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Competitive pressure and Product

market
managerial decisions competition
Product market competition and earnings
quality in China 559
Muhammad Ansar Majeed
Received 17 December 2015
School of Accounting, Dongbei University of Finance and Economics, Revised 20 March 2016
Dalian, China, and 11 April 2016
2 May 2016
Xian-zhi Zhang Accepted 4 May 2016

School of Accounting, Dongbei University of Finance and Economics/

Sino-German Management Control Research Center, Dalian, China

Abstract
Purpose – This study aims to examine the impact of product market competition (PMC) from existing
rivals and potential market entrants on earnings quality (EQ) in China.
Design/methodology/approach – This study examines the impact of PMC on EQ by using the EQ
measure of Kothari et al. (2005), and it uses measures for competition from existing and potential rivals.
This study analyzed Chinese firms for the period of 2000-2014 and also examined the impact of
International Financial Reporting Standards (IFRS) adoption and state ownership on the relationship
between PMC and EQ.
Findings – This study found a positive relationship between PMC and EQ. It also documents that
competition from existing rivals does not improve EQ by reducing real activity manipulation, but
competition from potential entrants does. The findings propose that market competition from existing
rivals is a relevant factor for determining EQ before and after IFRS adoption, but competition from
potential entrants improves EQ only after IFRS adoption. Moreover, the results suggest that market
competition plays no role in improving the EQ of state-owned enterprises (SOEs).
Originality/value – The results support the argument that PMC acts as a governance mechanism and
influences managerial decisions regarding financial reporting. Our study also helps to understand the
impact of change in the regulatory regime, i.e. IFRS adoption, on the relationship between PMC and EQ.
This study also helps demonstrate the impact of competition on management decisions with respect to
the EQ of SOEs.
Keywords China, IFRS, State-owned enterprises, Earnings quality, Product market competition
Paper type Research paper

