Very preliminary, comments welcome..doc

how far would management go to manage earnings? -the evidence from chinaguohua jiang liyan wangthe guanghua school of managementpeking universitybeijing 100871chinadecember 2003 very preliminary, comments welcome.the authors are assistant professor and professor, respectively, of the guanghua school of management, peking university, beijing 100871, china. we thank wenwen chen, chen li and jingqi lu for excellent research assistance. please send comments to and . i. introductionearnings management has been one of the most widely studied corporate behaviors in accounting literature. basing on this large body of research, accounting scholars have largely agreed that company management manages corporate earnings to meet certain targets. the incentives for earnings management include bonus contracts, debt covenants, initial public offerings and seasonal public offerings, etc. in terms of the means of earnings management, although accounting scholars recognize the possibility that management may manipulate real activities (company operation) to meet earnings targets, the vast majority of studies identify accrued earnings as the mean through which earnings management is achieved. one recent exception is roychowdhury (2003).earnings management (em hereinafter) leads to misleading accounting information being communicated to information users. various groups of capital market participants may suffer as a result, such as shareholders (bonus-driven em), creditors (debt covenant-driven em), and potential shareholders (ipo-driven em). however, other than under its extreme form (accounting frauds or crimes), accrual-based em does not seem to do serious harm to its victims. the reason is that the discretion on accruals is bounded by gaap (barton and simko, 2002). given the underlying economic transactions of a firm, the managements ability to report accrued earnings is limited. overtime, accruals will reverse as well, so management has to consider the implications of their discretion on current accruals for future earnings. this consideration in turns constraints accrual-based em as well.what if management can manipulate real activities (company operation) to manage earnings? that is- will managers go such a long distance to achieve their em targets? will in this case myopic em behaviors do significant harm to its “victims”? surveying the em studies with u.s. firms as samples, we find little research on these two questions. the reason is simple. the united states has one of the best-developed capital markets in the world. the complexity of its institutions guarantees that the market participants, including company management, do not engage in self-serving activities that is beyond a certain acceptable limit. however, what if the limit is loose? will managers engage in more real activity-based em in this case? our paper answers this question with data from chinas stock market.china opened its current stocks markets at shanghai and shenzhen in early 1990s. by september of 2003, there are more than 1,200 company stocks traded on the two exchanges, with a total market capitalization of 1,266 billion rmb (153 billion us dollars).in almost all aspects, chinas stock market is an emerging market. one significant difference between chinas stock market and other world markets is in the ownership structure of listed companies. when china embarked on economic reform in the late 1970s, its main purpose was to improve the operating efficiency of state-owned enterprises (soes). the introduction of stock market was one step in this reform. therefore, chinas government involvement in the development of stock market is instrumental and the governments top priority was to list soes on the new stock markets. after a soe went public, the government usually retained a controlling interest in the listed company. moreover, the shares retained by the government are not traded. this practice in fact divides shareholders into two groups: one group with un-traded shares who in most cases controls the listed company, and the other group with traded shares who lacks control over the company. government regulation of the stock market is very strict. as in an emerging market, the right to get listed on stock exchanges is a scarce commodity. chinas government actually sets a very high standard and even a quota system to list companies. for example, the quota system limits the book value of equity of the tradable shares to a certain amount. as a result, most soes that would like to get listed cant actually list their whole company. in addition, the soe itself may not be able to meet the past profitability requirement of listing. to list at least a part of the soe, the soes usually carve out the best parts of the corporation to form a new subsidiary and then apply to list the subsidiary. therefore, most listed chinas companies are actually subsidiaries of larger soes. soes hold controlling interests in the listed companies, and government in turn controls soes. central and local governments also directly own listed companies through their bureau of asset management. as a result, chinese government, through its various levels and different branches, still retain controlling interests in most listed companies. and listed companies, though nominally independent, face government interference in their internal operation.another feature of chinas stock market is that most management regards equity capital raised from the stock market as cost-free, and rightly so. because parent soes and/or various government agencies still own the majority of the common shares, and due to the lack of protection of minority shareholder rights, company management is still only responsible to the parent soes and government, brushing aside the rights of minority shareholders. in fact, equity capital raised on stock market is a substitute for bank loans. in the case