Value relevance, earnings management and corporate governance in China

    Value relevance, earnings management and corporate governance in China Yuan George Shan PII: DOI: Reference:

S1566-0141(15)00021-7 doi: 10.1016/j.ememar.2015.04.009 EMEMAR 412

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Emerging Markets Review

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Please cite this article as: Shan, Yuan George, Value relevance, earnings management and corporate governance in China, Emerging Markets Review (2015), doi: 10.1016/j.ememar.2015.04.009

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ACCEPTED MANUSCRIPT Value relevance, earnings management and corporate governance in China

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Yuan George Shan* School of Accounting and Finance The University of Adelaide Tel: (+61 8) 8313 6456; Fax: (+61 8) 8313 0170 Email: [email protected]

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ABSTRACT

This study investigates whether earnings management reduces the level of value relevance and whether good corporate governance restrains earnings management. Using handcollected data comprising 1,012 firm-year observations from all companies listed on the

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Shanghai SSE 180 and the Shenzhen SSE 100, the results show that the negative impact of

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value relevance for the companies engaged in earnings management is greater than the companies that have not engaged in earnings management engagement. Furthermore, the

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companies with good corporate governance practices are more likely to constrain earnings

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management than those without.

Keywords: China; Corporate governance; Earnings management; Value relevance JEL classification: G31; G32; G34; G38; M41

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Corresponding author

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ACCEPTED MANUSCRIPT Value relevance, earnings management and corporate governance in China

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Yuan George Shan School of Accounting and Finance The University of Adelaide Tel: (+61 8) 8313 6456; Fax: (+61 8) 8313 0170 Email: [email protected]

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ABSTRACT

This study investigates whether earnings management reduces the level of value relevance and whether good corporate governance restrains earnings management. Using handcollected data comprising 1,012 firm-year observations from all companies listed on the

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Shanghai SSE 180 and the Shenzhen SSE 100, the results show that the negative impact of

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value relevance for the companies engaged in earnings management is greater than the companies that have not engaged in earnings management engagement. Furthermore, the

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companies with good corporate governance practices are more likely to constrain earnings

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management than those without.

Keywords: China; Corporate governance; Earnings management; Value relevance JEL classification: G31; G32; G34; G38; M41

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ACCEPTED MANUSCRIPT 1. Introduction Since Ball and Brown (1968) began exploring the correlation between accounting

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earnings and stock returns, later studies (e.g. Ohlson, 1995) expanded to include market

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earnings to measure value relevance – a new concept of accounting information. A common feature of this research assumes that the value relevance could be empirically evident by the

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relationship between financial information and market price or return if the accounting

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figures would be able to reflect the information underlying stock evaluation (Francis and Schipper, 1999; Kothari, 2001). While earlier studies focused on the U.S. market, an increase in value relevance of accounting information has been found in global markets. Examples include Australia, France, the Netherlands and the UK (Alford et al., 1993), Germany (Harris

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et al., 1994), the UK, Australia and Canada (Barth and Clinch, 1996), six Asian economies (Graham and King, 2000) and 14 European countries (Aharony, Barniv and Falk, 2010).

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Increasingly greater attention on value relevance of accounting information is being devoted

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in the literature focusing on China due to its fast-growing stock market and unique market segmentation (Aharony et al., 2000; Chen et al., 2001; Haw et al., 1999; Lin and Chen, 2005;

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Liu et al., 2011; Liu and Liu, 2007; Samia and Zhou, 2004). This study is motived by empirical evidence that concludes that related-party transactions are widely used to manipulate earnings for financial reporting (Aharony, Wang and Yuan, 2010; Jian and Wong, 2010; Lo et al., 2010a; Wong et al., 2015), and good corporate governance mechanisms could moderate the level of tunneling in China (Gao and Kling, 2008; Jiang et al., 2010; Liu and Tian, 2012; Shan, 2013). For example, Shan (2013) takes China as a case and extends the study of Young et al. (2008) to examine whether corporate governance mechanisms can prevent tunneling from the perspective of the crucial principal-principal conflicts of interests between controlling shareholders and minority

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ACCEPTED MANUSCRIPT shareholders.† However these studies ignore the possibility of a “Domino” effect in terms of value relevance, earnings management and corporate governance mechanisms. These

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relationships remain under-researched in the current literature while growing calls persist to

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further investigate this area empirically (Chen, Wang and Zhao, 2009; Morris et al., 2011). This study fills the research gap by examining these relationships simultaneously and

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assessing whether the “Domino” effect among them exists. As a consequence, the two research questions are addressed as follows: (1) Does earnings management reduce stock

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valuation? (2) Do corporate governance mechanisms restrain earnings management? Specifically, the contribution of this study is fivefold. First, this study extends Ohlson (1995)’s price model by introducing a measure of earnings management between related-

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parties that can inflate earnings. Prior studies considered related-party sales to manage earnings. For example, Herrmann et al. (2003) report that Japanese companies use of income

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from the sale of fixed assets to manage earnings. Chen and Yuan (2004) find that Chinese

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listed companies use non-operating income to manipulate total earnings. Ge et al. (2010) find that Chinese listed companies use sales of goods and sales of assets to related-parties to

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manage earnings. However, these measures were mixed with normal and abnormal relatedparty transactions. In fact, earnings management often engages in abnormal related-party transactions (Gao and Kling, 2008; Lo and Wong, 2011). Therefore, this study examines †

Young et al. (2008) advocate that the principal-principal problem becomes as a major concern in emerging economies that are characterised by high ownership concentration, extensive family ownership and control, and weak legal protection of minority shareholders. Shleifer and Vishny (1997) suggest that the principal-principal conflict of interest between controlling shareholders and minority shareholders often results in asset appropriation or tunneling. Johnson et al. (2000) describe tunneling as the activity to transfer resources out of companies for the benefit of controlling shareholders, and it normally appears in two forms: direct transfer (Type I tunneling) and indirect transfer (Type II tunneling). In Type I tunneling the controlling shareholders simply transfer resources from the company for their own benefit through activities such as theft, fraud, assets sales and contracts, excessive executive compensation, loan guarantees, and expropriation of corporate opportunities. In contrast, Type II tunneling is more difficult to observe than Type I tunneling. The controlling shareholders can increase their share through dilutive share issues, minority freeze-outs, insider trading, creeping acquisitions, or other financial transactions that embezzle the interests of minority shareholders (Johnson et al., 2000). Type II tunneling is less relevant in emerging economies (Gao and Kling, 2008). However, Type I tunneling is more relevant in China as most asset appropriation was made through related party transactions (Cheung et al., 2006; Gao and Kling, 2008; Shan, 2013). Accordingly, the data collection for this study focuses on Type I tunneling (direct transfer of related-party transactions).

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ACCEPTED MANUSCRIPT whether there is an incentive for earnings management through related-party transactions and follows Jian and Wong’s (2010) abnormal related-party transactions model to remove any

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normal components of related-party transactions. ‡ The residual term of Jian and Wong’s

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(2010) model is considered as the abnormal related-party transaction which is used as the surrogate of earnings management in this study.

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Second, this study adds to the literature by determining the incentive for earnings

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management on stock price and corporate governance mechanisms using the two-stage least squares (2SLS) simultaneous equation approach. On one hand, Jiang et al. (2010) and Liu and Tian (2012) examine tunneling using inter-corporate loans. Shan (2013) investigates the impact of internal and external governance mechanisms on tunneling using the transactions of

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the multiple related-parties of the listed company. On the other hand, Ge et al. (2010) provide evidence that the management of Chinese listed companies use related-party sales to

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inflate earnings. These studies suggest that the stock valuation and corporate governance

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mechanisms could be simultaneously determined. Third, endogeneity is a serious problem in the literature of corporate governance

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(Balatbat, et al., 2004; Brown et al., 2011; Demsetz, 1983; Demsetz and Lehn, 1985; Demsetz and Villalonga, 2001; Farooque, et al., 2007; Farooque, et al., 2010; Setia-Atmaja, 2009). For example, Agrawal and Knoeber (1996) and Hermalin and Weisbach (2003) argue that corporate governance decisions are endogenously determined in response to agency problems of companies. Demsetz (1983), Demsetz and Lehn (1985) and Demsetz and Villalonga (2001) indicate that ownership structure is endogenous. With the objective to

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Gao and Kling (2008) suggest that the accounting measure for tunneling is difficult to distinguish through normal and abnormal related-party transactions. Thus, this study used Jian and Wong’s abnormal related-party transaction model (2010) that suggests the level of related sales and their associated operating profits will be abnormally high when the incentive of earnings management exists.