1. Introduction
There are two conflicting arguments regarding the effect of competitive pressure on
managerial decision-making. One school of thought (Datta et al., 2013; Horn et al., 1994;
Scharfstein, 1988) has claimed that product market competition (PMC) aggravates
managerial opportunism and intensifies agency conflict. Another school of thought
(Schmidt, 1997; Baggs and Bettignies, 2007) has reasoned that PMC acts as a Chinese Management Studies
Vol. 10 No. 3, 2016
disciplinary mechanism and decreases agency conflict and managerial slack. On the pp. 559-592
© Emerald Group Publishing Limited
1750-614X
JEL classification – G30, M4, M41 DOI 10.1108/CMS-12-2015-0285
CMS basis of these premises, examinations of the impact of PMC on financial reporting has
10,3 also produced conflicting results. One line of inquiry advocates that greater competition
reduces earnings quality (EQ) as firms disclose less information and managers choose
opaque information environments to protect proprietary information (Verrecchia, 1983;
Stivers 2004; Verrecchia and Weber 2006; Ali et al., 2014). The opaqueness of an
information environment may also be encouraged because competition exacerbates
560 managerial opportunism (Karuna, 2007). However, another line of inquiry proposes that
PMC disciplines management and, as a result, it improves the transparency of financial
reporting by enhancing EQ (Chhaochharia et al., 2009; Li, 2010a, 2010b; He, 2012;
Laksmana and Yang, 2014).
In light of these conflicting opinions regarding the impact of PMC on EQ, this
study provides empirical evidence to add to the extant literature from a developing
market, i.e. China. China has a unique institutional environment which provides
those who study it with an excellent opportunity to understand the effect of PMC on
management decisions regarding EQ in an emerging economy. China is still a
developing economy (despite being the second largest economy in the world) and it
has a underdeveloped capital market than other countries and a large number of
state-owned enterprises (SOEs). The Chinese capital market is less well-developed
compared to those of other large economies, so the banking sector and not the equity
market is a major source of finance for Chinese firms, which reduces the capital
market pressures to improve the quality of financial reports. According to Piotroski
(2014), the Chinese financial reporting environment is opaque. Piotroski and Wong
(2012) attributed the lower quality of Chinese firms’ financial reporting to
relationship-based transactions and to the importance of political connections in the
country’s corporate sector. The major hurdles to transparency also include weak
investor protection, ingrained business practices and limited capital market
pressures. Piotroski (2014) has also argued that, despite improvements in the
financial reporting environment, China lags behind other large developing
economies like India and Brazil. Moreover, the presence of a large number of SOEs
with different objectives, agency conflict and default risk has also changed the
dynamics of the institutional environment. These SOEs have a lower default risk
than private enterprises, as they may be bailed out by the state if they face financial
distress (Faccio, 2006) and their objectives are mainly socio-political. Furthermore,
these SOEs also face an agency conflict between majority and minority shareholders
(Ali et al., 2007). So, understanding the impact of PMC on managerial
decision-making in such a unique environment would contribute to the existing
literature. Previous studies (Datta et al., 2013; Laksmana and Yang, 2014) on
developed economies have helped researchers to understand the impact of PMC
on earnings management behavior. However, there has been a lack of work done on
emerging (developing) economies. China offers a unique institutional setting which
makes it interesting and valuable to examine the impact there of PMC on EQ. It
would also help to enhance the understanding of how business conditions influence
managerial decisions such as those concerning financial disclosure. Healy and
Wahlen (1999) have also suggested that the role of business factors in explaining
accrual quality would add value to the literature.
This study argues that PMC potentially influences management decisions
regarding EQ. Specifically, this study seeks to answer the following questions:
 Q1. What is the effect of product market competition from existing and potential Product
rivals on EQ in China? market
Q2. Does competitive pressure discipline managements and curtail earning competition
inflation or earning deflation in an emerging economy?
Q3. How does the competition from existing and potential rivals influence real
activity manipulation (RAM)? 561
Q4. What are the impacts of International Financial Reporting Standards (IFRS)
adoption (changes in regulatory regime) and state ownership on the relationship
between PMC and EQ?
The main objective of the study is to examine how competitive pressure influences EQ
in an emerging economy within a unique institutional environment. Another motivation
for this study is to understand the impact of two types of competitive pressures, i.e.
competition from existing rivals and competition from potential rivals, on EQ. This
study serves two main objectives. First, it examines the role played by competitive
pressure in shaping managerial decisions in an emerging economy by analyzing the
impact of PMC on EQ in a Chinese setting. Second, this study analyzes the role played by
IFRS adoption and state ownership on the relationship between PMC and EQ.
We contribute to the accounting and finance literature by documenting the impact of
PMC on EQ in the Chinese settings. Based on a sample of 20,532 firm-year observations
for the period spanning 2000-2014, this study documents that PMC (from existing and
potential entrants) is an important determinant of EQ. The results suggest that
competition (from existing and potential rivals) reduces agency conflict and managerial
opportunism and improves EQ by reducing accruals management. Our results support
the external governance mechanism hypothesis (Laksmana and Yang, 2014; He, 2012)
and contest the proprietary cost hypothesis (Verrecchia, 1983; Verrecchia and Weber
2006; Ali et al., 2014). Our results also suggest that market competition reduces both
earnings inflation and earnings deflation, but its impact on deterring earnings inflation
is more profound than it is for earnings deflation. Furthermore, we also propose that
PMC from existing rivals does not play a significant role in reducing RAM, but the
threat of competition from potential entrants reduces RAM. These results challenge the
argument put forward by Laksmana and Yang (2014) who suggested that competition
from existing rivals reduces RAM. Rather, we have argued that it is the competition
from potential entrants which limits RAM. Moreover, this study also examines the
impact of IFRS on the relationship between PMC and EQ and documents how PMC from
existing rivals improves EQ both before and after IFRS adoption. However, competition
from potential rivals plays a significant role only after IFRS adoption. We have explored
the impact of state ownership on the relationship between PMC further, as a large
number of listed firms in China are state owned, and we have documented how PMC
plays no statistically significant role in increasing (decreasing) EQ for SOEs. This may
be attributed to the fact that SOEs have different objectives and causes of agency
conflict than non-state-owned enterprises (NSOEs).
This study contributes to the literature on accounting disclosure and PMC in several
ways. First, we provide empirical evidence from a developing economy in support of the
argument that PMC both reduces agency conflict (Schmidt, 1997; Baggs and Bettignies,
2007) and improves EQ. Our results do not support the view that higher competition
CMS enhances the opaqueness of information environments (Verrecchia, 1983; Verrecchia
10,3 and Weber, 2006; Ali et al., 2014). Our results also contradict the “dark side of PMC ”
argument of Lee and Liu (2014) and Lin et al. (2015). Second, this study provides
empirical evidence from China. The unique Chinese institutional environment with its
concentration of ownership, its large number of SOEs and its status as an economy in
transition, makes this study important and interesting. Furthermore, we have also
562 examined the impact of competitive pressure on the financial reporting practices of
SOEs. This analysis helps foster an understanding of how changes in agency conflict
and corporate objectives influence the relationship between PMC and EQ. Our results
also differ from those of the study by Laksmana and Yang (2014) who proposed that
competition from existing rivals reduces real activity management. By contrast, our
results suggest that it is competition from potential entrants that reduces RAM and not
competition from existing rivals. These findings imply that the impact of different types
of competition on RAM also depends upon the institutional environment. Third, further
analysis has incorporated the impact of IFRS adoption on the relationship between
competition and EQ. This should help standard-setters to understand the impact that
IFRS has on reporting practices and, hence, it contributes to the IFRS literature. Our
study can potentially help others understand the effect that PMC has on managerial
decisions when there are changes in a regulatory regime. It could enhance the ability of
policymakers to introduce different sets of rules and regulations for less competitive
industries. So, essentially, we have proposed that competitive pressure not only shapes
managerial decisions but can also potentially influence the decisions taken by
policymakers. Fourth, by exploring the impact of PMC from potential entrants, we hope
to have helped others to understand how managerial decisions regarding financial
reporting are influenced by perceived competition. The greater part of the prior
literature has focused on competition from existing rivals, but our approach has
presented a new direction for the analysis of the impact of two different types of
competition on managerial decisions. Fifth, to the extent that PMC disciplines
management and reduces managerial opportunism, this study could be helpful for
enabling investors to understand the association between PMC and EQ, thereby
augmenting their ability to estimate the real numbers behind reported earnings for firms
facing less competition and that could be helpful for investors in China’s capital market.
The results also imply that by increasing industry competition, financial reporting
transparency can be increased which could lead to higher firm valuations and reduced
costs of capital as a result of lessened agency slack.
Our study is significantly different from preceding studies of Chinese settings such
as those by Wu et al. (2015) and Wang et al. (2015). Wu et al. (2015) studied the
moderating role of PMC on the relationship between business strategies and earnings
management, while Wang et al. (2015) examined the impact of business cycles on the
earnings management behavior of firms and proposed that earning management is
higher when growth rates are high and that competition serves to complement this
relationship. This study is different from both of the aforementioned papers in the
following ways. First, we have examined the direct impact of PMC on EQ and have
taken into account both aspects of competition, i.e. competition from existing rivals and
potential entrants. Both of the studies mentioned above focused only on competition
from existing rivals. Second, we have examined how competitive pressure influences the
earning inflation (deflation) behavior of firms. Third, this study has further examined
how changes in a regulatory regime, i.e. IFRS adoption and state ownership, influence Product
the impact of competitive pressure on EQ. market
The rest of the paper is organized as follows. Section 2 includes a review of the extant
literature and presents our hypotheses development. Section 3 describes the variable
competition
measurements and research design along with descriptive statistics. Section 4 provides
results and additional tests. Section 5 provides robustness checks, followed by Section 6,
which concludes the paper. 563
2. Institutional background and hypothesis development
2.1 Institutional background
Emerging economies, especially China’s, are quite different from developing economies
because their institutional environments are different and hence, the impact of PMC on
EQ may differ in Chinese settings. Therefore, an overview of the Chinese corporate
environment is essential to contextualize the distinctive nature of the association
between PMC and EQ. A prominent feature of almost all emerging economies is the
conspicuous role played by business groups (Khanna and Rivkin 2001). These business
groups act as an internal financial market and share risk. China is not different from
other economies in this regard because there are a large number of business groups in
China and these business groups aid member companies to raise capital (He et al., 2013).
Government connections in emerging markets (particularly in China) also play an
important role in the corporate sector as corporate political connections are associated
with lower financial constraints (Cull et al., 2015). The political connections of
controlling entrepreneurs result in “better access to debt financing, preferential tax
treatment, more government subsidies, and superior access to regulated industries”
(Feng et al., 2013). Direct and indirect interventions in corporate policies by its
government, e.g. leverage ratios, debt maturity and cash holdings, make China
fascinating and particularly different from other developed economies (Shao et al., 2015).
Chinese firms are usually engaged in abnormal related party transactions to manipulate
their earnings. Chinese firms increase earnings in their pre-initial public offering (IPO)
periods to improve their prospects of tunneling in the post-IPO period, thereby
exploiting investments by minority shareholders (Aharony et al., 2010). Another
peculiar feature of the Chinese institutional environment is its partiality for tunneling,
using intercorporate loans to manipulate firms’ earnings (Jiang et al., 2010). China’s
corporate governance mechanisms are inadequate to limit agency problems between
majority and minority shareholders (Li, 2010a, 2010b). Investor sophistication also
distinguishes the emerging capital markets (e.g. China) from the capital markets in
developed economies. In China, a large number of tradable shares are owned by
individual investors with limited investment skills. The trading turnover in the Chinese
equity market is exceptionally high. Both individual investors and institutional
investors have short-run investment horizons (Jiang and Kim 2015), implying that the
capital market pressures to improve EQ are limited. Another motivation to study EQ
comes from China’s listing regulations which provide incentives to distort economic
performance. According to those listing regulations, a firm will be delisted if a loss is
reported for three consecutive years. Such regulations create a strong motivation to
inflate earnings, and this is detrimental to the transparency of the information
environment in Chinese markets. The main objective behind the adoption of IFRS across
the world was to improve the information environment in which firms operated. China
CMS converged its accounting standards with IFRS on that basis, but its convergence only
10,3 accentuated the earnings management behavior of Chinese firms because IFRS is not
compatible with the legal and regulatory environment in China (He et al., 2012).
Emerging economies suffer from weak information environments and China is
considered among the lowest ranked economies as far as the information environment of
public firms is concerned. Developed economies with good public disclosure have lower
564 levels of information asymmetry and enjoy lower costs of capital, higher valuations,
well-functioning capital markets and superior economic development. According to
Piotroski and Wong (2012), the political, legal and cultural backgrounds of China
provide incentives for the opaqueness of the information environment there to continue.
As a result, the Chinese capital market, like other emerging markets, pays a price for its
poor information environment. For example, when firms have opaque information
environments and information is not released by them in a timely manner, any negative
information reported would result in large succeeding price reactions as soon as any bad
news reaches the market. This suppression of negative information would result in
left-skewed return distribution and hence Chinese equity market would be prone to a
higher frequency of market crashes than more open developed countries (Chen et al.,
2001). An opaque information environment and a lack of firm-specific information each
result in synchronous stock prices in emerging economies (Morcket al., 2000). The
presence of market frictions and the absence of arbitrageurs result in the delayed
impounding of the latest information about market prices, which establishes
momentum patterns (Jegadeesh and Titman, 1993; Chan et al., 1996). Chinese capital
faces all of these problems (i.e. frequent crashes, synchronous stock prices and
momentum pattern) (Piotroski and Wong, 2012).

