1 Value relevance, earnings management and corporate

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1 Value relevance, earnings management and corporate
Value relevance, earnings management and corporate governance in China
Yuan George Shan
School of Accounting & Finance, the University of Adelaide
Tel: (+61 8) 8313 6456
Email: [email protected]
This version: 28 February 2014
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Value relevance, earnings management and corporate governance in China
Yuan George Shan
School of Accounting & Finance, the University of Adelaide
Tel: (+61 8) 8313 6456
Email: [email protected]
ABSTRACT
With motivation to provide evidence of earnings management through abnormal related-party
transactions, this study investigates whether earnings management reduces the level of value
relevance and whether good corporate governance restrains earnings management. Using
hand-collected data comprising 1,012 firm-year observations from all companies listed 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 that have not engaged in earnings management
engagement. Furthermore, the companies with good corporate governance practices are more
likely to constrain earnings management than those without. These findings support the
premise that accounting information is relevant to stock price for large listed companies in
China. It provides the confidence of domestic and foreign investors’ decision-making relying
on the accounting data disclosed by the companies. This study also contributes evidence to
demonstrate that good corporate governance mechanisms can constrain earnings management
through abnormal related-party transactions. Thus, the legal reforms between 2001and 2005
were effective in improving the quality of corporate governance of large Chinese listed
companies. This evidence can be used by policy-makers and regulators for informing policy
developing in relation to disclosures of related-party transactions.
JEL classification: G30; M41
Keywords: China; Corporate governance; Earnings management; Value relevance
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1. Introduction
Since Ball and Brown (1968) began to explore the correlation between accounting earnings
and stock returns, latter studies, such as Ohlson (1995), expanded to include market 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
relationship between financial information and market price or return if the accounting
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, however,
an increase of value relevance of accounting information has been found in global markets.
Examples include Australia, France, the Netherland and the UK (Alford et al., 1993),
Germany (Harris 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). Increasingly greater attention on value relevance of accounting information in
China is being devoted in the literature due to its fast-growing stock market and its unique
market segmentation (Aharony et al., 2000; Chen et al., 2001; Haw et al., 1999; Lin and Chen,
2005; Liu and Liu, 2007; Samia and Zhou, 2004).
This study is motived by empirical evidence that concluded related-party transactions
are widely used to manage earnings for financial reporting (Aharony, Wang and Yuan, 2010;
Jian and Wong, 2010), 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,
2013a). For example, Shan (2013a) takes China as a case and extends the study of Young et
al., (2008) to examine whether corporate governance mechanisms prevent tunneling from the
perspective of the crucial principal-principal conflicts of interests between controlling
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shareholders and minority shareholders.1 Specifically, this study addresses the following two
research questions: (1) Does earnings management mitigate stock valuation? (2) Do corporate
governance mechanisms restrain earnings management?
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-parties that
can inflate earnings. Prior studies considered related-party sales to manage earnings. For
example, Herrmann et al. (2003) report Japanese companies use of income from the sale of
fixed assets to manage earnings. Chen and Yuan (2004) find that Chinese 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 of related-party to manage earnings.
However, these measures were mixed with normal and abnormal related-party transactions.
In fact, earnings management often engages in abnormal related-party transactions (Gao and
Kling, 2008; Lo and Wong, 2011). Therefore, this study examines whether there is an
incentive of earnings management through related-party transactions and follows Jian and
Wong’s (2010) abnormal related-party transactions model to remove any normal components
of related-party transactions. 2 The residual term of Jian and Wong’s (2010) model is
1
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 result in asset
appropriation or tunneling. Johnson et al. (2000) describe tunneling is 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 are 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, 2013a). Accordingly, the data collection for
this study focuses on Type I tunneling (direct transfer of related-party transactions).
2
Gao and Kling (2008) suggest that the accounting measure for tunneling is difficult to distinguish 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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considered as the abnormal related-party transaction which is used as the surrogate of
earnings management in this study.
Second, this study adds to the literature by determining the incentive of earnings
management on stock price and corporate governance mechanisms using 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 (2013a) investigate the
impact of internal and external governance mechanisms on tunneling using the transactions of
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
inflate earnings. These studies indicate that the stock valuation and corporate governance
mechanisms could impact each other simultaneously.