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ACCEPTED MANUSCRIPT avoid such a problem, this study develops a concise corporate governance index to measure the quality of corporate governance in the Chinese context.§

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Fourth, Shan (2013) argues that an improved legal environment provides an

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opportunity to investigate the effectiveness of corporate governance mechanisms and the incentive for earnings management. To be consistent with this argument, data were collected

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for the period between 2001 and 2005 covering the major economic reform and legal improvements. Matolcsy et al. (2011) argues that regulatory changes can affect corporate

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governance variables. Thus this study contributes evidence confirming Matolcsy et al.’s (2011) argument.

Fifth, the findings of this study (e.g. how good corporate governance mechanisms

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moderate earnings management) can be relevant to other emerging markets. China’s legal system was established on the framework of Civil Law originating in Germany and France

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(Claessens and Yurtoglu, 2013; Shan and Round, 2012). Its experience of economic reform

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and legal improvement regarding corporate governance can benefit policy-makers and regulators in the developing countries and transition economies that adopt Civil Law.

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Data was hand-collected and consist of 1,012 firm-year observations comprising all companies listed on the Shanghai SSE 180 and the Shenzhen SSE 100 from 2001 to 2005.** Evidence of value relevance for Chinese listed companies is confirmed on the basis of the modified Ohlson (1995)’s price model. The primary results indicate that companies engaged in earnings management have greater negative impact on value relevance than the companies

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The corporate governance index of this study is developed to use the characteristics of corporate governance discussed in Brown et al. (2011) and China’s two-tier board system (Shan and Round, 2012; Shan, 2013), which contains ownership structure, characteristics of board of directors and supervisory board, the independence of audit committee and the quality of external auditor (see Table 2). ** The Shanghai SSE180 Index was created by restructuring and renaming the SSE30 Index. Through scientific and objective methods it selects constituent firms that best represent the market. The SSE is a benchmark index reflecting the Shanghai market and serves as a performance benchmark for investment and a basis for financial innovation. The Shenzhen SSE100 is a benchmark index reflecting performance in the Shenzhen market and serves as a performance benchmark for investment and as a basis for the development of financial innovations.

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ACCEPTED MANUSCRIPT without earnings management, and companies with good corporate governance practices constrain earnings management. Additional analyses confirm the robustness of the primary

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results in four ways. First, the analysis of share type breakdown shows that the negative joint

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impacts of market earnings and earnings management that are found in A- and AH-shares but not in AB-shares, and corporate governance mechanisms are only effective to constrain

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earnings management in AB- and AH shares. Second, the test of effects of related-party sales indicates that related-party sales of goods have a negative impact on stock valuation, whereas

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related-party sales of assets are found to have no impact. Third, the results using alternative corporate governance ratings are consistent with the primary results. Fourth, the stock price at the end of March substitutes the stock price at the end of April used in the primary analysis

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for the modified price model, and results are consistent with the primary results. The paper is organized as follows.

The next section explores the institutional

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background in China. Section 3 reviews the previous literature and develops the hypotheses.

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Section 4 demonstrates how the sample is selected and data collected, describes models and variables, and provides model diagnostics. Section 5 reports the primary results and provides

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explanations for the results. A number of robustness checks are reported in Section 6. Finally, conclusions are presented in Section 7.

2. Institutional background The rapid development of China’s stock markets inevitably demands the establishment of centralised market regulatory bodies. In particular, the scandals in 1992, 1995, and late 1996 and early 1997 involving poor regulation by local government officials destabilised the securities market and undermined the broader financial system. As a result, the central government actively enhanced its control and supervision. In late 1992, the State

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ACCEPTED MANUSCRIPT Council Securities Commission (SCSC) and its executive organ, the China Securities Regulatory Commission (CSRC), were established. The SCSC is the macro policy-making

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body of the Chinese securities industry and the CSRC is the SCSC’s executive branch

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responsible for conducting daily supervision and regulation of the securities markets in accordance with the law. In practice, the SCSC and the CSRC took over most of the functions

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of the former regulatory body, the People’s Bank of China (PBOC) (Tan, 1999). The limits of the authority of the SCSC and the CSRC gradually expanded with the

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growth of the stock markets. In November 1993, the state council assigned the SCSC the responsibility to test the operation of a futures market to be carried out by the CSRC. In March 1995, the state council officially approved the Organisational Plan of the China

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Securities Regulatory Commission. Accordingly, the CSRC is validated as a deputy-ministrylevel unit and is authorised to supervise and regulate both securities and futures markets in

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accordance with the law. In April 1998, pursuant to the state council reform plan, the SCSC and the CSRC were merged to form one ministry-level unit directly under the state council.

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Both the power and functions of the CSRC have been strengthened. Five months later, the

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state council approved the provisions regarding the CSRC’s function, international structure and personnel, further confirming the CSRC as an enterprise unit directly under the state council, and as the authorised department governing the securities and futures markets in China. In November 1998 the central government held the National Finance Conference and decided to reform and restructure the national securities regulatory mechanism. The local securities regulatory departments and other organisations that engaged in securities formerly supervised by the PBOC were placed directly under the centralised supervision of the CSRC. China faced new dynamics following the WTO accession on 11 December 2001. This accession brought in unprecedented international competition, and made the reform of China’s financial markets and corporate governance urgent. WTO accession was expected to

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ACCEPTED MANUSCRIPT promote the sustained and healthy development of China’s economy. As a vital milestone, China entered a new phase of opening up and it offered an opportunity of historic

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significance for the long-term development of its stock markets (Shan and Round, 2012).

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After the long-term lack of a set of complete and coherent accounting theories, there was a call to establish a conceptual framework that would provide a theoretical

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justification for accounting practices and serve as guidance for resolving contemporary accounting issues. In 1992, the Accounting Standards for Business Enterprises (ASBE) was

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issued by the MOF and came into force on 1 July 1993.

By law all companies must prepare their financial statements using the Chinese specification of generally accepted accounting principles (GAAP). The principal sources of

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Chinese GAAP are the Accounting Law and Chinese Accounting Standards (CAS) (Pacter, 2007). From 1997 to 2001, the MOF issued 30 Exposure Drafts and 16 final CAS, plus

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supporting guidance.

The accounting reforms set out a three-level regulatory framework. At the top level,

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the Accounting Law enacted by the National People’s Congress in 1985 (revised in 1993 and

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1999) serves as the mother law. The second level of the regulatory framework is the accounting standards that are mandatory for all Chinese enterprises. At the third level, legal regulations consist of the industry-based accounting regulations promulgated by the MOF, and those for share capital enterprises and foreign-invested enterprises. According to the basic principles of the Company Law and the Securities Law, the Code of Corporate Governance for Listed Companies in China (the Code) has been formulated by the CSRC and the SETC. Both the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE) are responsible for issuing rules and guidelines for information disclosure, and for monitoring public companies in accordance with those rules.

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ACCEPTED MANUSCRIPT 3. Hypotheses development 3.1. Earnings management and value relevance

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Prior studies examine the impact of changes of accounting information on value

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relevance by using the Ohlson (1995)’s price model (e.g., Aharony, Barniv and Falk, 2010; Ballas and Hevas, 2005; Bao and Chow, 1999; Barth, 1991; Burgstahler and Dichev, 1997;

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Eccher et al., 1996; Fang et al., 2013; Fung et al., 2010; Graham and King, 2000; Landsman,

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1986; Liu et al., 2011; Liu and Liu, 2007; Wang et al., 2005). These studies focus on three main areas of value relevance: (1) the increase/decrease in value relevance of accounting information due to the application of environmental changes or new accounting standards (Aharony, Barniv and Falk., 2010; Ahmed, et al., 2006; Brown, et al., 1999; Chen, et al.,

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2001; Collins, et al., 1997; Fang, et al., 2013; Jaggi and Zhao, 2002; Lin and Chen, 2005; Wang, et al., 2005). For example, Collins et al. (1997) examine the changes in the value-

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relevance of earnings and book values from 1953 to 1993, and their findings suggest a

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decrease in value relevance of earnings but an increase in value relevance of book values. Chen et al. (2001) investigate whether Chinese investors perceive accounting information

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based on Chinese GAAP to be value-relevant during 1991–1998, and find that accounting information is value-relevant to Chinese investors. Aharony, Barniv and Falk (2010) were motivated by the mandatory adoption of the International Financial Reporting Standards (IFRS) in the European Union (EU) in December 2005 and compare value relevance of accounting information among 14 EU countries. They find that the incremental value relevance of goodwill, the expenses of research and development, and asset revaluations for investors; (2) the impact of company/industry features (Ballas and Hevas, 2005; Francis and Schipper, 1999; Lev and Zarowin, 1999). For example, Ballas and Hevas (2005) examine the cross-national differences on the value relevance of earnings and book value of equity for four EU countries and find earnings and book value of equity have value implications with 10

ACCEPTED MANUSCRIPT significant country and industry effects; (3) the relationship between earnings management and value relevance (Barth et al., 2008; Lang et al., 2006; Liu, et al., 2011; Paananen and Lin,

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2009).

