms in the same industry Measures of various corporate governance aspects Earnings management is a common practice in China s listed companies; the extent to which it is practiced however varies. The incentives to manage earnings or to tunnel depends on the amount of rents up for the controlling shareholder to grab and the quality of corporate governance in the listed firm. Cross sectional analyses of earnings management can better test 11 Therefore, both above the line and below the line items in an American income statement are included in China s operating income. 12

15 the paper s main hypothesis: earnings management is related to tunneling activities, and its degree determined by a series of corporate governance factors. Economists characterize corporate governance as a set of mechanisms protecting investors from opportunistic behavior; these mechanisms may be internal or external. Internal mechanisms include dispersed ownership structures, independent boards of directors, formal board processes, timely and accurate disclosure of relevant information, etc.; external mechanisms include the existence of active external take-over markets, a shareholder-friendly legal infrastructure, well-established capital markets, etc. We use a number of variables to capture various corporate governance aspects. S We define TOPSHARE as the percentage of shares held by the largest shareholder, or 1 S, where S 1 is the number of shares held by the largest shareholder and S is the total shares outstanding. This variable is a measure of the largest shareholder s interest in a company and also the largest shareholder s power in the board. Most corporate governance evaluation frameworks place positive values on a dispersed ownership structure 12. Specifically, it is argued that concentrated ownership (e.g., existence of one ultimate firm owner) is one of the main causes of Asian companies poor governance practices 13. The ability of controlling shareholders to expropriate minority shareholders is directly related to the degree to which they control the company. Obviously, a higher TOPSHARE corresponds to a lower governance level and a higher incentive to tunnel. Therefore, we expect a positive correlation between TOPSHARE and earnings management measures, ACC and IAACC. 12 Several recently released reports, such as the OECD CG report, ADB CG report, S&P company level corporate governance rating, and CLSA emerging market governance rating all assume dispersed ownership structure as a requirement for good governance. 13 See Claenssens, Djanov, and Lang (2000). 13

16 In addition, we define TOPEXECSHARE as the percentage of the shareholding held by the top executives, which include the CEO, the executive vice presidents, the chairperson and the vice chairpersons of the board of directors. TOPEXECSHARE measures the top executives interests in a company. Here, a higher TOPEXECSHARE indicates that the management s interests are more in line with that of the controlling shareholder in China s stock market. If the controlling shareholders intend to expropriate minority shareholders, then management teams who own more shares tends to be more cooperative. Executives have stronger incentives to window dress a listed company, since they share a larger interest in doing so. We expect a positive correlation between earnings management measures, ACC and IAACC, and TOPEXECSHARE. Klein (2002) finds that boards of directors are more effective in monitoring managers financial reporting behavior, if they are more independent of the CEO. In our research setting, board structure is not only a mechanism of monitoring a company s financial reporting process, but also an instrument to curb controlling shareholders tunneling behavior. We construct two variables to capture the independence (or the lack thereof) of boards in Chinese public companies. The first variable is CEO_DIR, which is a binary dummy variable that equals 1, if the company s CEO is also the chairperson of the board; otherwise, it equals 0. When the CEO is also the board chair, they have more control over the board. It is more difficult for minority shareholders to have a say on important issues in the company. Tunneling is, therefore, more likely to happen. Again, we expect a positive correlation between earnings management and CEO_DIR. The second variable is OUTSIDEDIR, which is defined as the ratio of the number of directors who do not receive any compensation from the company to the total number of directors. We believe that outside directors who do not receive compensation from the company 14