Third, endogeneity is a serious problem in the literature of corporate governance and
most studies blenches to discuss the possibility of endogeneity (Brown et al., 2011). For
example, Agrawal and Knoeber (1996) and Hermalin and Weisbach (2003) suggest 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 objective to avoid such problem this
study develops a concise corporate governance index to measure the quality of corporate
governance in the Chinese context.3
Fourth, Shan (2012a) argues that the legal environment improvement provide an
opportunity to investigate the effectiveness of corporate governance mechanisms and the
incentive of earnings management. To be consistent with this argument, data were collected
3
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, 2013a),
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).
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for the period between 2001 and 2005 covering the major economic reform and legal
improvements. 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 by 30 June 2003; ii) the Provisional Regulation on the Accounting for Sales of
Assets and Other Transactions between Related Parties (2001 RPT Measurement Regulation)
which was promulgated by the Ministry of Finance (MOF) at the end of 2001; iii) the Code
of Corporate Governance for Listed Companies in China (the Code) was promulgated in
January 2002; iv) the State-owned Assets Supervision and Administration Commission
(SASAC) which was was founded in 2003 as a functional body for top executive appointment,
supervisory board dispatch, and executives’ performance evaluation.
Fifth, additional analyses are established in accordance with current literature and
robust the findings and conclusion of this study including share type breakdown, the effect of
the related-party sales, alternative corporate governance ratings and alternative measure for
stock price.
Using hand-collected data including 1,012 firm-year observations that comprise all
companies listed on the Shanghai SSE 180 and the Shenzhen SSE 100 from 2001 to 2005,4
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
without earnings management, and companies with good corporate governance practices
constrain earnings management. Additional analyses prove the robustness the primary results
in four ways. First, the analysis of share type breakdown shows that the negative joint
4
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.
6
impacts of market earnings and earnings management are found in A- and AH-share but not
found in AB-share, and corporate governance mechanisms are only effective to constrain
earnings management in AB- and AH share. Second, the test of effects of related-party sales
indicates that related-party sales of goods have a negative impact on stock valuation, whereas
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
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
background in China. Section 3 reviews the previous literature and develops the hypotheses.
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
explanations for the results. A number of robustness checks are reported in Section 6. Finally,
conclusions are presented in Section 7.
2. Institutional background
China’s stock market has experienced many ups and downs in the last 60 years. In June 1949
the re-established Tianjin Stock Exchange marked the start of the Chinese stock market under
the communist regime. In 1956, after the completion of the socialist transformation from
capitalist system, the traditional socialist ideologies and the centrally planned economic
system rejected the existence of a stock market. In 1957, the socialist planned economic
system replaced the transitional economic and Chinese stock markets, and their financial
ideas disappeared for 25 years thereafter.
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After the Third Plenum of the 11th Communist Party of China Central Committee’s
adoption of economic reforms and Deng’s Open-Door policy in 1978, China restarted its
financial markets in order to drive its economic reforms. The government issued the first
treasury bonds in 1981 to finance its budget deficit. Soon after, many state-owned enterprises
(SOEs) issued financial and construction bonds to address fund shortages, with these funds
being urgently needed for economic reconstruction of the country (Tan, 1999).
Secondary markets were established and developed in ‘securities trading centres’
across the country in major provincial cities such as Guangzhou, Changzhou, Wuhan, Harbin
and Dalian under central government supervision. In April 1990, the central government
approved these trading centres, and provincial officials started designing their own exchanges
and applying to Beijing for permission to open them. This idea was supported by legislators
in the National People’s Congress. By the end of 1992, there were about 5,000 securities
trading centres, spawning the growth of approximately 70 specialised securities companies
and 1,000 institutions with securities operations. In 1989, the state council decided to
establish two stock exchanges to allow SOEs to raise external equity capital from the public.
The Shanghai Stock Exchange (SHSE) was the first and opened on 26 November 1990,
trading eight kinds of stock with a market value of RMB1 billion. The second, the Shenzhen
Stock Exchange (SZSE), was inaugurated on 3 July 1991 with five listed companies (Fung
and Leung, 2001). Meanwhile, China had been undertaking rapid reform of its corporations.
