Incentives for Earnings Management: Chinese
vs. Traditional Motives
Joeri de Wolf St. Nr.: 10003983
Date of submission, V2: 22.06.2014
Bachelor Thesis (BSc Accountancy & Control) University of Amsterdam
___________________________________________________________________________ Abstract
China’s financial market has been developing at an astonishing rate in recent years. This has given rise to a number of highly successful and influential firms. But as the economy moves away from its underdeveloped state and becomes more and more of a market economy, more Chinese managers try to use the supplementary lack of regulations to their advantage. This study focuses on the degree by which Chinese motives for earnings management differ from the traditional ones. These include the increase of bonus plans, the avoidance of violating debt covenants and meeting market expectations. Although a plethora of studies have been
conducted to identify which incentives motivate managers to manage their earnings, they neglect to show any consequences that might occur due to different economical characteristics. This study addresses such variations by focusing on the Chinese financial market. I find that, unlike traditional incentives as mentioned before, Chinese managers are driven by other motivations. Predominantly the fear of being delisted, tunnelling earnings to private accounts and abusing IPO’s to increase capital induce earnings management among Chinese firms. This is mainly caused by limited regulations due to the financial market still being
underdeveloped. Investors are barely protected from bad decisions from managers and the current accounting standards maintain a high degree of information asymmetry between firms and outsiders.________________________________________________________________
___________________________________________________________________________ Samenvatting
China’s financiële markt heeft in de afgelopen jaren een verbijsterende ontwikkeling gekend. Dit heeft het ontstaan van verscheidene grote en invloedrijke multinationals tot gevolg gehad. Maar terwijl de Chinese economie steeds verder weet te ontsnappen aan een
onderontwikkelde staat, proberen meer en meer Chinese managers gebruik te maken van de achterstand in regulatie. Deze studie richt zich op de mate waarmee Chinese motieven voor earnings management verschillen van de traditionele stimulansen. Deze zijn met name het behalen van voorspellingen, het vergroten van de bonus en het vermijden van het verbreken van schuldovereenkomsten. Alhoewel er al meerdere onderzoeken zijn gedaan naar de motieven voor earnings management, negeren deze de invloed die de economische
karakteristieken hierop kunnen hebben. Dit artikel richt zich op dergelijke variaties door te kijken naar de Chinese financiële markt. Ik heb gevonden dat, verschillend van de traditionele motieven zoals voorheen genoemd, Chinese managers voornamelijk door andere stimulansen worden gedreven. Met name het verliezen van het beursrecht, het tunnelen van winsten naar private rekeningen en het misbruiken van IPO’s om kapitaal te vergroten zijn redenen voor managers om over te gaan op earnings management. Dit wordt voornamelijk veroorzaakt door de beperkte regulatie tengevolge de onderontwikkeldheid van de financiële markt, dat nog steeds aanwezig is. Investeerders zijn nauwelijks beschermd tegen slechte en onethische beslissingen van managers. Daarbij komt dat de huidige accounting standaarden een hoge mate van informatie asymmetrie tussen bedrijven en buitenstaanders behouden.
Table of Contents
1. Introduction ... 5
2. Methods of Earnings Management ... 7
2.1. Real Earnings Management... 7
2.2. Accrual- Based Earnings Management ... 8
2.2.1. Big Bath Accounting ... 9
2.2.2. Income Minimization ... 9
2.2.3 Income Maximization ... 10
2.2.4. Income Smoothing ... 10
3. Benefits and Drawbacks of Earnings Management ... 11
3.1. Benefits of Earnings Management ... 11
3.2. Drawbacks of Earnings Management ... 12
4. Motives for managers to manage earnings: Traditional vs. China ... 13
4.1. Traditional motives for managing earnings... 14
4.1.1. Earnings management with regards to bonus plans ... 14
4.1.2. Earnings Management to avoid violating debt covenants ... 15
4.1.3. Earnings Management in order to meet market expectations ... 16
4.2. Chinese motives for earnings management ... 17
4.2.1. Earnings management when being delisted ... 18
4.2.2. Earnings management due to Tunnelling ... 19
4.2.3. Earnings Management prior to initial public offerings ... 20
5. Summary and Conclusion ... 23
1. Introduction
In recent years, the Chinese stock market has been developing at an astonishing pace and China’s reputation as a global economic giant has become undeniable. More and more, China is transitioning from a planned economy to a market economy. In conjunction with this rapid economic change, the need for a clear and strict corporate governance structure becomes increasingly important. Several measures have already been taken to induce greater transparency and accountability within the Chinese business environment: a separation between foreign and domestically tradable shares, the implementation of new accounting standards that show multiple correspondences with International Financial Reporting
Standards (IFRS) and obligating listed firms to report earnings on a quarterly basis (Noronha, Zeng & Vinten, 2008). Regardless, the establishment of a well-defined framework proceeds gradually as China’s financial market is still emerging.
Since February 2006, new Accounting Standards for Business Enterprises (ASBE) are to be used by all listed companies in China in order for reporting their financial statements. Especially for investors and forecasters, this significantly helps to improve transparency and boosts investors’ confidence in general. Studies show the process of harmonizing Chinese accounting standards is promising (Ip & Noronha, 2007). However, as it is now, the
regulatory system is very limited and many aspects of the accounting practices are not taken into account by the accounting standards. Wu et al. (2004) already found evidence that shows these accounting deficiencies have a considerable negative effect on the quality of reporting within the Chinese financial market. This has given rise to the notion that earnings
management is widely used, which is confirmed by a survey among managers of publicly listed firms (Ducharme, Malatesta, & Sefcik, 2004). More than 40 percent stated earnings management contributes to the success of the company. However, in recent years, cases of unethical earnings management have become more frequent.