2.2 Literature review and hypothesis development

The objective of financial reporting is to provide information to stakeholders (particularly to
the providers of capital) to reduce any information asymmetry between managers and
investors. However, managerial opportunism reduces the usefulness of financial reports by
manipulating them, resulting in higher information asymmetry. The managerial
motivations for earnings manipulation include punishment by financial markets for
lower-than-expected earnings (Skinner and Sloan 2002), a boosting of stock prices (Collins
and Hribar 2000) or earnings may be manipulated to obtain low-cost financing. Similarly,
previous research has found that firms tend to inflate earnings because of IPOs, seasoned
equity offerings and regulatory requirements (Piotroski, 2014). These arguments suggest
that managerial opportunism or agency conflict influence financial reporting.
Preceding research has described two channels by which PMC may influence managerial
decisions. The first line of inquiry stemmed from agency theory (Jensen and Meckling, 1976).
He (2012) suggested that PMC is a mechanism that reduces agency conflict. He (2012) argued
that PMC forces managements to pay dividends. He also reported that intense competition
also reduces agency conflict between majority and minority shareholders. Chhaochharia
et al. (2009) reported that PMC acts as a governance mechanism and suggested that
managerial interests are more aligned in industries that face higher competition. They also
argued that competition substitutes other governance mechanisms because firms in less
competitive industries have more governance mechanisms to align themselves to the
interests of their managements compared to more competitive industries. This argument
suggests that PMC not only acts as a governance mechanism but also substitutes other
governance mechanisms. Marciukaityte and Park (2009) found that PMC decreases agency Product
problems by restricting “misleading earnings management and improving earnings market
informativeness”. The alignment of the interests of managements with owners may be
caused by the higher liquidation risks faced by firms in competitive industries (Schmidt,
competition
1997). Li (2010b) reported that PMC is an important determinant of corporate disclosure, as
incentives induced by capital markets generally improve the quality of disclosures.
Laksmana and Yang (2014) reported that earnings management and RAM are more 565
customary in less competitive industries and argued that the “market consequences of
missing key targets pose serious problems in less competitive industries”. Product market
competition increases the scope of information environments for firms as analyst forecast
accuracy increases with increases in industry concentration (Datta et al., 2011). The reason
for EQ increasing with greater PMC may be attributed to the willingness of firms to improve
their information environments to reduce information asymmetry and lower financing costs,
as with decreases in the costs of obtaining information, investors will be willing to demand
lower rates of returns. Hoberg and Phillips (2010) provided evidence that the collection of
firm-specific information is less costly for firms in competitive industries compared to those
in uncompetitive industries. Fosu (2013) reported the positive effect of financial leverage on
firms’ performances and argued that competition improved the positive effect of leverage
which suggests that competition complements the governance induced by leverage in South
Africa. Kao and Chen (2013) analyzed the impact of PMC on dividend payments in an
environment of weak investor protection, i.e. Taiwan. In an environment of weak investor
protection, controlling shareholders (through CEO duality, pyramid corporate structure etc.)
hold onto profits instead of paying dividends. They suggested that intense competition (in
environments of weak investor protection) has a positive relationship with dividend
payments, while weak competition has a negative relationship with dividend payment. This
argument suggests that intense competition reduces agency conflict, while weak
competition does not. Selarka (2014) studied corporate governance reforms and argued that
PMC acts as a weak substitute for corporate governance and that relying only on
competitive pressure for an improvement in governance would be incongruous in the Indian
environment. Mohebbi and Kamyabi (2014) argued that increasing monopoly
(concentration), i.e. lowering competition, significantly increases discretionary accruals in
Iran, thereby reducing the quality and transparency of financial reports there, which distorts
the information environment in consequence. Chen et al. (2014) argued that PMC in China
acts as a governance mechanism and reduces the cost of equity capital. They argued that
competition increases innovation and production efficiency and aligns managerial interests,
which decreases systematic economic uncertainty. This discussion has led to our first
hypothesis:
H1. There is a positive relationship between product market competition and
earnings quality.
Our second line of inquiry argues that PMC reduces the quality of financial reporting, which
may be because of higher agency conflict and/or higher proprietary costs. Verrecchia (1983)
has argued that firms in highly competitive industries choose less informative disclosures or
opaque information environments to reduce predatory threats from competitors. Verrecchia
(1990) and Clinch and Verrecchia (1997) have suggested that lower levels of disclosure exist
in industries that have higher competition. Fan and Wong (2002) argued that firms try to
retain proprietary information to maintain their competitive advantages. Stivers (2004)
CMS stated that there is less likelihood of companies revealing proprietary information when
10,3 competition is high. Guo et al. (2015) argued that benefits and costs vary with PMC, and any
association between PMC and EQ is determined by variations in benefits and costs.
Verrecchia and Weber (2006) reasoned that PMC reduces the flow of proprietary information
as disclosure may harm the market share of firms. Ali et al. (2014) advanced the same
argument and reported that PMC is associated with a lower frequency of management
566 forecasts, which tend to have shorter time horizons. They argued that industry
concentration is associated with opaque information environments, as firms in such
industries choose to disclose less and avoid those financing decisions that require
(comprehensive) higher levels of disclosure. According to their study, firms in concentrated
industries prefer private placement over seasoned equity offerings because private
placement does not require comprehensive public disclosure and only a limited number of
people come across proprietary information which reduces the extent of any leaking of
proprietary information. Ali et al. (2014) further argued that firms in concentrated industries
are associated with lower disclosure ratings by analysts and they suffer from higher analyst
forecast dispersion, higher forecasting errors and more volatile revisions because of the
lower quality of their information disclosure. Ali et al. thus showed that there is a proprietary
cost associated with higher-quality disclosure in competitive industries. By using economic
deregulation as a quasi-natural experiment, Lee and Liu (2014) showed that an exogenous
increase in PMC increases the likelihood of earnings management and accounting frauds.
They also suggested that these negative effects of competition are more profound in firms
with higher book-to-market ratios. They further suggested that firms with active earnings
management policies are more likely to become involved in acquisitions to survive. Lin et al.
(2015) argued that higher competition leads to higher earnings management. They used
import tariff reduction as an exogenous shock and used differences in frameworks to study
the impact of foreign competition on the earnings management behavior of firms. Their
study suggested that higher competition induced by import tariff reductions exacerbates
agency problems and boosts unethical behavior, thereby increasing earnings management
for impacted firms. Lin et al. (2015) further suggested that predation risks perceived by firms
was the main driver of this behavior amongst them. As far as an agency view is concerned,
Karuna (2007) argued that intense competition leads to the higher monitoring of CEO
performance which, in turn, can stimulate agency conflict, thereby distorting the quality of
disclosures. This discussion gives rise to our second hypothesis:
H2. There is a negative relationship between product market competition and
earnings quality.
The following diagram shows the channels through which PMC affects EQ (Figure 1).