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Prior studies indicate that earnings management through related-party transactions can influence the quality of financial reporting (Jian and Wong, 2010; Lo and Wong, 2011; Shan,

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2014). For example, Jian and Wong (2010) discuss two incentives for controlling

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shareholders to engage in earnings management through related-party transactions. First, the controlling shareholders have the incentive to inflate earnings to avoid reporting losses. Second, the central and local governments of China as the ultimate controlling shareholders have incentives to help listed companies for funds raising and maintaining listing status

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purposes. Lo and Wang (2010) suggest that management are unlikely to improve the quality of financial reporting in terms of related-party transactions because earnings management

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through abnormal related-party transactions manipulated by the management can be observed, for instance, when the disclosure of the transfer pricing and methods for related-party

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transactions were voluntary in China before 2007.††

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Barth et al. (2001) and Holthausen and Watts (2001) review the literature of value relevance and implicitly suggest that accounting data are more informative when the data are highly related to share price or returns. Lang et al. (2006), Barth et al. (2008) and Paananen and Lin (2009) argue that accounting quality is operationalised with earnings management and value relevance. Higher accounting quality is associated with higher value relevance of book and market value of equity and less earnings management. Accordingly, the first hypothesis is formulated as follows: H1. Ceteris paribus, earnings management reduces the level of value relevance. ††

The Accounting Standard for Business Enterprises 36 (ASBE 36) specifies a mandatory disclosure of related enterprises, and the types and amounts of related-party transactions in the notes to financial statements of the listed companies in China. The disclosure of transfer pricing policies and methods was voluntary until 2007.

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3.2. Corporate governance and earnings management

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Prior studies investigate tunneling and/or propping in China through related-party

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transactions (e.g. Aharony, Wang and Yuan, 2010; Berkman et al., 2009; Chen, Jian and Xu, 2009; Cheung et al., 2009; Gao and Kling, 2008; Jiang, et al., 2010; Li, 2010; Liu and Liu,

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2007; Liu and Tian, 2012; Lo et al., 2010b; Peng et al., 2011; Shan, 2013; Wang and Xiao,

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2011). For example, Berkman et al. (2009) investigate the wealth expropriation of minority shareholders by controlling shareholders through issuance of loan guarantees to their related parties, and the finding indicates that the controlling shareholders affect the likelihood of expropriation. Chen, Jian and Xu (2009) examine whether Chinese-listed companies

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distribute dividends to signal future profitability and mitigate agency problems, or to tunnel and exacerbate agency problems. Their findings suggest that dividends are not only used for

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signalling or distributing free cash flows, but are also imposed by the controlling shareholders

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to engage in tunneling. Cheung et al. (2009) investigate related-party transactions between Chinese listed companies and their controlling shareholders in a two-year time slot during

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2001–2002. They conclude that minority shareholders are subject to both asset appropriation through tunneling and gain from propping from related party transactions with their controlling shareholders. Aharony, Wang and Yuan (2010) use a sample of 185 Chinese IPO firms during 1999–2001 to examine whether there is evidence that inflating earnings in the pre-IPO period is motivated by the prospect of opportunities for tunneling in the post-IPO period. Their results provide evidence of such tunneling to exploit economic resources from minority shareholders who bought at the IPO for the benefit of the parent company. Jian and Wong (2010) test whether Chinese listed firms prop up earnings by using abnormal related sales to their controlling owners. Their results support evidence of significant cash transfer via related lending from the listed firms back to controlling owners after the propping. Jiang 12

ACCEPTED MANUSCRIPT et al. (2010) investigate tunneling through inter-corporate loans among Chinese listed companies during 1996–2006. The results show the widespread use of corporate loans by

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controlling shareholders to extract funds from listed firms. Li (2010) suggests the corporate

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governance mechanisms alone are not sufficient to protect minority shareholders. To support this argument he investigates tunneling by controlling shareholders and provides evidence

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that controlling ownership significantly increases the severity of tunneling. Lo et al. (2010b) examine tunneling incentives using the relative gross profit ratios of related- and unrelated-

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party transactions to measure the transfer pricing strategies of Chinese listed companies. They find that if the listed firm is controlled by government, the profit is more likely to shift out, and as such tunneling effects increase with the proportion of state ownership. Shan (2013)

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studies the impact of internal and external governance mechanisms from the perspective of the principal-principal agency problem on tunneling, and the findings suggest that state

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ownership and the number of board of directors’ meetings are positively correlated with Type I tunneling, whereas the number of independent directors reveals a negative association.

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Other internal governance mechanisms including foreign ownership, the size of the board of

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directors, supervisory board size, number of professional supervisors and the number of supervisory board meetings were found to have no impact. According to principal–agent theory (classic agency theory), the primary objective of the company operated by its management, i.e., agent, is to maximize the wealth of shareholder. However, due to self-interest, management often do not align their interests with the shareholders’ interests. This divergence causes agency problems. These problem resulting from the separation of ownership and control, and costly enforceable contracts and information asymmetry between management and shareholders gives rise to agency costs (Jensen and Meckling, 1976; Rezaee, 2009; Shleifer and Vishny, 1997). The role of corporate governance is to mitigate the agency problem and reduce agency costs for creating value for 13

ACCEPTED MANUSCRIPT shareholders (Rezaee, 2009; Shleifer and Vishny, 1997). Prior studies find that companies with higher corporate governance ratings/indexes have better performance than the

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companies with lower ratings (e.g., Larcker et al., 2007), and companies with better corporate

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governance mechanisms have shown reduced earnings management (e.g., Duh et al., 2009; Garcia Osma, 2008; Sarkar et al., 2008; Shen and Chih, 2007).

From a theoretical

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perspective, companies with good corporate governance are expected to have a better competitive advantage than companies with poor corporate governance, where the level of

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corporate governance can be quantified by corporate governance ratings or indices. Accordingly, the second hypothesis is formed as follows: H2. Ceteris paribus, good corporate governance reduces the level of earnings

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4.1. Data collection

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4. Research design

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management.

The sample contains all companies listed on the Shanghai SSE 180 and the Shenzhen

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SSE 100 during 2001–2005. There are two reasons to choose this duration. First, this period was chosen because the Accounting Standard for Business Enterprises 36 (ASBE 36) had no mandatory requirement for the disclosure of the transfer pricing and methods for related-party transactions (Lo and Wong, 2011). Thus, this constitutes a good time frame to examine the management’ incentives for engaging in earnings management. Since 2006 the disclosure became mandated resulting in the significant reduction of related-party transactions among listed companies in China. Second, the 2001–2005 duration is considered as an important period of China’s economic reform and regulatory changes. These include i) the Guidelines for Introducing Independent directors to the Board of Directors of Listed Companies (the Guidelines) that was introduced in August 2001 and mandated on 30 June 2003; ii) the 14

ACCEPTED MANUSCRIPT Provisional Regulation on the Accounting for Sales of Assets and Other Transactions between Related Parties (2001 RPT Measurement Regulation) which was promulgated by

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the Ministry of Finance (MOF) at the end of 2001; iii) the Code was promulgated in January

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2002; iv) the State-owned Assets Supervision and Administration Commission (SASAC) which was founded in 2003 as a functional body for top executive appointment, supervisory

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board dispatch, and executives’ performance evaluation.

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As shown in Table 1, the final sample consists of 1,012 firm-year observations after removing 45 firm-year observations for financial institutions and insurance companies and 343 missing data. The distributional breakdown by share type contains 637, 225 and 150 firm-year observations for A-, AB- and AH-Share, respectively.‡‡

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The data were sourced in three ways. Data of related-party transactions and corporate

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governance characteristics, including independent director, board size, number of board meeting, professional supervisor, supervisory board size, number of supervisory board

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meeting were hand-collected through the annual reports of listed companies. Share prices

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were collected from SINA Finance 新浪财经 (http://vip.stock.finance.sina.com.cn/mkt/). Other accounting data were collected through Thomson ONE Banker. INSERT TABLE 1 ABOUT HERE

4.2. Model specification ‡‡

A-shares are common stock issued by mainland China firms, quoted in Renminbi, and listed on the mainland stock exchanges, and are reserved for trading by Chinese citizens. The A-share market was launched in 1990 in Shanghai. B-shares are issued by mainland China firms, traded in foreign currencies, and listed on the mainland stock exchanges. The B-share market was launched in 1992 and was restricted to foreign investors before 19 February 2001. H-shares are securities of companies incorporated in mainland China and nominated by the Chinese Government for listing and trading on the Hong Kong Stock Exchange, being quoted and traded in HKD. There are no restrictions on holdings by international investors. AB-share companies are those that have issued both A-shares and B-shares, with an initial A-share offering. They are also listed on the domestic stock exchanges in China. AH-share companies are those that have issued both A-shares and H-shares, and have floated their shares simultaneously on the Hong Kong Stock Exchange and on one of China’s two mainland stock exchanges.