Laws and regulations were established to allow stock-holding companies. The large SOEs
and financial institutions were transformed into shareholding companies.
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
promote the sustained and healthy development of China’s economy. As a vital milestone,
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China entered a new phase of opening up and it offered an opportunity of historic
significance for the long-term development of its stock markets (Shan and Round, 2012).
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
Council Securities Commission (SCSC) and its executive organ, the China Securities
Regulatory Commission (CSRC), were established. The SCSC is the macro policy-making
body of the Chinese securities industry and the CSRC is the SCSC’s executive branch
responsible for conducting daily supervision and regulation of the securities markets in
accordance with the law. Practically, the SCSC and the CSRC took over most of the
functions 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
growth of the stock markets. In November 1993, the state council assigned the SCSC
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
Securities Regulatory Commission. Under this, the CSRC is validated as a deputy-ministrylevel unit and is authorised to supervise and regulate both securities and futures markets in
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.
Both the power and functions of the CSRC have been strengthened. Five months later, the
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
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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.
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 justification
for accounting practices and serve as guidance for resolving contemporary accounting issues.
In 1992, the Accounting Standards for Business Enterprises (ASBE) was issued by the MOF
and came into force on 1 July 1993.
This development reveals a significant move towards the Anglo-Saxon model of
financial regulation. By law all companies must prepare their financial statements using the
Chinese specification of generally accepted accounting principles (GAAP). The principal
sources of 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 supporting guidance.
The accounting reforms set out a three-level regulatory framework. At the top level,
the Accounting Law enacted by the National People’s Congress in 1985 (revised in 1993 and
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 has been formulated by the CSRC and the SETC. Both the SHSE and the 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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3. Hypotheses development
3.1. Earnings management and value relevance
Prior studies examine the impact of changes of accounting information on value relevance by
using Ohlson (1995)’s price model (e.g., Aharony, Barniv and Falk, 2010; Ahmed et al., 2006;
Ballas and Hevas, 2005; Bao and Chow, 1999; Barth, 1991; Brown et al., 1999; Burgstahler
and Dichev, 1997; Chen, et al., 2001; Collins et al., 1997; Eccher et al., 1996; Fang et al.,
2013; Francis and Schipper, 1999; Fung et al., 2010; Graham and King, 2000; Jaggi and Zhao,
2002; Landsman, 1986; Lev and Zarowin, 1999; Lin and Chen, 2005; 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 applications
environmental changes or new accounting standards (Aharony, Barniv and Falk., 2010;
Ahmed, et al., 2006; Brown, et al., 1999; Chen, et al., 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-relevance of earnings and book values from
1953 to 1993, and their findings suggest a 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 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
11
relevance of earnings and book value of equity for four EU countries and find earnings and
book value of equity have value implications with 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, 2009).
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,
2013b). For example, Jian and Wong (2010) discuss two incentives for controlling
shareholders to engage in earnings management through related-party transaction. 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
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
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
transactions were voluntary in China before 2007.5
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 and 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:
5
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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H1: Ceteris paribus, earnings management mitigates the level of value relevance.
3.2. Corporate governance and earnings management
Prior studies investigate tunneling and/or propping in China through regarding related-party
transactions (e.g. Aharony, Wang and Yuan, 2010; Berkman et al., 2009; Chen et al., 2009;
Cheung et al., 2009; Gao and Kling, 2008; Jiang, et al., 2010; Li, 2010; Liu and Liu, 2007;
Liu and Tian, 2012; Lo et al., 2010; Peng et al., 2011; Shan, 2013a; Wang and Xiao, 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 et al. (2009) examine whether Chinese-listed companies 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
signalling or distributing free cash flows, but are also imposed by the controlling shareholders
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
2001–2002. They conclude that minority shareholders are subject to both asset appropriation
through tunneling and gain from propping up 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
13
via related lending from the listed firms back to controlling owners after the propping. Jiang
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
controlling shareholders to extract funds from listed firms. Li (2010) suggests the corporate
governance mechanisms alone are not sufficient to protect minority shareholders. To support
this argument he investigates tunneling by controlling shareholders and provides evidence
that controlling ownership significantly increases the severity of tunneling. Lo et al. (2010)
examine tunneling incentives using the relative gross profit ratios of related- and unrelatedparty 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
(2013a) studies the impact of internal and external governance mechanisms from perspective
of principal-principal agency problem on tunneling, and the findings suggest that state
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.