Figure 1.
This figure shows
the channels
throught which
product market
competition affects
earnings quality
3. Research design Product
3.1 Measurement of product market competition market
Following on from preceding research, the Herfindahl–Hirschman index (HHI) was used
as a proxy for PMC. HHI has been used as a measure of PMC extensively in industrial
competition
organization research (Gaspar and Massa, 2006; Hou and Robinson, 2006; Haushalter
et al., 2007; Hoberg and Phillips, 2010; Valta, 2012; Alimov, 2014). HHI is calculated as
the sum of the square of market shares in an industry (classified under the second-level 567
code of the China Securities Regulatory Commission [CSRC]) by using the following
formula:

Hj ⫽ 兺X
i⫽1
2
ij

X represents the market share of firm “i” in industry “j”, while market share is calculated
as the net sales of the firm scaled by the net total sales of its industry. Lower values of
HHI indicate that the market is shared among several competing firms, while higher
values of HHI denote that the market share is concentrated in the hands of only a few
large firms. For ease of explanation, a new variable is created by multiplying Hj with a
negative one. Higher values of PMC measures, i.e. PMC_EXIST, represent higher
competition and vice versa:

PMC_EXIST ⫽ (⫺1)Hj

Following Li (2010b) and Guo et al. (2015), we used a profitability-based measure of

competition from potential entrants (PMC_POTN) which was calculated as one minus
the aggregate industry net income divided by the aggregate industry total assets. Prior
studies have suggested that higher profitability is associated with large numbers of
potential entrants, as higher profits encourage market entrants.

3.2 Measurement of earnings quality

Following Datta et al. (2013), a modified Jones model was used as a measure of EQ as
described by Kothari et al. (2005) with return on assets to capture the discretionary part
of earnings management. These discretionary accruals represent the choices of
managers to manipulate earnings. The process to calculate discretionary accruals
involves two steps:

TAit
Ait
⫽ ␤1
1
At⫺1
⫹ ␤2 共
⌬REVit
At⫺1
⫺
⌬ARit
At⫺1
⫹ ␤3 兲
PPEit
At⫺1
⫹ ␤4
NIit⫺1
At⫺1
⫹ ␧it

TA is the total accrual calculated as net income before extraordinary items, minus the
cash flow from operations. Whereas ⌬REV represents the change in sales, ⌬AR is the
change in account receivables. PPE represents property, plant and equipment; NIit⫺1 is
lagged net income; and At⫺1 represents lagged total assets. The regression model
mentioned above was estimated for each year and industry, as classified by the
second-level code of the CRSC. The aforementioned regression model was estimated for
at least 15 observations for each year and industry classification. The coefficients were
CMS estimated using the model above and then the following equation was used to calculate
10,3 dictionary accruals represented by DA:

DAit ⫽ ␧it ⫽
TAit
Ait
⫺ ␤1共 1
At⫺1
⫹ ␤2
⌬At⫺1共
⌬REVit
⫺
⌬ARit
⌬At⫺1
⫹ ␤3
PPEit
At⫺1 兲⫹ ␤4
NIit
At⫺1 兲
568 The difference between total accruals and non-discretionary accruals is discretionary
accruals, as described in the model above. The estimated values of DA would be either
positive (when firms escalate earnings) or negative (when firms decrease earnings).
However, on both sides, large values of DA (positive/negative) represent higher levels of
earnings manipulation/management or lower EQ. The use of performance-matched
dictionary accruals, as described by Kothari et al. (2005), reduces the likelihood of there
being a mechanical relationship between EQ and PMC.