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ACCEPTED MANUSCRIPT Based on the hypotheses, this study employs a 2SLS simultaneous model, which contains two equations as follows. The first equation (Equation 1) is designed to test H1,

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which is modified on the valuation framework provided by Ohlson (1995) and introduces the

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earnings management proxy through abnormal related-party transactions which is consistent with Jian and Wong (2010), Lo and Wong (2011) and Shan (2014).§§ The second equation

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(Equation 2) is designed to examine H2 and measures the association between earnings

Value relevance equation (to test H1):

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management (ABNRPT) and corporate governance rating.

PRICEitAPRIL = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)

… (1)

Earnings management equation (to test H2):

4.3. Dependent variable

share price of firm i at four months after the fiscal year end of

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PRICEitAPRIL represents

… (2)

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ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)

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period t. As the fiscal year in China is consistent with the calendar year the share price is the closing price on 30 April (or the last trading day in April) in year t + 1. The closing share

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price on 30 April is used because all Chinese listed companies are required to announce and publish their annual reports with audited financial statements within four months after the end of the calendar year. This is consistent with Lin and Chen (2005), Liu and Liu (2007) and Ge, et al. (2010). Lo and Wong (2011) use the abnormal related-party transactions to measure the degree of earnings management through related-party transactions. Jian and Wong (2010)’s

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Chen et al. (2001) summarise that two advantages of the price model (value relevance model) over the return model. First, the price model provides the earnings coefficients without bias as share prices reflect the cumulative effect of earnings information (Kothari and Zimmerman, 1995), whereas the return model is biased as it assumes that the earnings coefficients tend towards zero. Second, the use of the Ohlson (1995)’s price model expands the scope of the research of value relevance because it considers that a company’s market value (proxied as share price) is associated with both book value of equity and accounting earnings, whereas the return model only considers the value relevance through accounting earnings.

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ACCEPTED MANUSCRIPT abnormal related-party transaction model is employed to develop the proxy of earnings management – abnormal related-party transactions (ABNRPT) as follows: … (3)

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RLPTi, t    1LEVERAGE i, t   2 FIRMSIZEi, t   3MKVE  1-6 INDUSTRY   i, t

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where, RLPT represents related-party transactions; LEVERAGE is measure by total debt to total assets; FIRMSIZE is the natural logarithm of total assets; MKVE is the market value of

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equity to the book value of equity; Industry dummy (INDUSTRY) reflects the company’s industry in accordance with the industry classification of the CSRC; the residuals (ε) is

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proxied as the abnormal related-party transactions (ABNRPT) and used as the dependent variable in the earnings management equation (Equation (2)) and used the value relevance

4.4. Independent variable

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equation (Equation (1)) to test the earnings management effect.

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Prior studies of China’s corporate governance focus on the effectiveness of individual

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governance factors derived from ownership structure, board of directors, supervisory board and the quality of external auditor (e.g., Gao and Kling, 2008; Lo and Wong, 2011; Shan,

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2013; Shan and McIver, 2011). However, these factors are unlikely to measure the overall quality of a company’s corporate governance (Brown, et al., 2011). The investors demand the development of corporate governance ratings that gather, analyse, and rank corporate practices of the company (Rezaee, 2009) and expect a composite governance measure would do better and be more comprehensive than the individual factors (Brown, et al., 2011). The composite measure of corporate governance is available in the literature. For example, Gompers et al. (2003) generate the G-index that was computed as a composite measure by using the equally weighted sum of 24 individual shareholder rights practices across five characteristics (delay a takeover, protect management, vote limit, limit a takeover 17

ACCEPTED MANUSCRIPT and state laws). DeFond et al. (2005) form a composite measure containing six categories of governance characteristics (board size, board independence, audit committee size, audit

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committee independence, shareholders’ rights and institutional ownership). Brown and

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Caylor (2006) develop Gov-Score by measuring the equally weighted sum of 51 governance

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practices that represent both internal and external governance factors. Given equal weight to each individual factor it presumes that governance elements are equally valuable and

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complement each other (Brown, et al., 2011). Some other studies use concise ratings of corporate governance that are more effective than those using all characteristics in large corporate governance databases, such as Institutional Shareholder Services (ISS) and Investor

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Responsibility Research Center (IRRC). For example, Brown and Caylor (2006) propose a concise governance score that only contains seven governance provisions underlying the 51

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elements in Gov-Score. According to the studies of composite measure of corporate

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governance and China’s two-tier board system, the index of corporate governance quality

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(CGQ) is computed and described in Table 2. INSERT TABLE 2 ABOUT HERE

Other independent variables include BVPS and EPS. BVPS represents book value of equity per share for firm i in fiscal year t and EPS equals annual earnings per share for firm i in fiscal year t.

4.5. Control variable Control variables are year and industry dummies in Equation (1), and ROA, firm size, firm age and year and industry dummies in Equation (2). Year dummy (YEAR) reflects the year effect during 2001–2005. The industry dummy (INDUSTRY) reflects the company’s 18

ACCEPTED MANUSCRIPT industry code in accordance with the industry classification of the CSRC. ROA reflects return on assets for firm i in fiscal year t. Firm size (FIRMSIZE) is the natural logarithm of total

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assets, and firm age (FIRMAGE) measures the number of years since initial listing (Shan,

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2013).

4.6. Model diagnostics

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Model diagnostics consists of multicollinearity diagnostics (MD) and the Ramsey’s regression specification error test (RESET). The MD is conducted in two ways. First, the Pearson and Spearman’s rank correlation coefficients presented in Panels A (for the value relevance equation) and C (for the earnings management equation) of Table 3 reveal that the

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values of any pairs of independent variables are well below the critical value of 0.8. Second,

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the variance inflation factor (VIF) test is also used, as multicollinearity may still exist even if the correlation value is small (Gujarati, 2003). The results, reported in Panels B (for the value

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relevance equation) and D (for the earnings management equation) of Table 3, show that the largest VIF is 1.52 and that the VIFs of all other independent variables are well below the

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critical value of 10. Thus, the regression model has no evidence of multicollinearity. INSERT TABLE 3 ABOUT HERE

The RESET is used to diagnose the potential of nonlinear partial effects and test whether the powers of fitted variables exist in both earnings management and the value relevance equation. The RESET begins with the second power until the fourth power for all independent and control variables, and the results (not reported in this paper) indicate no nonlinear effects.

5. Results and discussion

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ACCEPTED MANUSCRIPT 5.1. Descriptive statistics The descriptive statistics displayed in Table 4 provide a profile of the key variables in

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terms of all shares and years, share type breakdown and year breakdown. During 2001–2005,

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the mean (median) of PRICEitAPRIL is 10.45 (9.47) for all shares, with a mean (median) of 11.33 (10.43), a mean (median) of 11.21 (10.47), and a mean (median) of 8.12 (6.94) for A-, AB-

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and AH-shares respectively. This finding indicates that the average value of share price for domestic shares (i.e., A- and AB-shares) after the publication of a company’s annual report is

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greater than the average value of the share price for the stocks traded on Hong Kong Stock Exchanges (i.e., AH-shares). According to the year breakdown, as shown in Panel B of Table 4, the means of PRICEitAPRIL reveal a declining pattern during 2001–2005 with values of 15.2,

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11.8, 9.6, 9.81, and 6.77. This declining pattern was a symptom of the bearish market in China during these years. Similarly, the means of ROA indicate a significant downturn in

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firm performance with ratios of 0.23, 0.03, 0.05, 0.06 and 0.05 during 2001–2005.

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INSERT TABLE 4 ABOUT HERE

In terms of the index of corporate governance quality, as shown in Panel A of Table 4,

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during 2001–2005, the mean (median) of CGQ is 3.39 (3) for all shares, with a mean (median) of 2.21 (2), a mean (median) of 3.21 (3), and a mean (median) of 5.3 (6) for A-, AB- and AHshares respectively. This finding suggests that the average value of CGQ for AH-shares is greater than the average values of CGQ for A- and AH-shares. Moreover, the means of CGQ are 3.43, 3.4, 3.39, 3.33 and 3.38 during 2001–2005.