To further examine the subject of Chinese earnings management, this study provides additional insight in the factors incentivizing Chinese executives to resort to earnings management and to what extent these motivators differ from the traditional motives for managers in the European and American stock market. Therefore, the main research question of this thesis will be: to what extent differ the incentives for earnings management for Chinese firms from the traditional incentives to manage earnings?
Examples of traditional motives include the increasing of bonus compensation and an attempt to increase the stock price. Chinese managers on the other hand, seem less
economical characteristics between stock markets and is sure to have its effect on the goals that managers hope to achieve and how they hope to achieve it. By making a comparison with traditional motives, it shows in which ways the external regulatory environment contributes to earnings management. Furthermore, the results of this study could contribute to determining which direction China should go in the development of their economy in order to attain a more regulatory, stable and transparent stock market.
This study extents previous literature in this field by making a comparison between financial markets. Abundant literature exists that studies the different incentives that drive managers to earnings management (see Jiang, Petroni & Wang, 2010; Hashim, Salleh, & Ariff, 2013), but those are studies done within the constraints of one particular market and neglect to provide any similarities and differences with other markets. Based on an extensive literature review, this study provides a clear overview of incentives in the Chinese stock market,
compared to traditional stock markets. Results show Chinese managers are more driven by the fear of being delisted from the stock market, tunnelling earnings to private accounts and abusing an initial public offering (IPO) in order increase capital for the firm.
In order to establish these results, the remainder of this study is arranged as follows: In the next paragraph, the characteristics of earnings management will be further discussed. This entails the different methods by which the use of real and accrual-based earnings management can result in income-minimization, income-maximization and income-smoothing. The
benefits and drawbacks of using earnings management will be discussed in paragraph 3, as well as the initial idea as to why earnings management is allowed within current accounting standards. In paragraph 4 the results of the literature review will be shown and analysed. First off, the traditional motives for earnings management will be described and the effect earnings management has on achieving these motives. After that, the several incentives that drive Chinese managers will be summed up. In addition, this paragraph will also show earnings management results with regards to Chinese initial public offerings. Chinese IPO’s tend to deal with a considerable amount of underpricing. Considering this is partly caused by a misuse of the freedom that is associated with earnings management, this study provides an in-depth observation of books manipulation surrounding these events. Lastly, in paragraph 5, the summary of this study alongside a clear comparison between the two sets of motives. Here, the conclusion can be found. It shows what reasons drive managers to alter books. But, more importantly, this section also states why Chinese managers are not driven by traditional motives to manage earnings.
2. Methods of Earnings Management
A firms primary goal is to improve shareholder’s value by utilising the assets which they obtained by using debt and equity capital. Capital is raised, if investors decide to invest in the company. However, they will only choose to do so if they expect the future performances of the company to be positive. This implies that the firm benefits from reporting positive
earnings, as well as meeting analysts’ forecasts (Bartov, Givoly & Carla, 2002; Robb, 1998). But there will periods in which these expectations will not be met. To avoid a decrease in the stock price, firms resort to earnings management. Scott (2010) defines earnings management as “the choice by a manager of accounting policies, or actions affecting earnings, so as to achieve some specific reported earnings objective”. In the remainder of this paragraph, the different earnings management strategies will be discussed, and what benefits and possible risks arise from using these strategies.
Net income consists of a firm’s cash flow and net accruals. Either one can be altered to affect earnings. Trying to change the cash flow, a firm is obligated to diverge from their usual operations. This process, the changing of operations in order to change the cash flows, is called Real Earnings Management (REM) (Healy & Wahlen, 1998). The other option that exists, is increasing or decreasing the level of accruals. This is referred to as Accrual-based Earnings Management (AEM). The differences between these strategies are more clearly described in the following paragraphs.
2.1. Real Earnings Management
As mentioned before, firms can choose to boost reported earnings by changing operational processes within the company. The possible downside of this approach, is that it could have a negative effect on future performances of the company (Healy & Wahlen, 1998). Multiple deviation methods have been established to perform real earnings management. They can be categorized as follows: operating activities, financing activities and investment activities (Gunny, 2010).
The most evident way of improving ones earnings through altering operating
processes, is the lowering of expenditures. Relative hard-to-measure expenses like research and development and selling, general and administrative expenditures are often chosen to cut back on (Gunny, 2010). Because IFRS state that the latter are expensed in the period in which they are incurred, they have an immediate effect on the reported income. But cutting back on these departments is somewhat risky, as less expenditure in these areas could negatively affect
future firm performance. Due to reporting failures, as seen with WorldCom and Enron, managers increasingly prefer to resort to this type of measures. A survey among 312 U.S. listed companies showed managers readiness to influence real variables in an attempt to reach specified targets. Even if this would have a negative effect on the long-run performance (Graham, Harvey, & Rajgopal, 2005). This also results in some more unethical approaches. For example, if firms would intentionally overproduce, it also could positively influence earnings. As overhead costs are spread over more products, the costs of goods sold per unit will decrease.
With regards to deviating earnings by investment activities, possibilities include the structuring of purchase transactions (which they essentially are) as lease agreements in an attempt to skirt GAAP criteria (Dye, 2002). Another example of investment activities is the acquisition of another company. Although it is a significant expenditure, any profits of this company will be implemented in the future earnings of the acquiring firm. This could have an immediate positive effect on the stock price.