3.3 Estimation model and control variables

We used the following model to analyze the relationship between EQ and PMC. Various
structures of this model were used to test the propositions:

EQit ⫽ ␤0 ⫹ ␤1PMCit ⫹ ␤2Sizeit ⫹ ␤3BMit ⫹ ␤4Volatilityit ⫹ ␤5CFPSTDit

⫹ ␤6LNOAit ⫹ ␤7Growthit ⫹ ␤8LEVit ⫹ ␤9SOEit ⫹ Year
⫹ Industry ⫹ ␧it

Following prior studies, several firm-level variables were used as control variables.
Following Lee et al. (2006), two proxies for firm growth, i.e. growth (change in assets
scaled by lagged total assets) and market-to-book value (ratio of market value to book
value of equity) were used. According to Hribar and Craig (2007) and Liu and Wysocki
(2007), EQ may be affected by sales volatility (Volatility) and cash flow volatility
(CFO_STD). According to Chen et al. (2011), state ownership plays the role of “insurance
provider” for SOEs and, thus, they have few incentives to engage in earnings
management because of the lower sensitivity of CEO compensation contracts to
accounting profits, so a dummy variable (SOE) for state ownership was used whose
value was “one” to represent state ownership or “zero” otherwise. A firm is state-owned
if the majority of controlling shares are held by the state, and it is not state-owned if this
is not the case. Details of the state ownership of firms were obtained from the RESSET
database. Other control variables included size (Size), leverage (LEV) and the
beginning-of-the-period net operating assets (NOA) (Cheng and Warfield, 2005;
Ettredge et al., 2010). The industry and year dummies were used to control variations
across industries and business cycles. All standard errors were clustered by firms.

3.4 Sample description

The initial sample consisted of A-listed Chinese firms for the period spanning 2000 to
2014. The data were obtained from the RESSET database and from the China Stock
Market and Accounting Research (CSMAR) database. Industries with less than 15
observations were deleted for the calculation of the EQ measure. Industries with less
than ten firms were deleted for the calculation of the PMC measure (HHI), as firms with
higher values of HHI were expected to be from diminishing industries (Ali et al., 2009).
The final sample consisted of 20,532 firm-year observations with complete data from 35 Product
industries classified by the second-level code of the CSRC. The sample size decreased market
significantly from 20,532 to 6,787 when we used an information asymmetry variable
calculated by using analysts’ forecasts.
competition

3.5 Descriptive statistics and correlation matrix

Table I reports descriptive statistics for the key variables. An average firm in the sample 569
was from an industry with a mean PMC_EXIST value of ⫺0.080, which is similar to the
values reported by Hoberg and Phillips (2010) and Dhaliwal et al. (2014), while the
median value was – 0.059. The mean and median values of PMC_POTN were ⫺1.231
and ⫺0.803, respectively, which are similar to the PMC measurement made by Li
(2010b). The mean and median values of the EQ measure, based on absolute
discretionary accrual, were 0.074 and 0.048, respectively.
Table II presents the pairwise correlation between the variable used in the analysis. The
correlation between control variables, i.e. natural log of total assets (Size), book-to-market
ratio (BM), volatility of sales (Volatility), growth rate in sales (Growth), volatility of cash
flows (CFO_STD), lag net operating assets (LNOA), leverage ratios (LEV), institutional
investment (IO), analyst forecast (AF) and information asymmetry (InfoAsy), was
statistically significant and small in magnitude. Another noteworthy observation in this

Variables Mean Median SD P25% P75% N

EQ 0.074 0.048 0.098 0.021 0.092 20532

PMC_EXIST ⫺0.080 ⫺0.059 0.083 ⫺0.081 ⫺0.042 20532
PMC_POTN ⫺1.231 ⫺0.803 4.025 ⫺3.024 0.437 20532
Size 21.480 21.346 1.250 20.655 22.140 20512
MTB 0.004 0.003 0.013 0.002 0.004 18554
Volatility 0.170 0.105 0.268 0.054 0.194 18381
CFO_STD 0.114 0.046 0.389 0.024 0.086 20249
LNOA 1.114 0.605 3.832 0.454 0.731 20494
Growth 24.322 11.389 57.369 1.337 27.366 20490
LEV 0.095 0.046 0.170 0.012 0.128 18418
IO 0.146 0.099 0.155 0.031 0.213 11625
AF 1.630 1.609 0.676 1.099 2.197 8489
InfoAsy 0.108 0.071 0.113 0.035 0.141 6787

Notes: This table reports summary statistics for some characteristics of the sample. These statistics
are based on 20,532 observations spanning the period 2000-2014 for the firms meeting our data
requirements. These observations are taken from 35 industries based on the second-level code of the
CSRC; EQ represents earnings quality, based on discretionary accruals management using a modified
Jones model as described by Kothari et al. (2005); PMC_EXIST is a proxy for product market
competition using an HHI multiplied by negative one; PMC_POTN is a measure of product market
competition from potential rivals calculated as one minus aggregate industry net income divided by
aggregate industry total assets; Size is a natural log of total assets; MTB is a ratio of market-to-book
values of equity; Volatility is the standard deviation of sales; CFO_STD is the standard deviation of cash
flows from operations; LNOA is lag net operating assets; Growth represents growth in sales; Lev
represents a leverage ratio; IO represents institutional ownership; AF is analyst following, which
represents the number of analysts following the firm; InfoAsy represents information asymmetry Table I.
proxied for by analyst forecast dispersion Descriptive statistics
 10,3

570

matrix
CMS

Table II.
Pairwise correlation
Variable PMC_EXIST PMC_POTN EQ Size MTB Volatility CFO_STD LNOA Growth LEV IO AF InfoAsy

PMC_EXIST 1
PMC_POTN ⫺0.105***
EQ 0.012 ⫺0.012* 1
Size ⫺0.051*** ⫺0.047*** ⫺0.089*** 1
MTB 0.007 0.006 0.069** ⫺0.151** 1
Volatility ⫺0.020*** 0.005 0.112*** 0.054*** 0.071*** 1
CFO_STD 0.016** 0.036*** 0.096*** ⫺0.131*** 0.046*** 0.114*** 1
LNOA 0.0181*** 0.0308*** 0.0170** ⫺0.143*** 0.016** ⫺0.001 0.510*** 1
Growth ⫺0.0263*** ⫺0.101*** 0.158*** 0.046*** 0.019*** 0.443*** 0.122*** 0.106*** 1
LEV 0.0013 0.110*** 0.129*** 0.100*** ⫺0.005 ⫺0.039*** ⫺0.003 ⫺0.040*** ⫺0.038*** 1
IO 0.0078 ⫺0.054*** ⫺0.024*** 0.062*** ⫺0.004 0.017*** ⫺0.025*** ⫺0.001 0.019*** ⫺0.007 1
AF ⫺0.079*** ⫺0.050*** ⫺0.003 0.269*** 0.067*** 0.057*** ⫺0.001 0.016 0.113*** ⫺0.016 0.149*** 1
InfoAsy ⫺0.002 ⫺0.016 0.064*** 0.118*** ⫺0.012 0.058*** ⫺0.022** ⫺0.066*** ⫺0.010 0.032** 0.0161 0.134** 1