5.2. Primary result of 2SLS simultaneous model Table 5 presents the results of estimation of the 2SLS simultaneous model. The model fit reports adjusted R2 s of 0.4974 for the value relevance equation in Column (1) and 0.1025

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ACCEPTED MANUSCRIPT for the earnings management equation in Column (2). The F-statistics for both equations are statistically significant.

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INSERT TABLE 5 ABOUT HERE

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The first hypothesis (H1) was developed to examine whether the abnormal relatedparty transactions (ABNRPT), a proxy of earnings management, reduces the level of value

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relevance. The results, as presented in Column (1) of Table 5, reveal that BVPS (β = 0.67, t = 3.99, p < 0.01) and EPS (β = 4.82, t = 7.78, p < 0.01) are positively value-relevant to stock

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price which is consistent with Chen et al. (2001), Liu and Liu (2007) and Ge et al. (2010). However, EPS can be a surrogate for a function of earnings persistence factor (Ge et al., 2010), which can be operationalised by earnings management through abnormal related-party transactions (Lo and Wong, 2011). The results, as reported in Column (1) of Table 5, indicate

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that ABNRPT (β = –9.75, t = –2.92, p < 0.01) and the interaction term of EPS and ABNRPT

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(β = –19.33, t = –4.65, p < 0.01) are negatively value-relevant. Therefore, H1 is supported. The negative coefficient of –19.33 for EPS*ABNRPT provides decremental impact of equity

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valuation measured by stock price, i.e., 19.33 lower than companies that are not engaged in

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the abnormal related-party transactions. The second hypothesis (H2) was established to test whether the good CGQ, the index of corporate governance, reduces the level of earnings management measured by the abnormal related-party transactions (ABNRPT). The results presented in Column (2) of Table 5 indicate that CGQ (β = –0.01, t = –3.12, p < 0.01) is negatively related to ABNRPT. Thus, H2 is supported. The finding suggests that companies with good corporate governance practices constrain earnings management. In terms of control variables, ROA was found to have a negative impact on ABNRPT. However, FIRMAGE reveals a positive association which suggests the historical reputation and image of listed companies were often ignored by the companies because investors have

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ACCEPTED MANUSCRIPT limited investment choices due to underdeveloped stock market in China (Shan and Xu, 2012;

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Shan, 2013).

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6. Additional analyses

Additional analyses were conducted to extend and assess the robustness of the

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primary result of the 2SLS simultaneous model discussed earlier. 6.1. Share type breakdown

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Prior studies argued that B- and H-share companies reported more value relevant accounting information than A-share companies (e.g., Lin and Chen, 2005; Liu and Liu, 2007). Shan (2013, 2014) suggests that the proportion of ownership and monitoring power

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board of the directors and the supervisory board of each type of company is different. Accordingly, this study employs share type breakdown analysis in order to test the value

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relevance of the three share types applied under different accounting principles/standards. *** The 2SLS simultaneous model is modified as follows:

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Value relevance equation:

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PRICEitAPRIL = f (BVPSAit/ BVPSABit/BVPSAHit, EPSAit/EPSABit/EPSAHit, ABNRPTAit/ABNRPTABit/ABNRPTAHit, EPSA it*ABNRPTAit /EPSABit*ABNRPTABit/EPSAHit*ABNRPTAHit , YEARt, INDUSTRYi)

… (4)

Earnings management equation: ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)

… (5)

INSERT TABLE 6 ABOUT HERE The results, presented in Columns (3) and (5) of Table 6, reveal that BVPS and EPS are positively value-relevant to stock price for AB- and AH-shares, respectively, which is consistent with the primary result. However, the results in Column (1) for the estimated

***

For companies issuing A-shares only the financial reports of the companies are required to be prepared under the Chinese generally accepted accounting principles (Chinese GAAP). For companies issuing both A- and Bshares, the A-share part is required to be prepared under Chinese GAAP, whereas the B-share part is required to prepare under the International Financial Reporting Standards (IFRS). For companies issuing both A- and Hshares, the A-share part is required to be prepared under Chinese GAAP, whereas the H-share part is required to be prepared under either IFRS or the Hong Kong GAAP (Liu and Liu, 2007).

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ACCEPTED MANUSCRIPT coefficient on BVPS are insignificant, while those for the coefficient on EPS are significant and positive to value relevance, which are consistent with Lin and Chen (2005). The findings

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suggest that EPS is value-relevant, whereas BVPS is not value-relevant in the A-share market

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under Chinese GAAP.

The results reported in Columns (1) and (5) indicate negative joint impacts of market

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earnings and earnings management for A- and AH-shares, respectively, whereas such an impact is not found for AB-shares. The negative coefficient for A- or AH-shares indicates

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that 24.3 or 3.76 lower value relevance than the companies that have no abnormal relatedparty transactions.

The results presented in Columns (4) and (6) show that CGQ has a negative

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association with ABNRPT for AB- and AH-shares, whereas the negative association is not found for A-share firms. This finding is not surprising as the principal-principal conflicts of

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interest in A-share companies are more severe than in AB- and AH-shares companies. The highly concentrated ownership and weak monitoring power of the board of directors and

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supervisory board results in poor corporate governance quality to safeguard against tunneling

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or abnormal related-party transactions (Shan, 2013).

6.2. Effect of related-party sales on value relevance Ge et al. (2010) focus on two types of related-party transactions including sales of goods and sales of assets to examine whether the disclosures of these two types of relatedparty transactions are value-relevant to stock price before and after the 2001 RPT Measurement Regulation. Their findings suggest that the earnings of companies engaged in the two types of related-party transactions are less value-relevant to stock prices in the period before the 2001 RPT Measurement Regulation. Such results were not found after the 2001

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ACCEPTED MANUSCRIPT RPT Measurement Regulation.††† The motivation for conducting this robustness check is to confirm whether the findings of Ge et al. (2010) are consistent with the primary results for

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the period after 2001 in particular. The Ge et al. (2010)’s value relevance model is used to

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test the robustness of the primary results as follows:

… (6)

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PRICEitAPRIL = f (BVPSit, EPSit, EPSit*RLPSALESit, EPSit*RLPASSETSit,YEARt, INDUSTRYi)

INSERT TABLE 7 ABOUT HERE

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The results presented in Columns (1), (2) and (3) of Table 7 indicate that BVPS and EPS are positively value-relevant to stock price, which is consistent with the results of Ge et al. (2010). The estimated coefficients of EPS*RLPSALES are significant and negative to stock price in Columns (2) and (3) respectively, whereas the estimated coefficients of

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EPS*RLPASSETS are found to have no impact on stock price. The latter findings are

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inconsistent with the results of Ge et al. (2010). Arguably, the inconsistent findings are caused by the ignorance of the differences between normal and abnormal related-party

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transactions (Jian and Wong, 2010). Therefore, this study follows Jian and Wong (2010)’s model to develop an appropriate proxy of earnings management, ABNRPT, and then employs

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this in the value relevance model to examine whether there is an incremental or decremental impact on equity valuation to stock price.

6.3. Alternative corporate governance ratings Prior literature considered ownership concentration and board meetings of board of director and supervisory board as the factors of corporate governance mechanisms. For example, Shan and McIver (2011) find a negative relationship between ownership †††

The Ministry of Finance (MOF) promulgated the Disclosure of Related Party Relationship and Transactions (the 1997 RPT Disclosure Standard) in 1997. However, the 1997 RPT Disclosure Standard was not sufficient to moderate the earnings management incentives of Chinese listed companies (Ge et al., 2010). As a consequence, the MOF promulgated the 2001 RPT Measurement Regulation at the end of 2001 which intensified accounting rules for sales of assets (including sales of goods) between related parties.

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ACCEPTED MANUSCRIPT concentration and firm performance; frequent meetings are expected to improve board effectiveness and efficiency (Conger et al., 1998; Jackling and Johl, 2009; Shan, 2013; Shan

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and Xu, 2012). Other literature excluded Big 4 auditors as a factor of internal governance

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mechanisms (Rezaee, 2009; Shan, 2013). Accordingly, this study generates three alternative corporate governance ratings: (1) CGQ1 includes ownership concentration, the number of

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meetings of the board of directors and the number of meetings of the supervisory board in addition to the corporate governance mechanisms listed in Table 2; (2) CGQ2 only includes

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ownership concentration in addition to the corporate governance mechanisms listed in Table 2; (3) CGQ3 excludes Big 4 auditors as a mechanism in the corporate governance mechanisms listed in Table 2. The 2SLS simultaneous model is, consequently, modified as

Value relevance equation:

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follows:

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PRICEitAPRIL = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)

… (7)

Earnings management equation:

… (8)

INSERT TABLE 8 ABOUT HERE

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ABNRPTit = ƒ(CGQ1it/CGQ2it/CGQ3it, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)

The results presented in Columns (2), (3) and (4) of Table 8 report that CGQ1, CGQ2 and CGQ3 are all negatively related to ABNRPT. These findings are consistent with the primary results in Table 5.

