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Abstract

This paper investigates the earnings management activities in Chinese listed firms and the impact of the split share structure reform (SSSREF). We demonstrate that Chinese listed firms exhibited a long-term positive relationship between real and accrual-based earnings management activities over the 2002–2011 period. This reflects the environment of weak investor protection and lack of effective corporate governance in China. Our results also indicate that the SSSREF in China has not fundamentally improved firms' quality of financial information. This may be because ownership concentration remains high. However, it is of interest that the reform has created an incentive alignment effect exogenously. We find that firms' use of discretionary accruals was constrained, and they have consequently shifted to less detectable and under-scrutinized real earnings activities after the reform. This shift is similar to that seen with the direct regulatory changes in accounting reporting rules on firms' earnings behaviors in developed countries where the investor protection environment is strong. We suggest that firms' shifting between the accrual and real-based earnings methods is an overlooked area for investors to consider in the emerging market context, and may require the attention of regulators.

5. Conclusion

This paper contributes to the earnings management literature by examining the impact of the SSSREF on firms' real and accrual-based earnings behaviors in China. The distinctive settings of the SSSREF allow us to draw new inferences. First, this study is conducted in an emerging country context with weak investor protection. Second, the exogeneity of incentive alignment effect given by China's split share structure reform allows us to compare the results with previous studies looking at the impact of the direct regulatory changes in accounting reporting rules such as SOX and IFRS on earnings management in developed markets where corporate governance mechanisms and investor protection are stronger. We also contribute to the earnings management literature by providing empirical results on the relationship between real and accrual-based earnings management activities before and after the SSSREF. Our results delineate a long-term positive relationship between the two earnings management activities throughout our sample period from 2002 to 2011. This may result from the weaker environment for investor protection in China than in developed countries. The Chinese SSSREF has strengthened firms' incentive alignment exogenously as the interest and wealth of NTS shareholders are linked to firms' stock performance after the reform. Therefore, the SSSREF is distinguished from the SOX and IFRS in that it does not impose a direct comprehensive regulatory change in firms' accounting reporting practice. It is of interest that our results show a tendency for firms to use more real and less accrual-based earnings management in the post-reform period and that the long-term positive relationship between the two earnings activities is significantly reduced.