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represents significance level at 10%
regard was the positive relationship observed between EQ and the PMC measure Product
(PMC_EXIST), but this relationship was not statistically significant. However, there was a market
statistically significant negative relationship between PMC_POTN and the EQ measure.
competition
4. Results
4.1 Empirical findings
4.1.1 Product market competition and earnings quality. Table III reports the regression 571
results for the impact of PMC on EQ. The coefficient in Model 1 was ⫺0.1491 and was
statistically significant at 1 per cent which shows that with an increase in PMC, the
absolute discretionary accruals decreased. These findings provide evidence in favor of
H1 that PMC (PMC_EXIST) increases the EQ and hence implies that PMC_EXIST acts
as an external disciplinary mechanism which improves the transparency of the financial
numbers. Similarly, the coefficient of the second measure of PMC, i.e. PMC_POTN
(which measures competition from potential rivals), was ⫺0.0019 and was statistically
significant. This suggests that a threat of competition from potential entrants also plays
a monitoring role and improves the EQ and transparency of financial reports.
4.1.2 Taking into account the influence of the governance mechanisms. In Models 2
and 3, different variables were introduced to account for some external governance
mechanisms which were likely to influence EQ and the information environment. The
two external governance mechanisms used were institutional investors and analyst
coverage. These external governance mechanisms play a monitoring role which, in turn,
reduces agency conflict. Previous research has suggested that institutional holdings and
analysts following play a vital monitoring role and improve the information
environments of firms. The results in Model 2 show that the impact of PMC on EQ
increases in the presence of institutional ownership, which implies that institutional
holdings complement the monitoring role played by PMC (PMC_EXIST). Moreover, the
impact of PMC from potential entrants (PMC_POTN) on EQ was also improved by the
presence of institutional investors. Similarly, the analyst following (AF) was
insignificant in itself, but it complemented the competitive pressures of PMC on EQ in
both cases, i.e. PMC from existing rivals (PMC_EXIST) and from potential entrants
(PMC_POTN), which confirms the monitoring role played by PMC. It is important to
note that the inclusion of institutional investors complemented the relevance of the main
variable more, compared to AF, as it caused increases in the magnitude of the test
variable twice.
4.1.3 Taking into account the influence of the information environment. Prior
research (Krishnaswami et al., 1999; Thomas, 2002) has recognized a link between
analyst forecast dispersion and information asymmetry. Analyst forecast dispersion
(standard deviation of analyst earnings forecast) indicates uncertainty about the future
performance of a firm, which makes it difficult to obtain private intelligence or
information about the profitability of a firm (Jiang et al., 2005). Firms with higher
information asymmetry have greater incentives to manage earnings (Datta et al., 2013).
In Model 4, the information environment of the firm was also controlled because of its
possible impact on EQ. Once again, the inclusion of an information asymmetry variable
(InfoAsy) complemented the relevance of the test variable, i.e. PMC.
These findings suggest that PMC acts as an external disciplinary mechanism,
reducing managerial opportunism and resulting in financial reporting transparency.
These results were in accordance with some prior studies (Chhaochharia et al., 2009; He,
 10,3

572
CMS

Table III.
Product market
competition and
earnings quality
PMC_EXIST PMC_POTN
Variable Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4

PMC ⫺0.1492*** (⫺4.45) ⫺0.3025*** (⫺5.27) ⫺0.2165*** (⫺3.76) ⫺0.2079*** (⫺3.09) ⫺0.0019*** (⫺5.31) ⫺0.0043*** (⫺7.61) ⫺0.0045*** (⫺6.43) ⫺0.0054*** (⫺6.15)
Size ⫺0.0069*** (⫺7.64) ⫺0.0038*** (⫺2.9) ⫺0.0012 (⫺1.14) ⫺0.0009 (⫺0.82) ⫺0.0068*** (⫺7.46) ⫺0.0037*** (⫺2.91) ⫺0.0008 (⫺0.8) ⫺0.0006 (⫺0.56)
MTB 0.0085 (0.11) ⫺0.0727 (⫺0.82) 0.0272 (0.28) 0.7753*** (2.59) 0.0081 (0.11) ⫺0.0679 (⫺0.75) 0.0241 (0.24) 0.7244** (2.35)
Volatility 0.0018 (0.28) ⫺0.0095 (⫺1.07) 0.0111 (1.24) 0.0114 (0.98) 0.0023 (0.36) ⫺0.0095 (⫺1.09) 0.0113 (1.27) 0.0112 (0.98)
CFO_STD 0.0811*** (3.34) 0.3884*** (3.82) 0.3142*** (2.91) 0.3161** (2.44) 0.0816*** (3.35) 0.3874*** (3.83) 0.3140*** (2.93) 0.3153** (2.45)
LNOA ⫺0.0030 (⫺0.69) ⫺0.0127** (⫺2.29) ⫺0.0038 (⫺0.78) ⫺0.0054 (⫺0.91) ⫺0.0028 (⫺0.64) ⫺0.0127** (⫺2.33) ⫺0.0038 (⫺0.78) ⫺0.0057 (⫺0.97)
Growth 0.0003*** (5.07) 0.0002*** (3.44) 0.0002*** (3.44) 0.0003*** (3.31) 0.0003*** (4.98) 0.0002*** (3.41) 0.0002*** (3.36) 0.0003*** (3.31)
LEV 0.0615*** (4.11) 0.0573*** (3.48) 0.0238 (1.46) 0.0308 (1.47) 0.0616*** (4.09) 0.0601*** (3.71) 0.023167 (1.43) 0.029 (1.40)
SOE ⫺0.0042*** (⫺2.88) ⫺0.0032* (⫺1.67) ⫺0.0022 (⫺1.05) ⫺0.0021 (⫺0.91) ⫺0.0041*** (⫺2.78) ⫺0.0033* (⫺1.74) ⫺0.0023 (⫺1.13) ⫺0.0022 (⫺0.93)
IO ⫺0.0010 (⫺0.19) ⫺0.0011 (⫺0.21)
AF 0.0005 (0.33) 0.0002 (0.14)
Info_Asy 0.0367*** (3.51) 0.0338*** (3.29)
Constant 0.1749*** (8.27) 0.0995*** (3.04) 0.0030* (0.92) 0.0295 (0.97) 0.1956*** (9.40) 0.1440*** (4.55) 0.0439 (1.54) 0.0693*** (2.58)
Year Yes Yes Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes Yes Yes
R2 11.4 20.34 20.13 21.43 11.52 21.1 21.08 22.72
F-Statistics 14.12*** 13.51*** 9.77*** 9.75*** 14.14*** 13.83*** 10.13*** 10.06***