6.4. Alternative stock price for the value relevance equation The primary value relevance equation (Equation (1)) employed the share price firm i at four months (i.e., the closing price on 30 April or the last trading day in April in year t + 1. However, some studies employ the share price at the end of the third month, i.e., on 31 March or the last trading day of March (see e.g. Fung, et al., 2010; Ge, et al., 2010). Accordingly, 25

ACCEPTED MANUSCRIPT the stock price of the last trading day in March is used as the dependent variable in the value relevance equation (Equation (9)) as follows: Value relevance equation:

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PRICEitMARCH = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)

Earnings management equation:

… (10)

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ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)

… (9)

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INSERT TABLE 9 ABOUT HERE The results reported in Column (1) of Table 9 indicate that the estimated coefficients for BVPS and EPS are positively value-relevant, whereas the coefficients for ABNRPT and EPS*ABNRPT are negatively value-relevant to stock price. These findings are consistent

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with the primary results in Table 5, and suggest that there is no difference when using the

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stock price by the end of March or end of April as many Chinese listed companies announce

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7. Conclusion

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and publish their annual reports in March (Ge et al., 2010).

Driven by the motivation to provide evidence of earnings management through abnormal related-party transactions, this study employs a 2SLS simultaneous equation model to examine whether earnings management reduces the level of value relevance and whether good corporate governance restrains earnings management. Evidence relies on hand-collected data comprising 1,012 firm-year observations for all listed companies on the Shanghai SSE 180 and the Shenzhen SSE 100 from 2001 to 2005. The primary results show that the negative impact of value relevance for the companies engaged in earnings management is greater than the companies without earnings management, and the companies with good corporate governance practices are more likely to constrain earnings management. The

26

ACCEPTED MANUSCRIPT robustness of the primary results has been assessed in four ways. First, share type breakdown reveals that A- and AH-share companies have negative joint impacts of market earnings and

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earnings management on value relevance, but this finding does not apply to AB-share

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companies. Corporate governance mechanisms effectively moderate earnings management in AB- and AH shares. Second, the test of effects of related-party sales reports a negative

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impact on value relevance through related-party sales of goods, whereas related-party sales of assets are found to have no impact. Third, the results using alternative corporate governance

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ratings have no difference with the primary results. Fourth, the results by using the stock price at the end of March are consistent with the primary results. The findings of this study have several implications. First, the findings offer support

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that accounting information is relevant to the stock prices for large listed companies in China. It provides confidence to domestic and foreign investors for their decision-making that they

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can rely on the accounting information disclosed by the companies. Second, this study adds evidence to demonstrate that good corporate governance mechanisms can constrain earnings

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management through abnormal related-party transactions. Thus, the legal reforms between

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2001and 2005, such as promulgation of the Code and the Guidelines, were effective in improving the quality of corporate governance for large listed Chinese companies. Third, the 2001 RPT Measurement Regulation is indeed necessary as the joint impacts of market earnings (EPS) and earnings management (ABNRPT) decreased value relevance. Policymakers and regulators can use these findings to inform policy development initiatives concerning disclosures of related-party transactions that can moderate abnormal transactions. There are several limitations in this study. First, although the concise CGQ is developed in accordance with supporting literature and reflects the major characteristics of corporate governance mechanisms in the context of China’s two-tier board system, other practices of shareholder rights should be taken into account as additional characteristics to

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ACCEPTED MANUSCRIPT composite CGQ (Gompers et al., 2003; DeFond et al., 2005) when the data become publicly available in the future studies. Second, this study only proxies book value (BVPS), market

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earnings (EPS) and the level of earnings management (ABNRPT) in the value relevance

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equation to examine the association between accounting information and stock valuation. However, other accounting information, such as goodwill, research and development

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expenses (R&D) and asset revaluation can be value-relevant (Aharony, Barniv and Falk, 2010). Future studies should consider incorporating these variables and modifying the value

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relevance equation used in this study. Third, only corporate governance mechanisms are considered to be associated with earnings management in this study. However, Zhang et al. (2013) argue that accounting standards can also influence earnings management. Future

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research should consider the characteristics of accounting standards into the earnings

Acknowledgements

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management equation used in this study.

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I would like to thank the editor, Professor Jonathan A. Batten, and the anonymous

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reviewer(s) for the constructive comments. I also acknowledge the comments of Bryan Howieson and Indrit Troshani of School of Accounting and Finance of the University of Adelaide, and participants of the research seminars presented at the University of Adelaide and University of Western Sydney for the helpful suggestions.

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ACCEPTED MANUSCRIPT

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Shanghai SSE 180 x 5-year period (2001–2005) Shenzhen SSE 100 x 5-year period (2001–2005) Less: Observations for financial institutions and insurance companies Less: Observations that are eliminated due to missing data Total firm-year observations

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Table 1 Data.

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Breakdown by share type A-share AB-share AH-share Total firm-year observations

No. of observations 637 225 150 1,012 No. of observations 191 196 205 208 212 1,012

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Breakdown by year 2001 2002 2003 2004 2005 Total firm-year observations

No. of observations 900 500 (45) (343) 1,012

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ACCEPTED MANUSCRIPT

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Table 2 Constructing corporate governance index. 8

CGQi, t   Corporate Governance Mechanism j

CR I

j1

Description

Measurement with Supported Literature

STATEit – proportion of shares held by the state

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Corporate Governance Mechanism State ownership concentration

Award 1 mark if STATEit of firm i in fiscal year t is less than the median value of the sample in fiscal year t, 0 mark otherwise (Gao and Kling, 2012; Kim et al., 2005; Shan, 2013).

FOREIGNit – proportion of shares held by foreign investors

Board size

BOARDSIZEit – number of directors on the board of directors

Independent director

INDPit – number of independent directors on the board of directors

Award 1 mark if INDPit of firm i in fiscal year t is greater than the median value of the sample in fiscal year t, 0 mark otherwise (Shan, 2013; Shan and McIver, 2011; Shan and Xu, 2012).

Supervisory board

SBSIZEit – number of supervisors on the supervisory board

Award 1 mark if SBSIZEit of firm i in fiscal year t is greater than the median value of the sample in fiscal year t, 0 mark otherwise (Ding et al., 2010; Firth et al., 2007).

Professional supervisor

PROFSBit – number of supervisors with professional knowledge or work experience

Award 1 mark if PROFSBit of firm i in fiscal year t is greater than the median value of the sample in fiscal year t, 0 mark otherwise (Shan and McIver, 2011; Shan and Xu, 2012; Xiao et al., 2004).

Independence of audit committee

AUDITCOMit – independence of audit committee

Award 1 mark if firm i in fiscal year t has an independent audit committee, 0 mark otherwise (Abbott and Parker, 2000; Karamanou and Vafeas, 2005).

Big 4 auditor

BIG4it – availability of hiring Big Four auditor

Award 1 mark if firm i in fiscal year t hires a Big Four auditor, 0 mark otherwise (Gao and Kling, 2008; Peng, et al., 2011).

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D

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Foreign ownership concentration

Award 1 mark if FOREIGNit of firm i in fiscal year t is greater than the median value of the sample in fiscal year t, 0 mark otherwise (Chen et al., 2006; Shan, 2013; Shan and Xu, 2012). Award 1 mark if BOARDSIZEit of firm i in fiscal year t is greater than the median value of the sample in fiscal year t, 0 mark otherwise (Pearce and Zahra, 1992; Van den Berghe and Levrau, 2004).

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ACCEPTED MANUSCRIPT Table 3 Multicollinearity diagnostics.