Other internal governance mechanisms including foreign ownership, the size of the board of
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 interest with
shareholders’ interest. This divergence causes agency problem. The separation of ownership
and control, and costly enforceable contracts and information asymmetry between
management and shareholders arise agency costs (Jensen and Meckling, 1976; Rezaee, 2009;
Shleifer and Vishny, 1997). The role of corporate governance is to mitigate the agency
14
problem and reduce agency costs for creating value for shareholders (Rezaee, 2009; Shleifer
and Vishny, 1997). Prior studies find that companies with higher corporate governance
ratings/indexes have better performance than the companies with lower ratings (e.g., Larcker
et al., 2007), and companies with better corporate governance mechanisms are associated
with reduced earnings management (e.g., Duh et al., 2009; Garcia Osma, 2008; Sarkar et al.,
2008; Shen and Chih, 2007). From a theoretical perspective, companies with good corporate
governance are expected to have better competitive advantage than companies with poor
corporate governance, where the level of 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 management.
4. Research design
4.1. Sample and data
The sample contains all companies listed on the Shanghai SSE 180 and the Shenzhen SSE
100 during 2001–2005. 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). Since 2006
such disclosure became mandated resulting in the significant reduction of related-party
transactions among listed companies in China.
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
15
343 missing data. The distributional breakdown by share type contains 637, 225 and 150
firm-year observations for A-, AB- and AH-Share, respectively.6
The data were sourced in three ways. Data of related-party transactions and corporate
governance characteristics, including independent director, board size, board meeting,
professional supervisor, supervisory board size, supervisory board meeting were handcollected through the annual reports of listed companies. Share prices 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
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, which is
modified on the valuation framework provided by Ohlson (1995) and introduced the earnings
management proxy through abnormal related-party transactions which is consistent with Jian
and Wong (2010), Lo and Wong (2011) and Shan (2013b).7 The second equation (Equation 2)
6
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.
7
Chen et al. (2001) summaries two advantages of price model (value relevance model) over return model. First,
price model provides the earnings coefficients without bias as share prices reflect the cumulative effect of
earnings information (Kothari and Zimmerman, 1995), whereas return model is biased as it assumes that the
earnings coefficients 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 return model only considers the
value relevance through accounting earnings.
16
is designed to examine H2 and measures the association between earnings management
(ABNRPT) and corporate governance rating.
Value relevance equation (to test H1):
PRICEitAPRIL = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)
… (1)
Earnings management equation (to test H2):
ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)
… (2)
4.3. Dependent variable
PRICEitAPRIL represents share price of firm i at four months after the fiscal year end of 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 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
abnormal related-party transaction model is employed to develop the proxy of earnings
management – abnormal related-party transactions (ABNRPT) as follows:
RLPTi, t    1LEVERAGE i, t   2 FIRMSIZEi, t   3 MKVE  1-6 INDUSTRY   i, t
… (3)
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
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
proxied as the abnormal related-party transactions (ABNRPT) and used as the dependent
17
variable in earnings management equation (Equation (2)) and shifted into the value relevance
equation (Equation (1)) to test earnings management effect.
4.4. Independent variable
Prior studies of China’s corporate governance focus on how effective of individual/particular
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,
2013a; Shan and McIver, 2011). However, these individual governance factors are unlikely to
measure the overall quality of a company’s corporate governance (Brown, et al., 2011). The
investors demand for the development of corporate governance ratings that gather, analyse,
rank and 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
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
committee independence, shareholders’ rights and institutional ownership). Brown and
Caylor (2006) develop Gov-Score by measuring the equally weighted sum of 51 governance
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 are
18
complement each other (Brown, et al., 2011). Some other studies use concise ratings of
corporate governance that are more effective than those in all characteristics in large
corporate governance databases, such as Institutional Shareholder Services (ISS) and Investor
Responsibility Research Center (IRRC). For example, Brown and Caylor (2006) propose a
concise governance score that only contains seven governance provisions underlying the 51
elements in Gov-Score. According to the studies of composite measure of corporate
governance and China’s two-tier board system, the index of corporate governance quality
(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 contains 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. Industry dummy reflects the company’s industry code in
accordance with the classification of the CSRC. ROA equals return on assets for firm i in
fiscal year t. Firm size (FIRMSIZE) is the natural logarithm of total assets, and firm age
(FIRMAGE) measures the number of years since initial listing (Shan, 2013a).