17 are more independent than those who do receive compensation from the company in monitoring the management and controlling shareholders. We expect earnings management and OUTSIDEDIR to be negatively correlated. Controlling shareholders tend to expropriate minority shareholders when they are less likely to be challenged by other shareholders. An active takeover market does not exist in China s stock market. However, sometimes other shareholders consolidate their voting rights in order to seriously challenge opportunistic controlling shareholders. In China s stock market, the percentages of shares owned by large shareholders other than the largest shareholder and their degree of concentration, therefore, count for much. We use SHARE2_10 as a measure of the likelihood that other large shareholders challenge the largest shareholders. SHARE2_10 is defined as 10 S 2 SHARE2_10 = ( n *100), (3) S n= 2 where S n is the number of shares held by the n th largest shareholder, and S is the number of shares outstanding. SHARE2_10 is the sum of the squares of the percentage shareholdings held by the second to the tenth largest shareholders; this is a Hirfindal-type measure for the concentration of shareholding held by the second to the tenth largest shareholders. This variable captures the availability of the corporate control market. The larger the SHARE2_10, the more likely it is that the controlling shareholder will be challenged by other shareholders. Therefore, we expect a negative correlation between SHARE2_10 and ACC and IAACC. Finally, we construct a variable HBSHARE, which is a dummy variable with value equal to 1 if a listed company has H shares traded in the Hong Kong Stock Exchange or B shares traded in the Shanghai or Shenzhen stock exchange, 0 otherwise. Both H and B shares are mainly open to foreign investors. Firms issuing H or B shares must adopt international accounting standards, 15

18 and have their financial statements audited by internationally recognized accounting firms. Generally, listed companies with H or B shares face more stringent monitoring from investors. The management of these firms is subject to greater scrutiny from sophisticated investors. They are therefore less likely to tunnel. We expect a negative correlation between HBSHARE and earnings management Summary statistics Table 1 provides summary statistics of the variables. The mean (median) total accruals as a percentage of total assets is -1.53% (-0.1%). There is a big variation in ACC. The highest (lowest) ACC is 43.79% (-97.76%); the standard deviation is 10.98%. The mean (median) industry median adjusted accruals as a percentage of total assets is -0.6% (0%) Table Recall that our measure of the shareholding by the second to the tenth largest shareholders is a Hirfindal-type index. The summary statistics for this variable do not intuitively describe the shareholding by the second to the tenth largest shareholders in a company. Therefore, we also present the raw shareholding data, which is labeled RAWSHARE2_10. RAWSHARE2_10 represents the sum of the percentages of shareholding held by the second to the tenth largest shareholders. The mean (median) percentage of shares held by the second to the tenth largest shareholders in our sample firms is 16.81% (13.32%). In the company with the least shares held by the second to the tenth largest shareholders, less than one tenth of one percent of the shares were held by these shareholders. These statistics generally reflect the ownership 16

19 structure of China s publicly listed companies. The state controls most listed companies in China often through a holding company and the state shareholding dominates other shareholders. The fifth row in Table 1 summarizes the variable OUTSIDEDIR. In our sample, the mean (median) percentage of board members who do not receive any compensation from the company is around 49% (54%). In some companies, all of the board members receive some compensation from the company and in others none receive any compensation. However, we believe the variable should be considered on a discretionary basis given the fact that it is not only the board composition that matters, formalized board decision making mechanisms play an even more important role. The sixth row summarizes TOPSHARE, which describes the percentage of shares held by the largest shareholders. As we have discussed, most Chinese listed companies are directly controlled by the state either through a state asset management authority or indirectly through a holding company and the largest shareholder in a company usually holds a very high percentage of the company. The summary statistics of TOPSHARE confirm this. The mean (median) percentage of shares held by the largest shareholders in our sample firms is 44.3% (43.3%). In seventy-five percent of the companies, the largest shareholder controls nearly 30% of the shares. Such a concentrated ownership structure contrasts sharply with that seen in European and American public companies. Top executives, are found on average, to hold only a little over one hundredth of one percent of their company s shares. Meanwhile, the summary statistics also suggest that about 32.6% of the CEOs in our sample firms were also the chairperson of the board. Finally, we find that around 11% of the companies in our sample had either H shares or B shares available mainly to foreign investors at the end of