The last category of real earnings management is the deviation from financial activities. A good example of this is awarding stock options instead of dividends. If certain companies do not meet the predicted targets, they could be forced to award additional stock options as monetary dividends are not possible within the budget. This has a direct negative effect on the stock price. To prevent this from taking place, managers might decide to repurchase those stocks as soon as possible (Graham, Harvey, & Rajgopal, 2005).
2.2. Accrual- Based Earnings Management
In addition to real earnings management, managers can also decide to manipulate earnings by altering the accruals. The main goals of accruals is to allocate expenses and revenues to the year or month in which they actually occurred. Accrued revenues, for example, are services delivered or goods sold that have not been billed yet, such as rent that is paid in a subsequent period.
Although accruals serve the purpose of allocating expenses and revenues to the correct period, a certain degree of freedom also offers the possibility to arrange the books in such a way that merely shows improved earnings. Several measures can be taken by firms to raise earnings. For example, companies can decide to decrease the bad debt reserve. This directly increases the net accounts receivable account and, in it’s extension, increases the earnings for that period (Gunny, 2010). Considering this account is mainly based on an estimation of past
years, legislation allows for some extent of flexibility. Other examples of discretionary
accruals include warranty costs and inventory write-downs. Among U.S. banks, it is relatively common to make greater use of the loan loss provision in order to manipulate earnings
upwards (Robb, 1998).
In the following section, multiple examples will be given of the several income-altering results with regards to earnings that managers strive to achieve.
2.2.1. Big Bath Accounting
The first one is big bath accounting. This is a based on a simple line of reasoning, which encourages earnings to be presented worse than they are. At least in the current period. Jordan and Clark (2011)exemplify big bath accounting as taking a large non-recurring loss in a year where profits are already at a low level. Consequently, future earnings will not be burdened by this loss. The idea behind this approach is that, when the situation is already negative, making it worse will do no additional damage to either the company’s or management’s reputation (Clark & Jordan, 2011). The company suffers identical consequences, regardless of the amount by which they miss their target.
Big bath accounting has been discussed in accounting literature for quite some time, but the extent to which this practice is tested is limited. Most studies which include big bath accounting, primarily discuss it aside from the main subject. In a study regarding the impact of non-recurring items on predicting future earnings, Stephens and Cameron (1991)
concluded that such items are more often used to create a “big bath”, rather than smoothing income. Likewise, Yoon and Miller (2002) noted that operating performance is correlated to the degree of earnings management. In cases of extremely below-par performance, firms resort more to income-decreasing strategies instead of increasing ones.
It is worth noting however, that it is rather difficult to confirm that a firm uses big bath accounting with certainty. Implementing the rules stated by SFAS no. 109 has the exact same effect and is an acknowledged and encouraged accounting method. This statement implies that a current tax liability is recognized for future estimated taxes payable for the current year.
2.2.2. Income Minimization
This accounting strategy is highly similar to big bath accounting, but less severe. It is a strategy often chosen by firms that are politically visible. In times of high profitability, firms
may consider accruing additional expenses. One can think of the expense costs of research & development, advertising expenses, intangible assets or rapid write-offs of capital assets (Guenther, 1994). The main reason firms resort to this practice is minimizing the taxable income. Apart from accelerating future expenses into the current year, managers can also achieve this goal by deferring revenues to later periods. A requirement of this approach is that, in order to satisfy all accounting principles surrounding the deferring of revenue, all events that occur have to be postponed (Guenther, 1994). A good example is the shipment of goods. Delaying the actual shipment of goods for products of which cash has already been paid to past year-end, allows the firm to recognize revenue in that year. This entails that taxes will have to be paid that subsequent year as well.
2.2.3 Income Maximization
The opposite of income minimization is income maximization and is the method
predominantly associated with earnings management. Instead of lowering reported earnings, managers may attempt to increase them. This could be for bonus purposes, but also in the prospect of debt covenant violations. Considering these and many other financial advantages can be gained by reporting higher earnings, income maximization is arguably the strategy most often used. The majority of incentives that managers could have to resort to earnings management, have to do with income maximization. These incentives are more thoroughly discussed in paragraph 4 and the discussion, where a comparison will be made between traditional and Chinese motivations. Achieved by real earnings management as well as by accrual-based earnings management, many deliberate adjustments to the books are done in an attempt to maximize income. The focus of this study with regards to earnings management lies therefore particularly on this strategy.
2.2.4. Income Smoothing
In essence a combination of the two previous earnings management patterns, income
smoothing can be defined as the intentional negation of considerable fluctuations in earnings surrounding the level that is considered to be normal for a firm (Beidleman, 1973). On a regularly basis, firms attempt to reduce abnormal variations in earnings by means of sound accounting and management principles. The main argument for income smoothing is based on the use of budgets. Considering budgets are established with regards to previous performance, an argument for income smoothing lies in the acknowledgement that repeats of abnormally high earnings are unrealistic. Vice versa, budgets that are created after an extremely poor year
will offer next to no challenge. The second argument which Beidleman (1973) mentions for income smoothing is the notion that it is in the best interests of shareholders. Shareholders’ only relevant cash flows are dividends and capital gains. Establishing a stable earnings stream allows for higher dividends to be paid. Additionally, variability in earnings is significantly meaningful in determining the riskiness of a firm and has therefore a direct effect on the firm’s share price.