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represent significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality for the sample firms spanning 2000-2014 that met our data requirements; the dependent variable is earnings quality, as defined earlier. all models
include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms
2012; Laksmana and Yang, 2014). However, these results did not support the argument Product
that PMC operating in opaque information environments weakens financial reporting market
transparency (Datta et al., 2013; Lee and Liu, 2014; Lin et al., 2015).
Overall, the control variables included in all the models reported in Table III
competition
consistently suggested that firms with lower accounting quality tended to be small in
size, had lower leverage ratios with higher growth opportunities and higher volatility.
Our results also suggested that EQ was lower when cash flows from operations were 573
more volatile. According to Minton and Schrand (1999), higher cash flow volatility
results in higher financing costs, so the negative relationship of cash flow volatility with
EQ implies that firms with lower EQ have higher financing costs. Moreover, the results
reported that firms with high market-to-book ratios have lower EQ, which is in
accordance with prior research (Kuo et al., 2014). According to Maksimovic and Pichler
(2014), innovation-oriented firms are more concerned about disclosing private
information via their financial statements. This rationale also supported the reported
negative relationship between EQ and market-to-book ratios, as innovation-oriented
firms have higher market values of equity. However, the SOE dummy which
represented state ownership had a positive relationship with EQ, i.e. SOEs have higher
EQ as they have fewer incentives to manage earnings because their main objective is not
to return an accounting profit but to achieve extraneous political and social goals (Chen
et al., 2011).
4.1.4 The impact of product market competition on earnings inflation and earnings
deflation. The EQ measure used in this study captured the discretionary accruals
management by firms. These accruals were of two types, i.e. positive and negative, and
represented earning inflation and deflation respectively. The earnings, whether boosted
or suppressed, diminished the EQ. Tables IV and V provide the results for the impact of
PMC on earnings inflation/deflation.
Table IV reports the results for firms engaged in income escalation, and Table V
reports the results for firms engaged in income suppression. This analysis is important
because there is an argument that firms facing competitive pressure choose to suppress
earnings, as they do not want to inform existing and potential rivals about their real
incomes. Firms may suppress income to deter potential entrants that examine the
profitability of firms already in a market before deciding whether to enter that market
themselves, while existing rivals may increase production or loosen their credit policies
to catch up with highly profitable rival(s). Similarly, higher competitive pressures may
result in an earning escalation to reduce the performance pressures on managements.
The results reported in Table IV suggest that firms facing weaker PMC from both
existing and potential rivals have a greater tendency to escalate earnings. Our results
are highly significant, even after accounting for the effect of institutional holdings, as
well as analyst following and information asymmetry, which actually increased the
magnitude of the impact on earnings. Table V reports the effect of income suppression
and the results show that PMC reduces income suppression and leads to more
transparent financial reporting.
However, our results for competition from existing rivals are not significant when the
influences of analyst followings and information asymmetry are taken into account, as
reported in Models 3 and 4. However, the impact of PMC from potential rivals on earnings
deflation is robust and consistent after the inclusion of institutional holdings, analyst
followings and information asymmetry as reported in Model 1 through to Model 4, which
 10,3

574
CMS

Table IV.
Product market
competition and
earnings quality
PMC_EXIST PMC_POTN
Variables Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4

PMC ⫺0.1963*** (⫺4.60) ⫺0.3005*** (⫺3.79) ⫺0.3067*** (⫺3.82) ⫺0.3021*** (⫺3.18) ⫺0.0023*** (⫺4.88) ⫺0.0042*** (⫺5.97) ⫺0.0052*** (⫺5.70) ⫺0.0068*** (⫺5.55)
Size ⫺0.0034*** (⫺2.62) 0.0018 (1.14) 0.0018 (1.22) 0.0010 (0.59) ⫺0.0034*** (⫺2.62) 0.0016 (1.04) 0.002 (1.33) 0.001 (0.56)
MTB 0.0742 (0.40) ⫺0.0098 (⫺0.07) 1.0619* (1.83) 1.0486* (1.91) 0.0763 (0.41) ⫺0.0037 (⫺0.03) 0.9356* (1.64) 0.8873* (1.63)
Volatility ⫺0.016(⫺1.46) ⫺0.0185(⫺1.55) 0.0127 (1.00) 0.0091(0.55) ⫺0.0153 (⫺1.40) ⫺0.0186 (⫺1.58) 0.0128 (1.03) 0.0095 (0.59)
CFO_STD 0.0937*** (2.10) 0.7119*** (8.22) 0.5325*** (4.75) 0.6485*** (4.94) 0.0934** (2.10) 0.7091*** (8.19) 0.5302*** (4.74) 0.6445*** (4.95)
LNOA ⫺0.0145** (⫺2.34) ⫺0.0305*** (⫺2.95) ⫺0.0143 (⫺1.07) ⫺0.0261 (⫺1.60) ⫺0.0142** (⫺2.30) ⫺0.0294*** (⫺2.87) ⫺0.0127 (⫺0.95) ⫺0.0249 (⫺1.54)
Growth 0.0005*** (5.26) 0.0003*** (3.84) 0.0003*** (2.9) 0.0003*** (3.11) 0.0005*** (5.20) 0.0003*** (3.83) 0.0003*** (2.86) 0.0003*** (3.18)
LEV 0.0473*** (2.64) 0.0786*** (2.71) 0.0436* (1.67) 0.0657** (2.00) 0.0469*** (2.60) 0.0784*** (2.72) 0.0423* (1.63) 0.0623* (1.92)
SOE ⫺0.0064*** (⫺2.86) ⫺0.0063** (⫺2.21) ⫺0.0049 (⫺1.53) ⫺0.0050*** (⫺1.33) ⫺0.0063*** (⫺2.80) ⫺0.0064** (⫺2.26) ⫺0.0055* (⫺1.72) ⫺0.0051 (⫺1.39)
IO 0.0049 (0.53) 0.0042 (0.45)
AF 0.0015 (0.69) 0.0008 (0.35)
Info_Asy 0.0419*** (2.84) 0.0380***(2.63)
Constant 0.0954*** (2.96) ⫺0.0337 (⫺0.82) ⫺0.0601 (⫺1.19) ⫺0.0361 (⫺0.74) 0.1262*** (4.15) 0.0149(0.40) ⫺0.002(⫺0.06) 0.0298(0.70)
Year Yes Yes Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes Yes Yes
R2 16.45 35.02 28.55 32.30 16.56 35.62 29.54 33.84
F-Statistics 9.82*** 8.84*** 6.43*** 5.80*** 9.83*** 9.23*** 6.97*** 6.10***