20 Our summary statistics also show that, on average, the total assets (revenue) of our sample firms is Y1,781 (Y1,009) million, which is about US $ 215 ($122) million dollars. Compared to their Western counterparts then, China s listed companies are fairly small. 4. Empirical Results 4.1. The correlation between earnings management and corporate governance level In order for the controlling shareholders in China s listed companies to expropriate wealth from minority shareholders, they must keep their company s public listing status or obtain right offerings after the company goes public; since reported earnings tends to be the only important instrument used by regulators in IPO and right offering decisions, we believe that Chinese company s earnings management behavior is closely related to the controlling shareholders tunneling behavior. As discussed, we use total accruals (ACC) and industry median adjusted accruals (IAACC), both scaled by average total assets, as a measure for earnings management. Therefore, our empirical tests focus on the relationship between ACC/IAACC and corporate governance variables. The first set of corporate governance variables, SHARE2_10, HBSHARE and OUTSIDEDIR, measure the restraining mechanisms (internal and external) operating on the tunneling activities of controlling shareholders. We expect ACC and IAACC to be negatively correlated with them. The second set of corporate governance variables, TOPSHARE, TOPEXECSHARE, and CEO_DIR, measure the level of incentive for controlling shareholders to tunnel. We expect ACC and IAACC to be positively correlated with them. The relationship between TOPSHARE and the dependent variables requires further explanation. We expect the relation between ACC/IAACC and TOPSHARE to exhibit an inverse U-shape. As the largest shareholder s interest in the company increases, his opportunistic behavior increases. However, 18

21 when the largest shareholder s interest in the company reaches a certain level, his incentive to further expropriate the firm s wealth may decrease, since the net gain of tunneling is not that great any more. Therefore, we include the square of TOPSHARE in the regression. We expect a negative coefficient on this variable. We run the following regression model to test our hypothesis: ACC ( IAACC ) = α + β ln( SHARE2 _10 β SIZE i + β ( TOPSHARE ) 8 4 i + ε i i i 2 1 i ) + β OUTSIDEDIR + β TOPSHARE + β TOPEXESHARE + β CEO _ DIR + β HBSHARE + 5 i 2 6 i i 7 3 i i (4) In our empirical analyses, we use the natural log of SHARE2_10, instead of SHARE2_10 itself, to bring the coefficient on that variable to a scale compatible with the coefficients on other variables. We also include SIZE, defined as the natural log of total assets, in the regression to control for undetermined size effects Table Table 2 presents the univariate correlations between variables in the regression model. Statistically significant correlations are highlighted. ACC and IAACC are negatively correlated with ln(share2_10) and OUTSIDEDIR, however, the correlations are not significant. As expected, ACC and IAACC are significantly negatively correlated with HBSHARE. ACC and IAACC are significantly positively correlated with TOPSHARE, TOPEXESHARE, and CEO_DIR. Contrary to our expectation, ACC (IAACC) is insignificantly (significantly) positively correlated with the square of (TOPSHARE) Table 3 19

22 Table 3 presents the regression results. In general, the regression results support our main hypothesis. In Table 3, ACC (IAACC) is significantly positively correlated with TOPSHARE, TOPEXESHARE, and CEO_DIR, suggesting that expropriation of firm wealth increases with the largest shareholder s interest in the company, the top executives personal interest in the company, and the lack of independence of the board. ACC (IAACC) is also negatively correlated with the square of TOPSHARE, suggesting that as the largest shareholder s interest in the company reaches a threshold, his opportunistic behavior decreases. More strikingly, we find that HBSHARE is significantly negative, which implies that listed companies with H or B shares are not as keen to manage their earnings. However, the relation between ACC (IAACC) and ln(share2_10) is insignificant. Finally, both ACC and IAACC are positively correlated with SIZE, suggesting that earnings management and tunneling behavior are more problematic in larger companies. As discussed previously, our measure of the concentration of shareholding held by the second to the tenth largest shareholders is a Herfindal-type variable. After replacing this variable with RAW2_10, we re-run the regressions. The results are qualitatively identical to these shown in Table Earnings management to earn the rights to secondary and right issues Our analyses above show that Chinese listed companies earnings management depends on their corporate governance practices. Companies that pursue higher governance standards are less likely to manage their earnings. As we discussed in the previous section, the incentive to manage earnings also depends on how urgently the companies need to do so. Since regulators 20