One fundamental issue with smoothing is the lack of knowledge with regards to how much earnings are to be adjusted. All alterations require real-time feedback, as well as a considerable amount of control of current operations. If this information is missing, managers are forced to guess, which may result in overadjustment (Beidleman, 1973). Moreover, during some periods in a firms existence, income smoothing is simply impossible or unnecessary. Although most companies experience several extreme highs and lows in their earnings prospects, it does happen that firms are forced to endure prolonged hard times or maintain a continuous state of rapid growth. In the first case income smoothing serves no use while in the latter case, investors could be disappointed if they were formerly presented smoothed earnings.
3. Benefits and Drawbacks of Earnings Management
Freedom in arranging your books comes with an array of possibilities to smoothen your earnings. Although the “generally accepted accounting principles” (GAAP) allow such
measures in order to better show a company’s earnings, several drawbacks are associated with this freedom as well. In this paragraph the advantages and disadvantages of management accounting will be discussed. Disadvantages due to fraudulent reporting will be extensively discussed in paragraph 4.
3.1. Benefits of Earnings Management
Scott (2010) argues that the main obstacle overcome by earnings management is ‘blocked communication’. Due to the extensive time in the field, agents often obtain specialized information. It can be rather costly to declassify such information to other segments of the company. For example, managers regularly have access to insiders’ information with regards to future firm performance. Predictions concerning new firm strategies, changes in firm characteristics and changes in future market conditions are relevant for future earnings. But due to it’s complexity, these things are hard to communicate to outsiders. This is commonly known as ‘blocked communication’ (Jo & Kim, 2007). The same holds for management’s
report of financial information towards stakeholders. Earnings management allows firms to show a more truthful representation of the company’s earnings. This is, in essence, the main reason managers have some degree in freedom in arranging their books.
Another benefit is, as clearly stated before, the effect earnings management has on the share price. Reporting positive future earnings increases the book value of the company, which causes share price to increase. This is confirmed by a study performed by
Subramanyam (1996) among 2,808 firms in the period of 1973 till 1993. Results state that discretionary accruals are stated by the stock price, which shows that investors do react to changes in future earnings. This, however, also implies negative results tend to have the opposite effect and will lower the share price, creating the tendency for managers to manage earnings to a less ethical extent.
3.2. Drawbacks of Earnings Management
While overcoming blocked communication between the firm and it’s investors is one of the main goals of earnings management, the same strategies can also be used to increase this information asymmetry. Insiders of certain firms have been known to conceal private control benefits from outsiders. This is caused by the fear that, if these benefits are detected, outsiders are inclined to take certain disciplinary actions (Jo & Kim, 2007). Accordingly, controlling owners and managers could manage reported earnings in an attempt to mark true firm performance and private control benefits. For example, managers could use the discretion associated with financial reporting in order to overstate earnings and hide unfavourable earnings losses that could initiate outsider interference. Legal systems protect investors to some extent by giving them the right to discipline insiders (e.g. the replacement of managers) as well as regulations limiting insiders’ private control benefits.
An issue that could arise with the use of proper earnings management, is a decrease in share price. Essentially the same as one of the benefits described above, but with negative results rather than favourable. Good reporting requires firms to not only manage earnings upwards, but downwards as well. This causes share prices to decrease, although to a lesser extent than is to be expected. Sloan (1996) researched the effect of Real and Accrual-based earnings management on stock prices. He states that the persistence of earnings performance is highly dependent of the magnitude of the cash and accruals components of the firm’s earnings, but emphasises that investors do not realise this. This contradicts the traditional view that stock prices fully reflect all available information in the market.
A less obvious side effect of the possibility of managing earnings, is the decrease in effort put in by the manager. Essentially identical to moral hazard, some managers are aware they can somewhat smoothen results. This could result in them performing to a lesser extent (Scott, 2010). Knowing they have a certain degree of freedom in incurring revenue and expenses, managers could spread good periods over lesser ones. This could alleviate them from the pressure of meeting the targets in certain periods (Scott, 2010).
Fourthly, the total of earnings management done is relatively hard to measure. Researchers merely have access to the external financial papers; the yearly reports, the quarterly figures and press statements. Additionally, it is hard to estimate whether the change in profit is mainly caused by management or the current environmental circumstances. Though a plethora of studies have been conducted which implemented the measurement of earnings management, they regularly state the limits of their research mode. In this regards, extensive research has been done in this area, but the used techniques often lack power and tend to misspecify (Dechow, Hutton, Kim & Sloan, 2012). Additionally, many researchers isolate the causes and consequences of earnings management solely to the ‘discretionary’ components of accruals. Apart from the incompleteness of such models, the models itself specify on the wrong aspects. According to Healy (1985), most discretionary accruals models focus on working capital accruals. They simply consider all levels or changes in working capital accruals as discretionary accruals. The problem with these early models is the implied assumption that non-discretionary accruals remain constant. However, changes in the firm’s business activities will affect these accruals. The realisation of this problem subsequently led to more sophisticated models, which enables total accruals to be composed into discretionary and non-discretionary accruals (Dechow, Hutton, Kim & Sloan, 2012). But concerns remain that these models fail to capture all non-discretionary accruals as well.
Lastly, the degree of freedom associated with earnings management offers the
possibility for certain managers to misuse accruals. For their own benefit or in the company’s best behaviour, managers could resort to less ethical decisions. Incentives for such behaviour, as well as the degree by which these are influenced by the economical characteristics, are discussed in the next paragraph.