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Panel A: Pearson and Spearman’s rank correlations for variables of value relevance equation a BVPSit EPSit ABNRPTit BVPSit – 0.596*** –0.186*** (17.233) (–4.384) *** EPSit 0.553 – –0.187*** (15.402) (–4.406) ABNRPTit –0.287*** –0.337*** – (–6.957) (–8.292)

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Panel B: VIF diagnostic for variables of value relevance equation b Variable VIF SQRT VIF Tolerance BVPSit 1.47 1.21 0.6825 EPSit 1.52 1.23 0.6596 ABNRPTit 1.15 1.07 0.8720

R-Squared 0.3175 0.3404 0.1280

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Panel C: Pearson and Spearman’s rank correlations for variables of earnings management equation a CGQit ROAit FIRMSIZEit FIRMAGEit CGQit – 0.134*** 0.361*** –0.0288 (3.131) (8.975) (–0.667) ROAit 0.092** – 0.101** –0.267*** (2.132) (2.354) (–6.423) FIRMSIZEit 0.398*** 0.087** – –0.143*** (10.067) (2.028) (–3.356) FIRMAGEit –0.023 –0.007 –0.184*** – (–0.527) (–0.174) (–4.347)

R-Squared 0.2894 0.0116 0.2156 0.0447

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Panel D: VIF diagnostic for variables of earnings management equation b Variable VIF SQRT VIF Tolerance CGQit 1.41 1.19 0.7106 ROAit 1.01 1.01 0.9884 FIRMSIZEit 1.27 1.13 0.7844 FIRMAGEit 1.05 1.02 0.9553

BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; ABNRPTit = the level of abnormal earnings management resulting from related-party transactions, measured as the residual term of the regression of leverage, firm size, growth and the CSRC’s industry code for firm i in fiscal year t; CGQit = corporate governance quality, including eight corporate governance mechanisms (see Table 2 for the measurement) for firm i in fiscal year t; ROAit = return on assets for firm i in fiscal year t; FIRMSIZEit = firm size, measured as the natural logarithm of the book value of total assets for firm i in fiscal year t; FIRMAGEit = firm’s age, measured by the number of years since its initial listing for firm i in fiscal year t. Notes: a Pearson correlation coefficients are shown in the lower left; Spearman’s rank correlation coefficients are shown in the upper right. The first number represents the coefficient, and the second number in parentheses represents the t-value of significance. * if p < 0.10, ** if p < 0.05; *** if p < 0.01. All tests are two-tailed. b Gujarati (2003) suggests that there is no evidence of multicollinearity if the VIF value is below the critical level of 10. All values shown in Panels B and D of Table 2 are well below this critical level.

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Panel A: Breakdown by share type A-shares Med 10.43

2.97 0.22 3.39 0.08 21.99 6.73

3.56 0.33 2.21 0.07 21.74 4.99

3.57 0.26 2 0.06 21.85 5

2.88 0.19 3 0.05 21.88 7

2.85 0.18 3.43 0.23 21.74 5.37

2.7 0.18 3 0.05 21.64 6

2.88 0.16 3.4 0.03 21.88 6.06

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BVPSit EPSit CGQit ROAit FIRMSIZEit FIRMAGEit

Mean 11.8

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PRICEitAPRIL

2002 Med 14.51

AB-shares Mean Med 11.21 10.47

AH-shares Mean Med 8.12 6.94

2.61 0.14 3.21 0.03 21.61 8.98

2.7 0.18 5.3 0.17 22.9 5.71

2.77 0.14 3 0.04 21.63 9

2003

2004

2.51 0.17 6 0.05 22.92 6

2005

Med 11.23

Mean 9.6

Med 9.25

Mean 9.81

Med 8.46

Mean 6.77

Med 5.27

2.77 0.17 3 0.04 21.79 6

3.03 0.25 3.39 0.05 22.01 6.61

2.9 0.19 3 0.05 21.9 7

3.11 0.28 3.33 0.06 22.09 7.21

3.00 0.24 3 0.06 22.05 8

2.96 0.21 3.38 0.05 22.17 8.07

3.01 0.2 3 0.05 22.15 9

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2001 Mean 15.2

D

Panel A: Breakdown by year Variable

CR I

Mean 11.33

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PRICEitAPRIL BVPSit EPSit CGQit ROAit FIRMSIZEit FIRMAGEit

All shares & years Mean Med 10.45 9.47

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Variable

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Table 4 Descriptive statistics.

PRICEitAPRIL = domestic stock price per share for firm i at the end of the fourth month (the last trading day of April) after fiscal year t; BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; CGQit = corporate governance quality, including eight corporate governance mechanisms (see Table 2 for the measurement) for firm i in fiscal year t; ROAit = return on assets for firm i in fiscal year t; FIRMSIZEit = firm size, measured as the natural logarithm of the book value of total assets for firm i in fiscal year t; FIRMAGEit = firm’s age, measured by the number of years since its initial listing for firm i in fiscal year t.

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ACCEPTED MANUSCRIPT Table 5 2SLS simultaneous equation model (all shares).a, b Expected Sign

Value Relevance Equation PRICEitAPRIL

EPSit

+

ABNRPTit

–

EPSit*ABNRPTit

– [H1]

CGQit

– [H2]

ROAit FIRMSIZEit

ED

FIRMAGEit

Included Included 0.4974 28.21*** 1,012

–0.01*** (–3.12) –0.01* (–1.70) 0.004 (1.23) 0.003*** (2.76) Included Included 0.1025 4.94*** 1,012

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YEARt INDUSTRYi Adjusted R2 F-Statistic Observations

–0.09 (–1.21)

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+

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BVPSit

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Intercept

Column (1) 11.78*** (19.11) 0.67*** (3.99) 4.82*** (7.78) –9.75*** (–2.92) –19.33*** (–4.65)

Earnings Management Equation ABNRPTit Column (2)

T

Independent Variable

This table reports the results of the 2SLS simultaneous model: Value relevance equation:

AC

PRICEitAPRIL = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)

Earnings management equation: ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi) where, PRICEitAPRIL = domestic stock price per share for firm i at the end of the fourth month (the last trading day of April) after fiscal year t; BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; ABNRPTit = the level of abnormal earnings management resulting from related-party transactions, measured as the residual term of the regression of leverage, firm size, growth and the CSRC’s industry code for firm i in fiscal year t; CGQit = corporate governance quality, including eight corporate governance mechanisms (see Table 2 for the measurement) for firm i in fiscal year t; ROAit = return on assets for firm i in fiscal year t; FIRMSIZEit = firm size, measured as the natural logarithm of the book value of total assets for firm i in fiscal year t; FIRMAGEit = firm’s age, measured by the number of years since its initial listing for firm i in fiscal year t; Year dummy (YEARt) represents dummy variables that reflect the year; Industry dummy (INDUSTRYi) reflects the company’s industry in accordance with the industry classification of the CSRC. Notes: a The first number represents the coefficient estimate, and the second number in parentheses represents the tvalue of significance. b* if p < 0.10, ** if p < 0.05; *** if p < 0.01. All tests are two-tailed.

33

ACCEPTED MANUSCRIPT Table 6 2SLS simultaneous equation model (breakdown by share type).a, b

BVPSit

+

EPSit

+

ABNRPTit

–

EPSit*ABNRPTit

– [H1]

CGQit

– [H2]

ROAit FIRMSIZEit FIRMAGEit

VR Column (3) 14.22*** (14.09) 0.46* (1.78) 3.15*** (3.16) –7.25 (–1.55) –4.18 (–0.82)

EM Column (4) –0.14 (–0.81)

T

EM Column (2) –0.25** (–2.58)

–0.001 (–0.42) –0.08 (–1.31) 0.01** (2.47) 0.002** (2.21) Included Included Included Included 0.6326 0.1744 18.08*** 2.07*** 637

–0.01** (–2.13) –0.38*** (–8.88) 0.01 (1.06) 0.002 (0.55) Included Included Included Included 0.5105 0.362 12.38*** 6.31*** 225

AH-Shares VR Column (5) 5.86*** (6.54) 1.69*** (6.04) 1.7* (1.84) –1.53 (–0.27) –3.76*** (–2.81)

EM Column (6) 0.35*** (3.3)

–0.01* (–1.88) –0.0001 (–0.13) –0.02*** (–3.27) 0.0004 (0.18) Included Included Included Included 0.7188 0.2224 23.0*** 2.37*** 150

PT

ED

YEARt INDUSTRYi Adjusted R2 F-Statistic Observations

VR Column (1) 12.72*** (11.13) –0.15 –0.55 8.58*** (6.98) –1.6 (–0.15) –24.3*** (–3.76)

AB-Shares

RI P

Intercept

A-Shares

SC

Expected Sign

MA NU

Independent Variable

This table reports the results of the 2SLS simultaneous model:

CE

Value relevance equation:

AC

PRICEitAPRIL = f (BVPSAit/ BVPSABit/BVPSAHit, EPSAit/EPSABit/EPSAHit, ABNRPTAit/ABNRPTABit/ABNRPTAHit, EPSA it*ABNRPTAit /EPSABit*ABNRPTABit/EPSAHit*ABNRPTAHit , YEARt, INDUSTRYi)

Earnings management equation: ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi) where, PRICEitAPRIL = domestic stock price per share for firm i at the end of the fourth month (the last trading day of April) after fiscal year t; BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; ABNRPTit = the level of abnormal earnings management resulting from related-party transactions, measured as the residual term of the regression of leverage, firm size, growth and the CSRC’s industry code for firm i in fiscal year t; CGQit = corporate governance quality, including eight corporate governance mechanisms (see Table 2 for the measurement) for firm i in fiscal year t; ROAit = return on assets for firm i in fiscal year t; FIRMSIZEit = firm size, measured as the natural logarithm of the book value of total assets for firm i in fiscal year t; FIRMAGEit = firm’s age, measured by the number of years since its initial listing for firm i in fiscal year t; Year dummy (YEARt) represents dummy variables that reflect the year; Industry dummy (INDUSTRYi) reflects the company’s industry in accordance with the industry classification of the CSRC. Notes: a The first number represents the coefficient estimate, and the second number in parentheses represents the tvalue of significance. b* if p < 0.10, ** if p < 0.05; *** if p < 0.01. All tests are two-tailed.