23 use a single accounting variable as the key policy instrument, we expect earnings management behavior in China s listed companies to be more prominent around the decision thresholds. Since 1999, to obtain the right to hold secondary and right issues, a listed company must maintain, at minimum, a ROE of 6% for three consecutive years, and the average ROE over these three years must be no less than 10%. We test whether companies manage earnings to reach this threshold. We bisect our sample firms. The first group consists of firms reaching the decision threshold based on their ROE in 2000 and for the previous two years 14. The second group consists of firms that did not reach the threshold. We test whether the average ACC/IAACC in the first group is significantly higher than that for the second group. In this test, we consider two ROEs. The first is the core ROE, which is defined as profit from operations divided by book value of equity. The second is non-core ROE, which is defined as total profit divided by book value of equity. As discussed in Section 2, on China s standardized income statement, profit from operations is defined as sales revenue less cost of goods sold and operating expenses; whereas total profit includes profit from operating activities, gains (losses) from disposal of assets and investments, and other revenues and expenses. Therefore, profit from operations measures the profitability of a company s core business activities; total profit measures the profitability of both the core and non-core business activities of a company. We believe that it is easier for managers and controlling shareholders to manipulate reported profit through non-core activities, since they can exercise a larger degree of discretion over these none-core business activities Table 4a and Table 4b 14 To be included in this category, the companies have to satisfy two conditions: first, ROE for each of the three years (including 2000) is above 6%; second, the average ROE for the three years is above 10%. 21

24 Table 4a presents the results of the t-tests. Since the test requires three consecutive annual ROEs, companies that were not listed at the end of 1998 and 1999 are missing from the sample. The sample size drops to 784. Panel A of Table 4a reports the tests with the threshold based on core ROEs. In 2000, six hundred and sixteen companies reached the decision threshold based on their reported core ROE. The test result indicates that the average ACC/IAACC in companies exceeding the threshold is significantly larger than that in companies failing to achieve the threshold. Panel B reports the test with the threshold based on non-core ROE. Four hundred and twenty-seven companies reached the right offering threshold based on their reported non-core ROEs in Notice that the t-statistics in Panel B are more significant than those in Panel A, suggesting that many companies use non-core business activities as vehicles for managing earnings in order to pass the right offering threshold. The results presented in Table 4a may be caused by extreme values in the sample. We test this hypothesis using the Kruskal-Wallis test and Table 4b presents the test results. In Panel A (Panel B), we report the test results with the threshold based on core ROE ( non-core ROE). As the parametric tests indicate, the results-based on non-parametric tests also suggest that the ACC/IAACC values of firms that pass the policy thresholds are significantly larger than those in firms failing to pass the policy thresholds Earnings management to maintain tunneling opportunities A listed company will be labeled ST, if it reports a net loss for three consecutive years 15. ST firms generally face large pressure from the shareholders and the government to 15 ST stands for special treatment. It applies to listed companies making losses for three straight years or listed companies with abnormal financial positions. ST stocks are traded with a 5% price limit each day vs. 10% for 22