4. Motives for managers to manage earnings: Traditional vs. China
Here the possible motivators will be discussed which persuade managers to alter their books. In this paragraph, a strong separation will be made between Chinese and the
European/American stock markets. As China’s economy is still in development, different aspects of its regulation still differ from the more developed stock markets. This causes managers to pursue different goals and manage earnings to a different degree. The focus of this study will therefore be on the different factors that initiate the decisions of managers to manage earnings between the Chinese and European/American stock markets. The remainder of this paragraph compares the results from different studies that investigated the motivators for earnings management. Furthermore, this study will offer a more in-depth insight in earnings management prior to Chinese IPO’s. China is known for its remarkable amount of underpriced stock issues (Chan & Wang, 2004). This has attracted a considerable amount of attention to trace the possible causes. Earnings management, among other things, is known to influence the stock price and is partially responsible for this underpricing..
4.1. Traditional motives for managing earnings
First off, the traditional motives for earnings management will be discussed. This entails the different incentives that drive managers to manage earnings in developed market economies. Thus, to determine the traditional motives used for earnings management, this study will primarily focus on research on earnings management in the European and United States stock markets and determine what factors predominantly incentivize managers.
4.1.1. Earnings management with regards to bonus plans
An increasing amount of firms have developed an earnings-based bonus scheme which rewards corporate executives. This has led to the believe amongst academic researchers that those executives will be more tempted to resort to income-increasing earnings management in order to maximize their bonus reward. Multiple studies have been conducted which indicated a correlation exists between the amount of earnings management and managers’ bonus plans (Healy, 1985; Gaver, Gaver & Austin, 1995). Healy noted that a many possible ways exist for managers to reward employees and, more importantly, themselves for work done. Amongst those possible ways of compensation, two are highly dependent of the firm’s accounting earnings: performance plans and bonus schemes. The first offers managers a certain amount of cash or stock if they succeed in meeting long-term (often from three to five years) targets. These goals are often stated in terms of earnings per share, return on total assets or return on equity (Healy, 1985). Bonus schemes are essentially no different from performance plans, except that they tend to be over a less extensive period. Usually they are evaluated on a yearly basis. Watts and Zimmerman (1978) were the first to imply that bonus
schemes strongly influence a manager’s incentive to use accruals in order to increase their compensation. Healy’s subsequent study among 250 large U.S. industrial corporation showed results which are inconsistent with the null hypothesis that there is no association between discretionary accruals and managers’ incentives to increase bonus plans. Bonus schemes do create incentives for managers to choose accounting strategies that maximize the height of their bonus awards. A strong correlation is visible between the degree of incentive and the amount of accruals made. This does not solely imply the use of income-increasing, but also income-decreasing accruals. For example, they regularly choose income-decreasing accruals if their bonus plans have an upper bound and income-increasing accruals when this is not the case (Healy, 1985).
With regards to the conclusion of Healy’s study, some remarks need to be made. The results of this study show sufficient evidence bonus schemes and performance plans increase managers’ incentives to manage earnings. However, Healy clearly states that this problem can be partly alleviated if bonus schemes were based on stock price, rather than earnings.
Considering stock price is highly dependent on the reported earnings as well, determining bonus rewards on this factor would result in the same alterations. Moreover, it would require increased reported earnings for the firm as a whole. Traditional bonus schemes, which are mainly focused on one aspect of the earnings, offer only incentive to increase the earnings that are relevant for the value of the bonus. With respects to the magnitude of misvaluation due to bonus-increasing accruals, it does less damage to the firm if it is focused on a part of the earnings, rather than the firms’ performance as a whole.
4.1.2. Earnings Management to avoid violating debt covenants
Another incentive to manage earnings could arise from the future possibility of violating a debt covenant. Debt covenants are agreements between company and creditor. They usually state financial limits or thresholds which the company is not allowed to break. Essentially, they provide a safety net for creditors that allow them to reconsider made obligations in case the risk situation of the company changes. Examples range from imposing a cash dividend threshold and prohibiting compensation for employees (negative debt covenants) to the obligation of maintaining certain financial ratios and enforcing life insurance policies (positive debt covenants). Depending on the contract, a breach of such covenants allows the lender to convert it’s debt to equity, demand full payback of the loan, initiate bankruptcy measures or adjust the level of interest payments. Considering that these initiatives form a serious danger to the company’s financial stability, a last resort in managers’ eyes is the
manipulation of earnings (Sweeney, 1994). Even if defaulting is unavoidable, executives still choose to apply income-increasing accounting measures. The idea behind this is the
expectation that, by lessening the degree with which is covenant is broken, managers can strengthen their bargaining position in the case of renegotiation.
The desired results of avoiding covenant violations can be achieved in several ways. First off, firms could choose to change accounting method (i.e., deviating from an accelerated to a straight-line depreciation method). Furthermore, Healy (1985) notes they could also manipulate accruals and transfer earnings between periods. As changing accounting measures is a rather costly endeavour and is in many cases already chosen due to previous debt
constraints, firms often use accrual management.
The notion that managers prevent covenant violation by managing earnings is widely represented in modern literature. Multiple studies exist that prove it’s validity (Sweeney, 1994; DeFond & Jiambalvo, 1994; Franz, HassabElnaby & Lobo, 2012). All violation firms show a significant increase in the number of accruals. Solely with earnings-increasing results, primarily done in years prior to violation.
However, with regards to these studies, it is worth noting that a sample bias is present. As mentioned before, firm outsiders have merely access to external financial papers; the yearly reports, the quarterly figures and press statements. The relative costs of determining a firms debt covenants is therefore rather costly, which forced aforementioned researchers to narrow their sample criteria to firms who were unable to avoid violation. Managers that succeeded in avoiding violation, regardless whether this was caused by earnings manipulation or not, are not taken into account.
