With major scandals around the world shaking investors' faith in published company financial information, the problem of earnings management has recently come under the spotlight. Top executives have been found to manage their earnings aggressively, through accounting sleight-of-hand and corporate policies to improve their companies' announced performance.

In a recent study, Ding Yuan, Associate Professor of CEIBS, Zhang Hua, Research Fellow of CEIBS and Zhang Junxi investigate the role played by a firm's ownership structure (both ownership concentration and different ownership types) in earnings management.

By analyzing 273 private-owned and state-owned Chinese companies listed in 2002, this study is the first one compares earnings management practices between Chinese private-owned and state-owned listed firms. Ding and his co-authors reveal that an inverted U-shape relationship exists between ownership concentration and earnings management practices. It is clear that private-owned listed companies tend to maximize their accounting earnings more. However, the entrenchment effect of ownership concentration on earnings management is weaker in private-owned listed firms than in state-owned listed firms.

Earnings management is always a means to an end, and uncovering the motives for earnings management is the key to explaining the issue. In a developed capital market, with separation between ownership and management, and broad shareholder bases, earnings management is driven by the desire to prop up the company's stock price, as stock price is often the key basis for managerial compensation, which may include stock options or other incentive plans. However, in some less developed capital markets these motives may no longer be relevant. In such markets, even listed companies have a highly-concentrated ownership structure and top managers are (or directly represent the interests of) controlling shareholders. The Chinese stock market is a good example of such a context: the floating shares typically accounts for only a small proportion of listed firms' total shares, and until mid-2005, stock options were prohibited.

Nevertheless, earnings management is found to be prevalent in Chinese listed companies. Previous studies provide strong evidence that Chinese listed companies boost their earnings dramatically in order to gain authorization for an IPO, to issue new shares or to avoid being delisted. The implicit assumption is that meeting the regulatory requirements is the companies' incentive to manage their earnings.

The present study adds to the literature by addressing the same issue from a different perspective, namely, an agency perspective, i.e. looking at earnings management structure as a sign of the agency problem in modern corporations. We argue that the conflict of interests between controlling shareholders and minority shareholders is the root cause of earnings management in China. Since ownership structure is the primary determinant of agency cost, this study attempts to link companies' ownership structure with their earnings management behavior. The current transitional nature of the Chinese economy provides a valuable opportunity for examining the behavior of companies with different ownership types, i.e. state blockholders or private blockholders.

As stated by the Chinese government, the original purpose of the stock market was to help state-owned enterprises (SOEs) raise funds and improve their operating performance. For this historical reason, the majority of current listed Chinese companies originate from restructured SOEs and are still controlled by the State and/or other non-listed SOEs. Yet despite this background, a distinctive group of listed companies, accounting for slightly more than 10% of all such firms, has emerged in the Chinese market: listed firms controlled by private owners. Selecting a sample consisting of both private-owned listed companies and state-owned listed companies for the purpose of comparison, we are able to examine whether and how ownership concentration and ownership type affect firms' earnings management practices.

We put forward three hypotheses regarding the relationship between ownership structure and earnings management. The first relates to the negative effect of ownership concentration on the agency problem. Building on research by Morck, Shleifer and Vishny (1988), we argue that increased shareholding by controlling owners makes those insiders entrenched from outside monitoring. In situations where expropriation of controlling owners would result in lower actual earnings, they will manage earnings upward, to avoid any leakage of information on their misbehavior.

Our second hypothesis is based on the theory that ownership concentration also reduces agency costs, by aligning the interests of controlling owners with those of the company. Gomes (2000) suggests that high ownership concentration is a signal of the controlling owner's commitment to build a reputation for not expropriating minority shareholders. Therefore, the alignment effect suggests that increasing ownership concentration beyond the minimum level for effective control will reduce opportunistic behavior by controlling owners, and hence their incentive for managing earnings upward.

The third theory concerns the inefficiency of state ownership. Extant literature suggests that state ownership entails inferior governance quality compared to private ownership, due to the contracting ability problem (Alchian, 1977; Shleifer, 1998). Companies with private ownership will thus have a less serious agency problem, and hence a lower incentive for managing earnings upward. More specifically, we predict that ownership concentration will give rise to a weaker entrenchment effect in private-owned companies than in state-owned companies.

We use two measures of earnings management for the purposes of this study. The first is the conventional "discretionary accruals", which measures earnings management practices through non-cash operating transactions. The second is the "Non-operating income / sales" ratio, which captures the earnings management effects of non-operating transactions with related parties. The relationship between earnings management and ownership is then examined.

This paper provides evidence that the earnings management practices of Chinese listed firms are influenced by ownership concentration as measured by the total percentage interest in the hands of the largest shareholder. Specifically, our study shows that the relationship between shareholding concentration and earnings management follows an inverted U-shape pattern: when the ownership concentration level is low, the agency cost is high. Initially, large shareholders tend to maximize accounting earnings in order to reap benefits in the future (entrenchment effect). However, when the ownership concentration reaches a high level, large shareholders become the true owners of the firm, and are thus more likely to seek to preserve its future growth potential by minimizing accounting earnings (alignment effect). Our results show that in our sample of Chinese listed firms, until the top-shareholder concentration reaches the vicinity of 55%, the correlation between ownership concentration and earnings management is positive, while beyond that ownership concentration level the relationship becomes negative.

Our analysis also shows that private-owned listed firms favor earnings boosting methods more than their state-owned counterparts. This result reflects the specificity of the Chinese capital market, where private-owned firms are still in a weaker position because of specific political and historical factors. They are thus under pressure to report a better-than-real financial performance to reassure the market. Meanwhile, the effect of ownership concentration as a factor increasing earnings maximization is less marked in private-owned firms, because their large shareholders are inclined to act as the actual owners, which means their incentives to expropriate the firm are comparatively low.

All our ownership concentration and type measures hold significant coefficients of the same sign in the regressions for both earnings management measures (discretionary accruals and non-operating income over sales). This suggests Chinese listed firms tend to use both non-cash accrual items at operating level, and non-operating transactions with related parties, to maximize (or minimize) their accounting earnings.

One major limitation of our paper is that our "non-operating income over sales" measure makes no distinction between normal gains and losses and abnormal transactions with related parties. In future research, it would be very interesting to examine the relationship between discretionary accruals and certain directly-related party transaction measures.

 

The article is a summary of "Private vs. State Ownership and Earnings Management: Evidence from Chinese Listed Companies" published in Corporate Governance (March, 2007).