4.6. Model diagnostics
19
Model diagnostics consists of multicollinearity diagnostic (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 value relevance equation)
and C (for earnings management equation) of Table 3 reveal that the values of any pairs of
independent variables are well below the critical value of 0.8. Second, 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 value relevance equation) and
D (for 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 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 earrings management and 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. Result and discussion
5.1. Descriptive statistics
The descriptive statistics displayed in Table 4 provide a profile of the key variables in terms
of all shares and years, share type breakdown and year breakdown. During 2001–2005, 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-, ABand 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 company’s annual report is
20
greater than the average value of 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,
11.8, 9.6, 9.81, and 6.77. This declining pattern was a symptom of bearish market in China
during these years. Similarly, the means of ROA indicate a significant downturn in firm
performance with ratios of 0.23, 0.03, 0.05, 0.06 and 0.05 during 2001–2005.
INSERT TABLE 4 ABOUT HERE
In terms of the index of corporate governance quality, as shown in Panel A of Table 4,
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 value relevance equation in Column (1) and 0.1025 for
earnings management equation in Column (2). The F-statistics for both equations are
statistically significant.
INSERT TABLE 5 ABOUT HERE
The first hypothesis (H1) was developed to examine whether the abnormal relatedparty transactions (ABNRPT) as a proxy of earnings management reduces the level of value
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
price that are consistent with Chen et al. (2001), Liu and Liu (2007) and Ge et al. (2010).
21
However, EPS can be surrogated as a function 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
that ABNRPT (β = –9.75, t = –2.92, p < 0.01) and the interaction term of EPS and ABNRPT
(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
valuation measured by stock price, i.e., 19.33 lower than companies that are not engaged in
the abnormal related-party transactions.
The second hypothesis (H2) was established to test whether the good CGQ as 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.
But FIRMAGE reveals a positive association which suggests the historical reputation and
image of listed companies were often regardless by the companies because investors have
limited investment choices due to underdevelopment stock market in China (Shan and Xu,
2012; Shan, 2013a).
6. Additional analyses
Additional analyses were conducted to extend and assess the robustness of the primary result
of 2SLS simultaneous model discussed earlier.
6.1. Share type breakdown
22
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
(2012a, b) suggest that the proportion of ownership and monitoring power board of directors
and supervisory board of each type of company is different. Accordingly, this study employs
share type breakdown analysis in order to test the value relevance of the three share types
applied under different accounting principles/standards. 8 The 2SLS simultaneous model is
modified as follows:
Value relevance equation:
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-share, respectively, which are
consistent with the primary result. However, the results in Column (1) the estimated
coefficient on BVPS is insignificant, while that the coefficient on EPS is significant and
positive to value relevance, which are consistent with Lin and Chen (2005). The findings
suggest that EPS is value-relevant, whereas BVPS is not value-relevant in A-share market
under Chinese GAAP.
The results reported in Columns (1) and (5) indicate negative joint impacts of market
earnings and earnings management for A- and AH-share, respectively, whereas such impact
is not found for AB-share. The negative coefficient for A- or AH-share indicates that 24.3 or
8
For companies issuing A-shares only the financial reports of the companies are required to prepare under the
Chinese generally accepted accounting principles (Chinese GAAP). For companies issuing both A- and B-share,
the A-share part is required to prepare under Chinese GAAP, whereas the B-share part is required to prepare
under the International Accounting Standards (IAS). For companies issuing both A- and H-share, the A-share
part is required to prepare under Chinese GAAP, whereas the H-share part is required to prepare under either
IAS or the Hong Kong GAAP (Liu and Liu, 2007).
23
3.76 lower value relevance than the companies that have no abnormal related-party
transactions.
The results presented in Columns (4) and (6) show that CGQ has a negative
association with ABNRPT for AB- and AH-share, whereas the negative association is not
found for A-share firms. This finding is not surprising as the principal-principal conflicts of
interest in A-share companies are more severe than that in AB- and AH-share companies.
