Year

2011

Degree Name

Doctor of Philosophy

Department

School of Accounting and Finance

Abstract

Earnings management is a universal phenomenon in firms’ financial reporting. The purpose of earnings management is to demonstrate reasonable earnings quality that meets either the shareholders’ expectation, or the requirement of obtaining relevant authorization from regulators (Francis et al., 2005). Thus, earnings management has much in common with earnings quality (represented by accruals quality, earnings persistence, earnings predictability, and earnings smoothness in this research). Highly managed earnings can yield low-quality earnings (Lo, 2008), as the “artificial” information may lead to an incorrect decision. However, the absence of earnings management is insufficient to guarantee high-quality earnings, because other factors can (such as capital market and management compensation) contribute to the quality of earnings (Lo, 2008).

McKeown, Mutchler, and Hopwood (1991, hereafter MMH) create a model to classify firms as financially stressed and non-stressed. Altman (2006) develops an Emerging Market Score model (EMS, hereafter) to group firms as bankrupt and non-bankrupt firms which is conceptually different from the MMH model. This study did not assume that a bankrupt or near-bankrupt firm has a positive relationship with financial distress. Therefore, in this study financial distress and bankruptcy are two different constructs. The firms listed on the new emerging market of China can be described by combining both MMH and EMS models. Due to the imperfect delisting system in the Chinese stock exchange, some firms are in financial distress and should be bankrupt in terms of the criteria used in developed countries. However, they are still being listed on the stock exchanges flagging their near-bankruptcy status to investors.

This study adopts the two models (MMH and EMS) to examine the significant differences in earnings quality and the efficiency of earnings management in relation to the firms’ financial status of being stressed and non-stressed as per the MMH model, the near bankruptcy status of being bankrupt and non-bankrupt as per the EMS model; classifying firms into four quadrants: (1) financially stressed and bankrupt (SB), (2) not financially stressed but bankrupt (NSB), (3) financially stressed and not bankrupt (SNB), and (4) not financially stressed and not bankrupt (NSNB). However, due to the zero sample firms in the quadrant of NSB, this study focuses on firms in the quadrants of SB, SNB, and NSNB by disregarding the firms in the quadrant of NSB.

To the author’s best knowledge, no research until now has been published on the different four earnings attributes (accruals quality, earnings persistence, earnings predictability, and earnings smoothness) of firms in China classified into three quadrants - SB, SNB, and NSNB and whether there are efficient or opportunistic earnings management in related to the four earnings attributes in Chinese-listed firms. Using the discretionary accruals as a proxy for earnings management, this study empirically investigates significant differences in the four earnings attributes and how the four earnings attributes affect future profitability, examining the efficiency of earnings management in each firm classification (SB, SNB and NSNB), and thus filling a void in the literature.

One purpose of this study therefore, is to investigate earnings quality of Chinese companies listed in the Shanghai and Shenzhen stock exchanges from 2003 to 2007 by classifying them as SB, SNB, and NSNB firms. This study measures earnings quality by the four earnings attributes: accruals quality, earnings persistence, earnings predictability, and earnings smoothness.

Since the computation of MMH firm-year model and accruals quality require past and future year’s data, this study covers the analysis period from 2000 to 2008. To mitigate concern that differences in sample composition might drive comparisons for each kind of firm, this study further requires that data on all variables are available for each year for the sample period. The data are collected from the database (China Stock Market and Accounting Research) that offered financial data of Chinese companies. Since determining the MMH firm-year model requires past three years of relevant data as a variable, and therefore the beginning firm-year is 2003. The regression model of accruals quality also requires one-year-ahead cash flow from operations as a variable, and therefore the end firm-year is 2007. The usable firms representing as samples in the three quadrants varied from 2003 to 2007. The final sample consists of 987 firms with a total of 4935 firm-year observations for the period 2003-2007.

In determining earnings quality of firms in China, this study finds that SB firms have the lowest earnings quality measured by each of the four earnings attributes. SNB firms have higher earnings quality compared with SB firms. NSNB firms have the highest earnings quality. This study also finds that earnings quality deteriorated over the study period, the number of SB firms with the lowest earnings quality increased, and the number of NSNB firms with the highest earnings quality decreased for the fiscal years 2003 to 2007.

The other purpose of this study is to examine the relation between earnings management and each earnings attribute among the Chinese firms classified into the three quadrants - SB, SNB, and NSNB. This study using a regression model, measures the four earnings attributes on a firm-and year-specific basis, in a rolling five-year windows, t-4,…t. In preparing data for the regression model that measures whether earnings are managed efficiently or opportunistically, this study ranks each earnings attribute in each year to form deciles.

The results reveal that SB firms are more inclined to choose opportunistic earnings management and SNB firms are more inclined to choose efficient earnings management. NSNB firms choose more efficient earnings management than SNB firms. The results also reveal that earnings management is a better measure than earnings quality in predicting future profitability, because the indicators of earnings management (proxy by discretionary accruals) have more positive significant coefficients than earnings quality in predicting future profitability. Additionally, the results reveal that NSNB firms provide a better indication than both SNB and SB firms in predicting future profitability in relation to each earnings attribute.

The findings of this study can have positive implications for the development of accounting standards and practices in China. The findings provide useful input to a review of the relevant regulations, as well as insights for regulators who are attempting to improve the efficiency of China’s capital markets and implement corporate governance provisions to prevent opportunistic behaviour by managers. It may prove useful for auditors to have a better understanding of how managers exercise the discretion inherent in accounting standards to mask poor performance in financially troubled firms, and to enhance the quality of financial reports and thus increase the efficient allocation of capital in the emerging market. The findings are also useful to other parties (such as analysts, creditors, and researchers) who use accounting numbers to assess failure probability, default risk, and the liquidation value of the firm, since these individuals need to be aware of regulation-related earnings quality when analysing the financial statement of listed Chinese firms. A limitation that needs to be considered when interpreting the results is possible that earnings attributes and earnings management variables are all impacted by variables not included in this study.

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