of bank loan, companies will have to answer to banks, but the companies do not have to answer to minority shareholders at all. given these features of chinas stock market, there exist two strong incentives for companies to manage earnings.first, it is difficulty to get listed on the stock exchanges, and it is also easy to get delisted from the exchanges. chinas sec sets specific requirements for companies to stay listed. once any of these requirements are not met, companies would be put into probation, and if the companies do not satisfactorily improve their performance, they will be delisted at the end of the probation period. section two of this paper provides a chronicle of these requirements. delisting is a big deal on any stock markets, but it is a bigger deal for chinas listed companies. as discussed earlier, these listed companies went through a very tough process to get listed, once they got listed, they normally achieved star status in their respective local areas. listing not only helps these companies raise capital, which is basically cost-free in contrast to other financing channels such as bank loans, it is also been regarded as a performance measure of the local government heads. therefore, companies, once facing the possibility of delisting from the stock exchanges, have stronger than usual incentive to find ways to meet requirements to stay listed. the soes behind the listed companies, and the government agencies behind soes, also have strong incentive to support the listed companies (chen, lee and li, 2003). on august 13, 2003, sohu business news reports a story. zong heng corporation of jian su province had two consecutive loss years in 2001 and 2002. the stock exchange put the company stock under special treatment (*st, i.e., probation). if the company does not make profits in 2003, the stock will be delisted. moreover, the semiannual financial report to be released is going to report losses and predict a loss of the third quarter. to avoid delisting of zong heng stock, it is reported that jian su government gets involved in restructuring of the company in the hope to turn profit in 2003. one company insider was quoted as saying: “although time is short, if the (government-backed) restructuring moves fast, it is entirely possible that we have a profit year and avoid delisting.”second, most listed companies also raise additional capital from the stock market through rights offerings. chinas sec places even stronger constraints on the privilege to do rights offering. a company must meet return-on-equity (roe) thresholds in the years prior to a rights offering. section two of this paper provides a chronicle of these requirements. given that management regards equity capital raised on stock market as cost-free, it is in their interest to pursue rights offering even that means they have to manage company earnings. plus, there is evidence that the parent soes encourage and help listed companies to raise more capital and then tunnel the money into the parent companies (jian and wong, 2003).compared to the incentives that prompt u.s. managers to engage in earnings management (bond contracts, debt covenants, ipo and seo, etc.), the incentives of chinas company management to avoid delisting from the stock exchanges and to raise more capital through rights offerings are much stronger. if accrual-based em is not enough to meet respective qualification requirements, we conjecture that with the backing of soes and governments, chinas listed companies may engage in radical form of em such as managing real activities of the company to meet these requirements. there is no guarantee that this type of em will benefit shareholders. it only keeps the companies listed or helps them loot more capital, but potentially could have damaged the company in the long run.it is the purpose of this paper to examine real activity-based em in chinas listed companies. this paper adds to the em literature in the following ways. first, we identify two em incentives that have been less commonly studies before, managerial incentive to avoid delisting from stock exchanges and to raise more capitals. second, we identify some real activities-based em techniques in addition to conventional accrue-based em techniques, namely asset sales/purchase/exchanges and equity sales/purchase. third and most importantly, our paper shows that company management could go as far as altering real activities to meet earnings targets. the evidence of em in accounting literature has been abundant, but how far would management go to do em is not clear. this paper provides evidence that management would go further than accrual management to manage earnings. a few recent papers also study earnings management in chinas stock market. jian and wong (2003) find that listed companies manage earnings through related-party sales, and parent soes of listed companies tunnels resources into or away from the listed companies to extract benefits from the listed companies. liu and lu (2002) find that corporate governance is an important factor in deciding whether companies manage earnings. weak corporate governance companies with a large controlling shareholder tend to manage earnings to exceed regulatory thresholds and at times tunnel resource away from the listed companies. chen, lee and li (2003) find that local government uses its tax and fiscal policies to help listed companies from its jurisdiction manage earnings to circumvent central government regulatory requirements. our study differs from the three papers in that we look at more dramatic forms of earnings management. that is, we look at real activities that in essence change the operation of the listed companies. our study presents a striking phenomenon of earnings management at high costs.ii. a chronicle of csrc requirements on stock listing and rights offeringin this section, we provide a chronicle of csrc requirements on