4.1.3. Earnings Management in order to meet market expectations
The third main reason managers have to report increased earnings is the need to meet market expectation. Succeeding in exceeding certain potential earnings thresholds set by analysts’ forecasts has become increasingly important in today’s culture. They could range from simple internet discussions and financial reports shown by the press to deliberations of corporate boards.
This increased awareness of reaching forecasts is not surprising. Strong recent
evidence indicates firms both alter earnings and expectations in order to meet expectations set by the public. In this regard, the percentage of firms meeting analysts’ forecasts increased from 50 percent in the late 80’s to over 65 percent in the years after 1992 (Lopez & Rees, 2002; Kasznik & McNichols, 2001). Further results show that the inability to reach
expectations thresholds has a direct negative effect on the share price. There are cases that show a decrease of 25% to 50% in following the slightest earnings disappointments.
Conversely, share price for succeeding firms rises significantly as well. This market premium is greater still if firms succeed in meeting expectations in several consecutive years (Kasznik & McNichols, 2002). This study also notes that potential rewards are not accounted for in analysts’ forecasts. Essentially, this implies that meeting expectations just once could generate a considerable amount of additional capital. If they meet expectations, the obtained market premium contributes to meeting the next forecasts, as these forecasts do not include any rewards. Over a longer period, this allows the firm to consistently perform for several years and further increase the market premium.
The magnitude of these consequences have developed managers’ concerns about failing to meet expectations. Theory suggests that, if income smoothing can be used to reduce the amount of earnings surprises, stock price will increase due to an improved predictability and dependability. Therefore, earnings management is seen by management as a tool to avoid market disappointments. Management’s discretion over accounting accruals provides them with the ability to eliminate negative earnings surprises, which they do utilize (Payne & Robb, 2000). If pre-managed earnings are initially below expectations thresholds, managers resort to income-maximizing earnings management with the help of discretionary accruals.
Alternatively, if pre-managed earnings already exceed expectations, managers deal with conflicting incentives. On the one side, they consider the use of income smoothing so that they can compile the earnings surplus for future periods. On the other hand, there is the option to preserve the positive earnings surprise with the prospect of a favourable share price
respond by the market. Overall, risk-averse managers tend to prefer the first option and store earnings for future periods (Payne & Robb, 2000). Thus, regardless of the height of the pre-managed earnings with respect to analysts’ forecasts, management uses discretionary accruals to alter the reported earnings.
4.2. Chinese motives for earnings management
A study among several directors of Chinese firms provided additional insight regarding motivations for earnings management. The firms were all publicly listed and were randomly picked from a list of publicly listed companies. Their directors were provided with a
questionnaire, based on 27 potential questionable earnings management intentions. Results were rather remarkable. The majority of the respondents stated they altered their books out of altruistic motivations, predominantly in the best interest of the company (Hashim, Salleh &
Ariff, 2013). The most obvious examples include the prevention of a drop in share price and the reduction of tax burdens. But other factors contribute to the managers decision as well. To ensure the continued development of certain projects and to avoid a loss of confidence, by employees as well as banks.
Though it is a relatively easy way to determine one’s motivation, the utility of this research is somewhat debatable. It is highly unlikely directors will admit to alteration of the books if it is out of an unethical motivation. Despite the claim of anonymity, the firm would be taking a risk by admitting to such practices.
4.2.1. Earnings management when being delisted
Several studies have investigated the reasons for managers to alter their bookkeeping. A rather comprehensive one is a literature review done by Yang, Chi and Young (2012). Remarkably, one of the main reasons Chinese companies manage their earnings is to avoid delisting.
The Chinese stock market focused it’s development to facilitate the restructuring of the economy as well as to promote economic improvement. Most listed firms during this transition come from state owned enterprises (SOE’s). But to maintain a grip on these firms during this development, the central government implemented a strict quota system (Chen, Lee & Li, 2008). This creates an obstacle for starting firms. Accordingly, the primary source for firms is the issuance of stock. But to be given the rights to perform an initial public offering and subsequent stock issues, firms are to be enlisted in the Chinese stock exchange. So in order to maintain access to the capital market, firms are obligated to uphold the tough regulations set by the Chinese Securities Regulatory Commission. The Chinese Securities Regulatory Commission designates companies as ‘ST’ (Special treatment) if they report a net loss for a two-year period. An additional year will change this listing to ‘*ST’. This is a warning of being delisted. Being removed from the stock exchange will significantly decrease capital. Therefore, there is a considerable amount of pressure to report relatively positive results, especially during such financial risks.
This incentive is further enlarged by a local governments right to select only a limited number of firms to go public under their jurisdiction. Considering these privileges are
predominantly given to the largest companies, a competition commences among firms to report the highest earnings. (Yang, Chi & Young, 2012). Furthermore, the companies that manage to make the list are of great importance to the local economy. This is combined with the fiscal decentralization in the 1990’s, which forces local governments to compete with each
other for mobile capital. Therefore, a common interest arises between listed firms and local governments to raise more capital from the stock market (Chen, Lee & Li, 2008). Hence listed firms are strongly encouraged by local governments to report high earnings, which will
increase stock price and, in it’s extension, the amount of capital.
4.2.2. Earnings management due to Tunnelling
Ortega and Grant (2003) identified the techniques most often used by Chinese companies in order to manage earnings. Similar to the techniques used in other financial markets, the postponement or advancement of the time at which operational or sales revenue is recognized is common in the Chinese mainland as well. Additionally, firms often tend to turn to the various expense accounts. Interest expenses for constructions in process (CIP), for example, is allowed by GAAP to be capitalized. However, the interest expense for the current year can be changed, if a company transfers CIP to their fixed assets. Firms could even refrain from ever closing their CIP accounts, because they are lower than depreciation expenses and buildings under construction are not depreciated. Alternatively, Chinese firms have been known to change depreciation methods altogether in an attempt to increase reported earnings (Ortega & Grant, 2003). Within the area of real earnings management, important Chinese firms are regularly given subsidies by local governments to improve their performance and meet certain capital market requirements. And lastly, and most importantly, a considerate amount of Chinese firms manage earnings by using related-party transactions to transfer revenues or losses between entities. This opens up the possibility for one of the larger incentives within the Chinese financial market; tunnelling.