The highly concentrated ownership and weak monitoring power of board of directors and
supervisory board result in poor corporate governance quality to safeguard tunneling or
abnormal related-party transactions (Shan, 2013a).
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 related-party
transactions are value-relevant to stock price before and after the Provisional Regulation on
the Accounting for Sales of Assets and Other Transactions between Related Parties (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 stocks price
in the period before 2001 RPT Measurement Regulation. Such results were not found after
2001 RPT Measurement Regulation.9 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
the period after 2001 in particular. The Ge et al. (2010)’s value relevance model is used to
robust the primary results as follows:
9
The Ministry of Finance (MOF) promulgated the Disclosure of Related Party Relationship and Transactions
(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 Provisional Regulation on the Accounting for Sales of Assets and Other Transactions
between Related Parties (2001 RPT Measurement Regulation) at the end of 2001, which intensified accounting
rules for sales of assets (including sales of goods) between related parties.
24
PRICEitAPRIL = f (BVPSit, EPSit, EPSit*RLPSALESit, EPSit*RLPASSETSit,YEARt, INDUSTRYi) … (6)
INSERT TABLE 7 ABOUT HERE
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 are 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
EPS*RLPASSETS are found to have no impact on stock price. The latter findings are
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
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 shift to the
value relevance model to examine whether there is an incremental or decremental impact of
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 concentration and firm
performance; the frequent meetings are expected to improve board effectiveness and
efficiency (Conger et al., 1998; Jackling and Johl, 2009; Shan, 2013a; Shan and Xu, 2012).
Other literature excluded Big 4 auditor as a factor of internal governance mechanisms
(Rezaee, 2009; Shan, 2013a). Accordingly, this study generates three alternative corporate
governance ratings: (1) CGQ1 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; (2) CGQ2 only includes ownership
25
concentration in addition to the corporate governance mechanisms listed in Table 2; (3)
CGQ3 excludes Big 4 auditor as a mechanism in the corporate governance mechanisms listed
in Table 2. The 2SLS simultaneous model is, consequently, modified as follows:
Value relevance equation:
PRICEitAPRIL = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)
… (7)
Earnings management equation:
ABNRPTit = ƒ(CGQ1it/CGQ2it/CGQ3it, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)
… (8)
INSERT TABLE 8 ABOUT HERE
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 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 or robust their results by using the share price at the end of
third month, i.e., on 31 March or the last trading day of March (e.g., Fung, et al., 2010; Ge, et
al., 2010). Accordingly, 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:
PRICEitMARCH = f (BVPSit, EPSit, ABNRPTit, EPSit*ABNRPTit, YEARt, INDUSTRYi)
… (9)
Earnings management equation:
ABNRPTit = ƒ(CGQit, ROAit, FIRMSIZEit, FIRMAGEit, YEARt, INDUSTRYi)
… (10)
INSERT TABLE 9 ABOUT HERE
26
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
with the primary results in Table 5, and suggest that there is no difference to surrogate the
stock price by the end of March or the end of April as many Chinese listed companies
announce and publish their annual reports in March (Ge et al., 2010).
7. Conclusion
Driven by the motivation to provide evidence of earnings management through abnormal
related-party transactions, this study employs 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-collection 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 engagement, and the companies with good
corporate governance practices are more likely to constrain earnings management. The
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
earnings management on value relevance, but this finding does not apply to AB-share
companies. Corporate governance mechanisms are effectively moderate earnings
management in AB- and AH share. Second, the test of effects of related-party sales reports a
negative impact on value relevance through related-party sales of goods, whereas relatedparty sales of assets are found to have no impact. Third, the results using alternative corporate
27
governance 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
that accounting information is relevant to the stock price for large listed companies in China.
It provides confidence to domestic and foreign investors for their decision-making relying on
the accounting information disclosed by the companies. Second, this study adds evidence to
demonstrate that good corporate governance mechanisms can constrain earnings management
through abnormal related-party transactions. Thus, the legal reforms between 2001and 2005,
such as promulgation of the Code and the Guidelines, were effective in improving the quality
of corporate governance for large Chinese listed companies. Third, the 2001 RPT
Measurement Regulation is indeed necessary as the joint impacts of market earnings and
earnings management decreased value relevance. Policy-makers 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 (see Table 2) 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 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 earnings (EPS) and the level of earnings management (ABNRPT) in the
value relevance equation to examine the association between accounting information and
stock valuation. However, other accounting information, such as goodwill, research and
development expenses (R&D) and asset revaluation can be value-relevant (Aharony, Barniv
and Falk, 2010). Future studies can address this limitation. The third limitation lies in the
28
small sample size and short time span. With this limitation, the results of this study should be
interpreted cautiously.