stock listings and rights offering. during the short history of chinese stock markets, regulation has to change frequently to keep pace with the fast development of the markets. in terms of delisting policy, the chinese company act of 1993 mandates that if a listed company suffers three consecutive loss years, its stock will be suspended from trading on the exchanges and put into probation. if the company does not make satisfactory improvement during the probation period, its stock will be delisted. from february 2001, the probation period is one year and during the probation period, the company stock is up under particular transfer (pt) status. however, after january 1, 2002, crsc removed pt status and installed special transfer (st) status instead. csrc also shortened the probation period to half-a-year. it is clear that crsc monitors closely those firms who do not show profitability in consecutive years and deal with them with the punishment of delising.in terms of rights offering, in 1993, csrc requires two years of profits for companies to be eligible for rights offering. in september 1994, csrc stops to require profits only, but require the average return on equity (roe) of the previous three years not below 10 per cent. in january 1996, csrc further tightens the requirements to require roe not below 10 per cent in each of the previous three years. in march 1999, the requirements change to average roe not below 10 per cent and roe not below 6 per cent in each of the previous three years. in march 2001, cscr requires weighed-average roe not below 6 per cent in the previous three years.the csrc requirements create two critical thresholds for listed companies, one is zero profit and the other is 6 per cent or 10 per cent roe. if possible, a company will prefer to report small profit instead of small loss to avoid getting into a delising trap, or to report a roe above 6 per cent or 10 per cent instead of slightly fall short in case the company needs to raise more capital from stock market in the next few years. prior studies have documented out-of-proportion number of firms reporting small profits, or reporting roe slightly higher than 6 per cent or 10 per cent, depending on which years data was used.prior literature has ably documented that once a company is going to miss all meaningful earnings thresholds (zero profit, analysts forecast, earnings of the same period in the previous year), management tends to “take a big bath” to earnings (abarbanell and lehavy, 2001). a “big bath” to current earnings creates earnings reserve for future years. therefore, in this paper, we identify three scenarios where earnings management is suspected: big loss firms whose roe fall below negative 10 per cent (big loss group), small profit firms whose roe fall between zero per cent and 2 per cent (small profit group), and rights offering firms whose roe fall between 6 per cent and 8 per cent (rights offering group). all other firms are put into one group: other firms group.iii. identifying real activity-based earnings management techniqueswe identify five real activities that we suspect were used to manage earnings, equity sales, equity purchase, asset sales, asset purchases, and asset exchanges. for the sake of this paper, we call these activities earnings management activities. equity sales refer to companies selling ownership in another firm, sometimes a subsidiary. equity purchases refer to companies buying ownership in another firm. if these transactions are purely based on fair market prices, the room for earnings management is limited. however, as discussed earlier, a parent soe usually controls the listed company, and the soe tends to control a net of other companies. furthermore, the local government behind the soe controls more companies. this complex net of connections offer listed company opportunities to engage in equity sales and equity purchases that generate profits. surveying the news reports on these so called “restructuring transactions”, it at first appears that the “restructuring transactions” do not make economic sense for at least one party in the transactions, but tracing the roots of each party, quite often, will lead to the controlling shareholders of the listed company or local government. it is not rare that ownership sold (purchased) by the listed companies in one year was purchased back (sold) in another year. there are a few ways equity sales/purchases would affect earnings and roe. for equity sales, the earnings the sold equity generates from beginning of the year to the date of sales could be recognized; for equity purchases, the earnings the purchased equity generates would be recognized. assuming companies have a good idea about the earnings-generating ability of the equity, they would certainly pick subsidiary to sell, or other company to purchase so that their earnings target is met. also, for equity sales, gains may be generated because selling price is higher than book value of the sold equity. a more subtle impact of equity sales/purchases is that equity sales/purchases may change the consolidation base of financial reporting. a subsidiary which was consolidated in financial reporting may not need to be consolidated after the listed company sold a certain portion of its holding in this subsidiary. after equity purchase, the listed company may need to consolidate a new subsidiary. therefore, we believe listed companies, with the backing of parent soe and local government, may “strategically” use equity sales/purchases to manage earnings.similar arguments can be made for asset sales, asset purchases and asset exchanges. therefore, in this paper, we examine whether chinese listed companies use these five activities to manage earnings. iv. empirical resultswe hand-collect earnings management activities for 704 listed companies on the shanghai stock exchange which had announced their 2002 annual results before