Tunnelling is a description for a specific kind of financial fraud. It is most recently defined as “the transfer of assets and profits out of firms for the benefit of those who control them” (Johnson, La Porta, Lopez–de–Silanes & Shleifer, 2000). One might think of a
manager or multiple major shareholders of a publicly traded firm who order their firm to sell off a part of it’s assets to second company at extremely low prices. Usually, this manager or shareholders own the second company, in which case they will profit significantly from this sale. The crucial difference between tunnelling and outright stealing is the subtlety behind it. Considering all the legal requirements and procedures are adhered to, tunnelling is more difficult to trace than simply writing of the firm’s money to a private bank account.
If controlling shareholders wish to transfer part of the firm value, they are forced to alter and mask the actual performance of the firm and hide their private benefits from outside
investors. Therefore, the use of earnings management is inherently related to tunnelling. However, usually independent boards, high-quality disclosure, external takeover markets and dispersed ownership structures are in place to safeguard the investments of minor
shareholders. Thus, fewer of these corporate governance systems leads to higher private control benefits, as well as decreasing the chances of these benefits being detected (Johnson, La Porta, Lopez-de-Silanes & Shleifer, 2000).
China, with it’s upcoming economy and the increase in publicly listed firms, was previously lacking in providing the proper safekeeping of the investments of minor
shareholders. And although the Chinese Securities Regulatory Commission (CSCR) has been implementing regulations to address these problems typically found in emerging markets, the current environment still presents managers with limited regulations in which they could easily resort to tunnelling behaviour.
Looking at all listed firms in the Chinese stock market from 1999-2001, it shows a strong correlation exists between regulations that influence the ability to tunnel and the amount of earnings management (Liu & Lu, 2007). These are results from financial situations which are considered to be the most conspicuous, namely when a listed firm is obligated to manage earnings to exceed particular return on equity (ROE) thresholds and, as mentioned in the section before, when firms face the risk of being delisted. Liu & Lu provide evidence that, in these moments, tunnelling is a major driver of earnings management in Chinese listed companies.
4.2.3. Earnings Management prior to initial public offerings
IPO underpricing is the increase in stock price in a firms first day of going public. It is the difference between the initial offering price and the first-day closing price. Many believe that underpriced IPO’s cause corporations to miss out on a significant sum of money, while others state that it is an inevitable phenomenon when going public. But compared to other stock markets, the Chinese stock market deals with extremely high amounts of underpricing. Initial public offerings in the United States and European stock markets tend to be underpriced by about 18%, whereas stock issued in Chinese IPO’s realize an average increase of
approximately 178% (Chan & Wang, 2004). This has attracted a great deal of attention from researchers, in order to detect the different causes to this deviation. Apparently this is for a great deal caused by the practice of “window-dressing”, managing earnings previous to an initial public offering (IPO). Considering the magnitude of this variation, factors effecting earnings management previous to IPO’s will be discussed separately.
On average, IPO firms manage their earnings on a more conservative basis (Ball & Shivakumar, 2008). Their study shows that firms do improve their financial reporting quality prior to an IPO. This does not entail inflating earnings in order to raise stock price on the moment of actually going public. However, a sample of 500 IPO’s on the London stock market indicate that firms tend to manage their earnings with a keen eye on upholding accounting standards. Public investors in particular are aware of the information asymmetry between them and the company and require a higher quality of reporting (Ball & Shivakumar, 2008). This includes reporting reputation effects and effects of cost of capital. Additionally, internal and external auditors, analysts, rating agencies, the press, litigators and boards are encouraged to monitor these firms. This enhanced regulation motivates managers of about-to-be publicly listed companies to improve the quality of their reporting. Moreover, the moment they publish the prospectus, the issuing firm is significantly more liable to lawsuits and other litigations. If managers refrain from adhering to the higher requirements of their financial reporting, they increase the possibility of this happening (Ball & Shivakumar, 2008).
But despite these strict accounting principles and many auditors, IPO stock tends to be overvalued and perform poorly on a longer time span. This is often referred to as “the new issue puzzle”; the question as to why non-issuing firms perform significantly better compared to firms in their first years after an initial public offering. Loughran & Ritter (1995) concluded that investors have to, on average, invest 44% more money in first-time issuing firms to be left with the same wealth five years later, maintaining the market capitalization is relatively identical and if they hold it for the same amount of time. They ascribe this predominantly to the misvaluation of IPO’s. Many young companies experience period of rapid growth prior to the IPO. This creates the belief of investors that they might have stumbled upon the next Microsoft.
Although underpricing is not uncommon, the increase in Chinese stock value by 178% is rather alarming. For starters, the characteristics of Chinese IPO’s and the Chinese stock market in general, differs greatly from economic markets in other countries. This also implies that the results of studies regarding IPO’s in other nations cannot be simply
implemented in the Chinese market. A unique feature of the Chinese stock market is the separation between A-shares and B-shares (Chen, Firth & Kim, 2004). The former are shares that are solely restricted to domestic investors, while the B-shares are restricted to non-PRC (People’s Republic of China) citizens. While both categories deal with underpricing, the increase in B-share price on the first day of going public (10%) is remarkably lower than the
A-share increase (145%). This indicates a strong cause which primarily originates within the constraints of the Chinese stock market.