29
Table 1
Data.
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 observation
No. of observations
900
500
(45)
(343)
1,012
Breakdown by share type
A-share
AB-share
AH-share
Total firm-year observation
No. of observations
637
225
150
1,012
Breakdown by year
2001
2002
2003
2004
2005
Total firm-year observation
No. of observations
191
196
205
208
212
1,012
30
Table 2
Constructing corporate governance index.
8
CGQi, t   Corporate Governance Mechanism j
j1
Corporate Governance
Mechanism
State ownership
concentration
Description
Measurement with Supported Literature
STATEit – proportion of shares held by the state
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, 2013a).
Foreign ownership
concentration
FOREIGNit – proportion of shares held by foreign investors
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, 2013a; Shan and Xu, 2012).
Board size
BOARDSIZEit – number of directors on the board of directors
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).
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,
2013a; 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).
31
Table 3
Multicollinearity diagnostics.
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.
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)
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
Mean VIF
1.38
R-Squared
0.3175
0.3404
0.1280
Panel C: Pearson and Spearman’s rank correlations for variables of earnings management equation a
CGQit
ROAit
FIRMSIZEit
FIRMAGEit
BIG4it
***
***
CGQit
–
0.134
0.361
–0.0288
0.46***
(3.131)
(8.975)
(–0.667)
(12.009)
ROAit
0.092**
–
0.101**
–0.267***
0.066
(2.132)
(2.354)
(–6.423)
(1.541)
FIRMSIZEit 0.398***
0.087**
–
–0.143***
0.278***
(10.067)
(2.028)
(–3.356)
(6.712)
***
FIRMAGEit
–0.023
–0.007
–0.184
–
0.039
(–0.527)
(–0.174)
(–4.347)
(0.911)
BIG4it
0.466***
0.063
0.314***
0.039
–
(12.209)
(1.456)
(7.677)
(0.916)
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
BIG4it
1.32
1.15
0.7571
Mean VIF
1.21
R-Squared
0.2894
0.0116
0.2156
0.0447
0.2429
32
Table 4
Descriptive statistics.
Panel A: Breakdown by share type
Variable
PRICEitAPRIL
BVPSit
EPSit
CGQit
ROAit
FIRMSIZEit
FIRMAGEit
All shares & years
Mean
Med
10.45
9.47
Mean
11.33
A-shares
Med
10.43
AB-shares
Mean
Med
11.21
10.47
AH-shares
Mean
Med
8.12
6.94
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
2.61
0.14
3.21
0.03
21.61
8.98
2.7
0.18
5.3
0.17
22.9
5.71
2.88
0.19
3
0.05
21.88
7
2.77
0.14
3
0.04
21.63
9
2.51
0.17
6
0.05
22.92
6
Panel A: Breakdown by year
2001
Variable
PRICEitAPRIL
BVPSit
EPSit
CGQit
ROAit
FIRMSIZEit
FIRMAGEit
2002
2003
2004
2005
Mean
15.2
Med
14.51
Mean
11.8
Med
11.23
Mean
9.6
Med
9.25
Mean
9.81
Med
8.46
Mean
6.77
Med
5.27
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
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
33
Table 5
2SLS simultaneous equation model (all shares). 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(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. The first number represents the coefficient estimate, 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.