34

ACCEPTED MANUSCRIPT Table 7 Robustness check of Ge et al. (2010)’s value relevance model (stepwise).a, b Column (1)

Column (2)

Column (3)

BVPSit

+

EPSit

+

7.16*** (12.4) 0.86*** (4.25) 3.49*** (4.94)

EPSit*RLPSALESit

?

EPSit*RLPASSETSit

?

7.31*** (12.62) 0.77*** (3.81) 4.8*** (5.91) –14.42*** (–2.9) –0.42 (–0.69) No No 0.16 26.38*** 1,012

12.21*** (20.18) 0.7*** (4.31) 5.98*** (9.19) –25.96*** (–6.31) 0.06 (0.11) Included Included 0.4981 30.28*** 1,012

RI P

No No 0.1467 46.8*** 1,012

MA NU

YEARt INDUSTRYi Adjusted R2 F-Statistic Observations

T

Expected Sign

SC

Independent Variable Intercept

This table reports the results of Ge et al. (2010)’s value relevance model:

ED

PRICEitAPRIL = f (BVPSit, EPSit, EPSit*RLPSALESit, EPSit*RLPASSETSit,YEARt, INDUSTRYi)

CE

PT

where, PRICEitAPRIL = domestic stock price per share for firm i at the end of the fourth month (the last trading day of April) after fiscal year t; BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; RLPSALESit = the ratio related-party sales of goods and services to total sales for firm i in fiscal year t; RLPASSETSit = the ratio related-party sales of assets to total sales for firm i in fiscal year t; Year dummy (YEARt) represents dummy variables that reflect the year; Industry dummy (INDUSTRYi) reflects the company’s industry in accordance with the industry classification of the CSRC.

AC

Notes: a The first number represents the coefficient estimate, and the second number in parentheses represents the tvalue of significance. b* if p < 0.10, ** if p < 0.05; *** if p < 0.01. All tests are two-tailed.

35

ACCEPTED MANUSCRIPT Table 8 2SLS simultaneous equation model with alternative measures of CGQ.a, b Independent Variable

Expected Sign

Value Relevance Equation

Earnings Management Equation ABNRPTit Column (2) –0.07 (–1.00)

+

EPSit

+

ABNRPTit

– – [H1]

CGQ1it

– [H2]

CGQ2it

– [H2]

CGQ3it

– [H2]

ED

EPSit*ABNRPTit

ROAit

PT

FIRMSIZEit

AC

CE

FIRMAGEit YEARt INDUSTRYi Adjusted R2 F-Statistic Observations

MA NU

BVPSit

Included Included 0.4974 28.21*** 1,012

ABNRPTit Column (4) –0.09 (–1.21)

SC

11.78*** (19.11) 0.67*** (3.99) 4.82*** (7.78) –9.75*** (–2.92) –19.33*** (–4.65)

RI P

Column (1) Intercept

ABNRPTit Column (3) –0.08 (–1.12)

T

PRICEitAPRIL

–0.004** (–2.60) –0.005*** (–2.90) –0.01* (–1.84) 0.004 (1.06) 0.003*** (2.93) Included Included 0.093 3.86***

–0.01* (–1.75) 0.004 (1.15) 0.003*** (2.95) Included Included 0.094 3.95*** 1,012

–0.01*** (–3.12) –0.01* (–1.70) 0.004 (1.23) 0.003*** (2.76) Included Included 0.093 3.88***

This table reports the results of the 2SLS simultaneous model: Value relevance equation: PRICEitAPRIL = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)

Earnings management equation: ABNRPTit = ƒ(CGQ1it/CGQ2it/CGQ3it, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi) where, PRICEitAPRIL = domestic stock price per share for firm i at the end of the fourth month (the last trading day of April) after fiscal year t; BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; ABNRPTit = the level of abnormal earnings management resulting from related-party transactions, measured as the residual term of the regression of leverage, firm size, growth and the CSRC’s industry code for firm i in fiscal year t; CGQ1it/CGQ2it/CGQ3it, = three alternative measurements of corporate governance quality are employed in the earnings management equations. CGQ1 it includes ownership concentration, the number of meetings of the board of directors and the number of meetings of the supervisory board in addition to the corporate governance mechanisms listed in Table 2; CGQ2 it only includes ownership concentration in addition to the corporate governance mechanisms listed in Table 2; CGQ3 it excludes Big 4 auditor as a mechanism in the corporate governance mechanisms listed in Table 2. ROAit = return on assets for firm i in fiscal year t; FIRMSIZEit = firm size, measured as the natural logarithm of the book

36

ACCEPTED MANUSCRIPT value of total assets for firm i in fiscal year t; FIRMAGEit = firm’s age, measured by the number of years since its initial listing for firm i in fiscal year t; Year dummy (YEARt) represents dummy variables that reflect the year; Industry dummy (INDUSTRYi) reflects the company’s industry in accordance with the industry classification of the CSRC.

AC

CE

PT

ED

MA NU

SC

RI P

T

Notes: a The first number represents the coefficient estimate, and the second number in parentheses represents the tvalue of significance. b* if p < 0.10, ** if p < 0.05; *** if p < 0.01. All tests are two-tailed.

37

ACCEPTED MANUSCRIPT Table 9 2SLS simultaneous equation model by using alternative dependent variable.a, b Expected Sign

Value Relevance Equation PRICEitMARCH

EPSit

+

ABNRPTit

–

EPSit*ABNRPTit

– [H1]

CGQit

– [H2]

ROAit FIRMSIZEit

ED

FIRMAGEit

PT

YEARt INDUSTRYi Adjusted R2 F-Statistic Observations

–0.09 (–1.21)

SC

+

MA NU

BVPSit

RI P

Intercept

Column (1) 12.32*** (18.27) 0.61*** (3.30) 4.63*** (6.84) –12.18*** (–3.34) –20.84*** (–4.58)

Earnings Management Equation ABNRPTit Column (2)

T

Independent Variable

Included Included 0.4528 23.59*** 1,012

–0.01*** (–3.12) –0.01* (–1.70) 0.004 (1.23) 0.003*** (2.76) Included Included 0.1025 4.94*** 1,012

CE

This table reports the results of the 2SLS simultaneous model: Value relevance equation:

AC

PRICEitMARCH = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi) Earnings management equation: ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi) where, PRICEitMARCH = domestic stock price per share for firm i at the end of the third month (the last trading day of March) after fiscal year t; BVPSit = book value of equity per share for firm i in fiscal year t; EPSit = annual earings per share for firm i in fiscal year t; ABNRPTit = the residual term of the regression of leverage, firm size, growth and the CSRC’s industry code for firm i in fiscal year t; CGQit = corporate governance quality, including eight corporate governance mechanisms (see Table 2 for the measurement) for firm i in fiscal year t; ROAit = return on assets for firm i in fiscal year t; FIRMSIZEit = firm size, measured as the natural logarithm of the book value of total assets for firm i in fiscal year t; FIRMAGEit = firm’s age, measured by the number of years since its initial listing for firm i in fiscal year t; Year dummy (YEARt) represents dummy variables that reflect the year; Industry dummy (INDUSTRYi) reflects the company’s industry in accordance with the industry classification of the CSRC. Many Chinese listed companies publish their annual reports during March (Ge et al., 2010). Accordingly, PRICEMARCH, the domestic stock price per share for firm i at the end of the third month (the last trading day of March) is used to robust the primary findings in Table 5. Notes: a The first number represents the coefficient estimate, and the second number in parentheses represents the tvalue of significance.

38

ACCEPTED MANUSCRIPT

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PT

ED

MA NU

SC

RI P

T

if p < 0.10, ** if p < 0.05; *** if p < 0.01. All tests are two-tailed.

AC

b *

39

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