Two major reasons can be pointed out that create this deviation. The first is the possible delay between the issue of IPO shares and the subsequent enlistment of those shares (Chen, Firth & Kim, 2003). Some firms, who are aware of this long listing lag, have the tendency to price the IPO rather cheaply to compensate investors for the uncertainty
associated with this duration of enlistment. The other is information asymmetry between firm and investor, due to the large degree of uncertainty resulting from China’s change towards a market economy with modern financial markets (Kao, Wu & Yang, 2009). Both firms and investors are forced to deal with new requirements and regulations. Results show that these regulations encourage an additional amount of earnings management, which in turn induced IPO firms to overstate their earnings performance to attain more favourable prices (Kao, Wu & Yang, 2009). These new regulations include two aspects: prizing regulations, which state that IPO prices are a function of accounting performance. And penalty regulations, which penalize companies that are overly optimistic in forecasting its earnings. Despite the penalties for overenthusiastic reporting, the implementation of these regulations shows an increase in income-maximizing behaviour among firms.
Lastly, with regards to the previous paragraph, additional data shows that IPO’s provide Chinese managers with an additional opportunity to resort to tunnelling behaviour. This sheds a different light on the aforementioned reasons of the underpricing of Chinese stock. Although the newly implemented regulations are sure to cause a considerate amount of genuine misvaluation of Chinese firms, several managers take advantage of the ambiguous environment. Considering the study done by Kao, Wu and Yang (2009) solely supports the hypothesis that a correlation exists between the new regulations and underpricing, it neglects to discuss the possibility of tunnelling opportunities driving these misvaluations.
A study by Aharony, Wang and Yuan (2010) confirms that some managers abuse the financial situation to increase tunnelling possibilities in the future. They provide evidence that, in underdeveloped markets, earnings regarding party-related sales can be managed upwards in the pre-IPO period as new investors fail to “see through” this kind of earnings manipulation. Motives for utilizing this opportunity is the prospect for tunnelling behaviour in the post-IPO period. Results show that managers use this to their advantage in order to create a tunnelling opportunity in the post-IPO period by not repaying net outstanding corporate debt that the parent companies have to their subsidiaries. A correlation can be appointed between earnings management prior to IPO’s and tunnelling behaviour afterwards.
5. Summary and Conclusion
This study is focused on addressing the different incentives for earnings management by Chinese managers compared to the traditional motivators raised by managers. Although earnings management has extensively been investigated in current literature, few studies exist that discuss the variation in incentives with regards to different financial markets. This study provides evidence that the characteristics of a financial market do affect managers’ decision to resort to income-increasing manipulation of the books and the degree with which they do so. Following an extensive literature review with an emphasis on different financial markets, it has become apparent that Chinese managers have distinctive reasons to manage earnings.
Traditional motivations include the desire to increase bonus plans, the fear of violating debt covenants and the realization that missing certain expectations and forecasts’ thresholds could result in considerable losses for the company. China, on the other hand, is mainly concerned with both fighting and utilizing the several weaknesses and ambiguities that are present in their current economy. Firstly, while traditional companies attempt to uphold certain debt covenants, Chinese firms manage earnings due to a fear of being delisted. A more altruistic motive for earnings management, Chinese managers attempt to counter strict
regulations with regards to publicly listed firms. Regulations that allow only a selected number of publicly listed firms per region force companies in an unavoidable competition to attain the highest earnings. Though somewhat similar and both resulting in a considerate decrease in capital, it shows the different goals that firms strive for to ensure the continuity of their existence.
With regards to bonus plans being a traditional motive for earnings management, Chinese managers increase private banking accounts by tunnelling, rather than trying to enlarge their compensation. As other regulations fail to keep up with development of the financial market, limited regulation with regards to earnings management provides Chinese managers with the possibility to tunnel relatively easy. Since underdeveloped countries lack in legal constraints concerning tunnelling, it is technically legal and management will therefore not be punished for such behaviour.
Furthermore, this study shows that there is a strong variation in incentive and degree of earnings management prior to initial public offerings. These results are hardly surprising, considering the magnitude by which Chinese IPO’s are underpriced, compared to firms listed in the European and American stock markets. In the latter, more developed ones, managers
face a considerate amount of attention from auditors, analysts and rating agencies prior to entering the stock market. Studies show this causes firms to refrain from income-maximizing strategies and rather manage earnings in a conservative matter with a keen eye on accounting standards. Research in the Chinese stock market shows results which give reason to infer these firms are induced to earnings management by less ethical incentives. Although the economy undoubtedly increases the information asymmetry between first-time issuing firms and investors, a significant amount of the underpricing arises because investors see this as a good opportunity to tunnel some of the earnings. This also explains the lesser importance of meeting analysts’ forecasts for Chinese firms. The information asymmetry ensures investors are uncertain of what to expect and will therefore discredit companies to a lesser degree if they fail to meet expectations.
Thus, the developing state of China gives rise to several issues regarding earnings management. The current lack of a consistent framework of accounting standards offers too many opportunities for earnings management. Furthermore, the legal system is insufficient in clearly stating and detailing the consequences and punishments for improper use of earnings management. Rigorous and strict regulations, especially on related-party transactions and the use of discretionary accruals, are highly recommended. Though they cannot completely rid the market of earnings management, they are sure to reduce it and make it easier to prosecute managers that misuse this freedom.
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