25 improve their operating performance and corporate governance. If an ST firm s performance does not improve within two or three years, the company may face de-listing. Therefore, we expect that managers and controlling shareholders have a strong incentive to avoid reporting losses. We select a sub-sample of firms that reported a net loss in 1998, 1999, and 2000, and firms that reported a net loss in 1998 and 1999, but a net income in In this sub-sample, firms reporting a net loss in the third year will be labeled ST ; firms reporting a net income in the third year avoid being labeled ST. We test whether ACC/IAACC are significantly higher in firms that successfully avoided the ST labeling Table 5a and Table 5b Table 5a (Table 5b) reports the t-test (Kruskal-Wallis test) results. Seventeen firms experienced three consecutive loss years; fourteen firms reported losses for two years, but managed to report a net income in the third year. Consistent with our expectation, Table 5a suggests that the average ACC/IAACC of firms that avoided the ST threshold is significantly higher than that of firms that did not avoid the ST threshold, indicating that managers manipulate earnings upward to avoid the possibility of de-listing. Non-parametric tests presented in Table 5b report similar results When tunneling becomes difficult normal stocks. If a ST firm cannot improve its performance over the next year, it will be labeled as PT, which stands for Particular Transfer. PT stocks are traded only on Fridays with a maximum 5% upside limit to the last trading day s closing price, but no restriction on the downside. A PT firm will be de-listed, if it cannot become profitable within a certain period of time (usually two to three years). 23

26 As explained in previous sections, earnings management in Chinese listed companies is a special form of tunneling. The incentive to tunnel or to manage earnings is weakened, if the controlling shareholders are subject to more stringent monitoring by investors. In order to tap international capital and to migrate their investor bases to a better mix, some Chinese listed companies have issued H shares or B shares to foreign investors 16. Companies issuing H/B shares have to present a set of financial reports that are based on international accounting standards. These companies often find themselves under greater pressure from regulatory authorities or foreign investors to disclose more firm-specific information. Foreign investors also demand more detailed explanations of how raised capital is used. We hypothesize that firms with H/B shares have weakened incentives to manage earnings. Our regression analyses presented in Tables 3 show that HBSHARE is negatively correlated with ACC/IAACC. In other words, firms with H/B shares are less likely to undertake income increasing earnings management Table 6a and Table 6b In Table 6a and Table 6b, we further demonstrate this point. We classify our sample firms into two groups: one with H/B shares and the other with none. Consistent with the regression results, Table 6a shows that the average ACC/IAACC of firms that have H/B shares is significantly lower than that of firms that do not have H/B shares, suggesting that when tunneling become difficult, managers are less likely to manage earnings. Non-parametric test results shown in Table 6b confirm this conclusion. 16 H shares are common shares trade in the Hong Kong Stock Exchange; B shares are common shares mainly open to foreign investors, they are traded in the domestic exchanges. 24

27 Taken together, our empirical results suggest that managers and controlling shareholders in China s publicly listed companies manipulate earnings to achieve objectives that eventually help them to expropriate minority shareholders wealth. We also show that such manipulation is associated with a firm s corporate governance mechanisms. 5. Conclusion In this study, we examine the relations between the so-called tunneling behaviors of controlling shareholders, corporate governance and earnings management in China s publicly traded companies. For a sample of 894 firms listed on the Shanghai and Shenzhen stock exchanges in 2000, we analyze the relations between total accruals and industry median adjusted accruals, our proxies for earnings management, and a series of corporate governance variables. Consistent with our expectations, we find that total accruals are positively correlated with the largest shareholder s interest in a company, top executives interests in the company, and whether the board of directors is chaired by the CEO, suggesting that tunneling is more problematic in companies with powerful controlling shareholders, with CEOs that have great personal interests in companies, and with boards that are less independent. Our analyses also suggest that when the largest shareholder s interest in a company reaches a certain level, his opportunistic behavior decreases. In addition, we find that total accruals in our sample firms are correlated with the place shares are listed. Specifically, we find that the total accruals and industry median adjusted accruals of companies that have H shares traded on the Hong Kong Stock Exchange or B shares traded on the domestic exchanges are lower than those of companies that only have shares sold to domestic investors. This evidence suggests that tunneling by controlling shareholders is constrained by more stringent accounting rules and closer investor monitoring. 25