Independent
Variable
Expected Sign
Value Relevance
Equation
PRICEitAPRIL
Intercept
BVPSit
+
EPSit
+
ABNRPTit
–
EPSit*ABNRPTit
– [H1]
CGQit
– [H2]
Column (1)
11.78***
(19.11)
0.67***
(3.99)
4.82***
(7.78)
–9.75***
(–2.92)
–19.33***
(–4.65)
ROAit
FIRMSIZEit
FIRMAGEit
YEARt
INDUSTRYi
Adjusted R2
F-Statistic
Observation
Included
Included
0.4974
28.21***
1,012
Earnings Management
Equation
ABNRPTit
Column (2)
–0.09
(–1.21)
–0.01***
(–3.12)
–0.01*
(–1.70)
0.004
(1.23)
0.003***
(2.76)
Included
Included
0.1025
4.94***
1,012
34
Table 6
2SLS simultaneous equation model (breakdown by share type). This table reports the results of the
2SLS simultaneous model:
Value relevance equation:
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. The first number represents the coefficient estimate, 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.
Independent
Variable
Expected
Sign
Intercept
BVPSit
+
EPSit
+
ABNRPTit
–
EPSit*ABNRPTit
– [H1]
CGQit
– [H2]
ROAit
FIRMSIZEit
FIRMAGEit
YEARt
INDUSTRYi
Adjusted R2
F-Statistic
Observation
A-Shares
VR
Column
(1)
12.72***
(11.13)
–0.15
–0.55
8.58***
(6.98)
–1.6
(–0.15)
–24.3***
(–3.76)
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
AB-Shares
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)
–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
35
Table 7
Robustness check of Ge et al. (2010)’s value relevance model (stepwise). This table reports the
results of Ge et al. (2010)’s value relevance model:
PRICEitAPRIL = f (BVPSit, EPSit, EPSit*RLPSALESit, EPSit*RLPASSETSit,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; 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. The
first number represents the coefficient estimate, 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.
Independent
Variable
Intercept
Expected Sign
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
YEARt
INDUSTRYi
Adjusted R2
F-Statistic
Observation
No
No
0.1467
46.8***
1,012
36
Table 8
2SLS simultaneous equation model with alternative measures of CGQ. 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)
APRIL
where, PRICEit
= 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;
CGQ2it only includes ownership concentration in addition to the corporate governance mechanisms listed in Table 2; CGQ3it
excludes Big 4 auditor as a mechanism in the corporate governance mechanisms listed in Table 2. ROA it = 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 (INDUSTRY i) reflects the
company’s industry in accordance with the industry classification of the CSRC. The first number represents the coefficient
estimate, 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.
Independent
Variable
Expected
Sign
Value
Relevance
Equation
PRICEitAPRIL
Column (1)
Intercept
BVPSit
+
EPSit
+
ABNRPTit
–
EPSit*ABNRPTit
– [H1]
CGQ1it
– [H2]
CGQ2it
– [H2]
CGQ3it
– [H2]
11.78***
(19.11)
0.67***
(3.99)
4.82***
(7.78)
–9.75***
(–2.92)
–19.33***
(–4.65)
ABNRPTit
Column
(2)
–0.07
(–1.00)
ABNRPTit
Column
(3)
–0.08
(–1.12)
ABNRPTit
Column
(4)
–0.09
(–1.21)
–0.004**
(–2.60)
–0.005***
(–2.90)
ROAit
FIRMSIZEit
FIRMAGEit
YEARt
INDUSTRYi
Adjusted R2
F-Statistic
Observation
Earnings Management
Equation
Included
Included
0.4974
28.21***
1,012
–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***
37
Table 9
2SLS simultaneous equation model by using alternative dependent variable. This table reports the
results of the 2SLS simultaneous model:
Value relevance equation:
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.The first number represents the
coefficient estimate, 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.
Independent
Variable
Expected Sign
Value Relevance
Equation
PRICEitMARCH
Intercept
BVPSit
+
EPSit
+
ABNRPTit
–
EPSit*ABNRPTit
– [H1]
CGQit
– [H2]
Column (1)
12.32***
(18.27)
0.61***
(3.30)
4.63***
(6.84)
–12.18***
(–3.34)
–20.84***
(–4.58)
ROAit
FIRMSIZEit
FIRMAGEit
YEARt
INDUSTRYi
Adjusted R2
F-Statistic
Observation
Included
Included
0.4528
23.59***
1,012
Earnings Management
Equation
ABNRPTit
Column (2)
–0.09
(–1.21)
–0.01***
(–3.12)
–0.01*
(–1.70)
0.004
(1.23)
0.003***
(2.76)
Included
Included
0.1025
4.94***
1,012
38
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