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represent significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality; the dependent variable is earnings inflation (positive discretionary accruals) using a modified jones model as described by Kothari et al. (2005); all
models include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms
 PMC_EXIST PMC_POTN
Variables Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4

PMC 0.0942* (1.89) 0.2883*** (3.26) 0.0898 (1.06) 0.0497 (0.51) 0.0014** (2.43) 0.0040*** (4.22) 0.0032*** (2.97) 0.0034*** (2.73)
Size 0.0102*** (8.52) 0.0076*** (5.54) 0.0029** (2.44) 0.0020* (1.88) 0.0100*** (8.38) 0.0073*** (5.47) 0.0025** (2.14) 0.0016 (1.46)
MTB 0.0066 (0.09) 0.0527 (0.52) ⫺0.0005 (⫺0.01) ⫺0.5589* (⫺1.83) 0.0081 (0.11) 0.051 (0.49) ⫺0.0019 (⫺0.02) ⫺0.5598* (⫺1.73)
Volatility ⫺0.0215*** (⫺2.99) ⫺0.0119 (⫺1.24) ⫺0.0131 (⫺1.23) ⫺0.0158 (⫺1.28) ⫺0.0219*** (⫺3.05) ⫺0.0116 (⫺1.22) ⫺0.0132 (⫺1.24) ⫺0.0153 (⫺1.26)
CFO_STD ⫺0.0656*** (⫺3.65) ⫺0.1935*** (⫺2.57) ⫺0.1829** (⫺1.96) ⫺0.1726* (⫺1.83) ⫺0.0666*** (⫺3.73) ⫺0.1932*** (⫺2.58) ⫺0.1829** (⫺1.97) ⫺0.1726* (⫺1.85)
LNOA ⫺0.0048 (⫺1.07) ⫺0.0015 (⫺0.43) 0.0013 (0.34) 0.001 (0.25) ⫺0.0049 (⫺1.08) ⫺0.0002 (⫺0.06) 0.0018 (0.48) 0.0017 (0.42)
Growth ⫺0.0001 (⫺0.88) 0.0001 (⫺0.78) ⫺0.0001** (⫺2.33) ⫺0.0001** (⫺2.13) 0.0000 (⫺0.77) ⫺0.0001 (⫺0.71) ⫺0.0001** (⫺2.24) ⫺0.0001** (⫺2.10)
LEV ⫺0.0646*** (⫺3.21) ⫺0.0220* (⫺1.85) 0.0086 (0.55) 0.0017 (0.10) ⫺0.0648*** (⫺3.21) ⫺0.03** (⫺2.18) 0.0092 (0.60) 0.0034 (0.19)
SOE 0.0014 (0.75) ⫺0.0011 (⫺0.49) ⫺0.0024 (⫺0.95) ⫺0.0035 (⫺1.26) 0.0013 (0.67) ⫺0.001 (⫺0.44) ⫺0.0025 (⫺1.02) ⫺0.0036 (⫺1.31)
IO 0.0033 (0.63) 0.003 (0.56)
AF 0.0003 (0.15) 0.0001 (0.06)
Info_Asy ⫺0.0288** (⫺2.33) ⫺0.0277** (⫺2.27)
Constant ⫺0.2522*** (⫺9.61) ⫺0.1877*** (⫺6.25) ⫺0.0443 (⫺1.41) ⫺0.0859*** (⫺2.73) ⫺0.2629*** (⫺9.93) ⫺0.2262*** (⫺7.15) ⫺0.0645* (⫺1.87) ⫺0.0936*** (⫺3.46)
Year Yes Yes Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes Yes Yes
R2 9.55 12.73 15.94 17.16 9.63 13.41 16.64 17.99
F-Statistics 9.14*** 8.83*** 7.07*** 5.71*** 9.15*** 8.80*** 6.41*** 5.80***

Notes: *** Represent significance at 1%; ** represent significance at 5%; * represent significance level at 10%; this table reports OLS results examining the impact of product market
competition on earnings quality; the dependent variable is earnings deflation (negative discretionary accruals) using a modified jones model as described by Kothari et al. (2005); all models
include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms

Table V.
575

Product market
competition
market
Product

earnings quality
competition and
CMS implies that none of these governance mechanisms can be regarded as a substitute for PMC
10,3 from potential entrants.

4.2 Additional tests

4.2.1 Product market competition and real activity manipulation (RAM). The preceding
discussion has shown that PMC acts as a governance mechanism, which reduces agency
576 conflict, aligns the interests of managements with shareholders (owners) and, in turn,
improves the quality of reported earnings (based on accrual-based earnings
management). However, managerial opportunism and agency conflict, which results in
lower-quality earnings, is not limited to accruals management. It also extends to RAM.
RAM occurs when managers take actions, which alter the timing and organization of
investments, operations and/or financing transactions, to influence the outcomes of the
accounting system (Gunny, 2010). So the ultimate objective of RAM is to influence the
accounting outcome, in the form of reported numbers, by changing the underlying
operations of a firm. According to Gunny (2010), managers may be more inclined to
engage in RAM because it less risky than accruals, undergoes less regulatory scrutiny
and/or because of a limited flexibility to manage accruals in the first place. However,
RAM is not without costs, as it reduces firms’ values (Farooqi et al., 2014). As RAM also
diminishes the outcomes of accounting systems (i.e. financial reports), we also analyzed
the relationship between PMC and RAM to understand its role in lessening the quality
of earnings. Following Roychowdhury (2006) and Zang (2012), three measures were
used to capture RAM, i.e. a positive, abnormal level of cost of production (because of
manipulation in the production process); a negative, abnormal level of cash flow from
the operation (because of discounted sales or a soft credit policy); and a negative,
abnormal level of discretionary expenses (by manipulating discretionary expenses).
First, we calculated the normal level of cash flows, production costs and discretionary
expenses using the following models:

CFOit
At⫺1
⫽ ␤1
1
At⫺1
⫹ ␤2共 兲
REVit
At⫺1
⫹ ␤3
⌬REVit
At⫺1
⫹ ␧it

PRODit
At⫺1
⫽ ␤1
1
At⫺1
⫹ ␤2
REVit
At⫺1 共 兲
⫹ ␤3
⌬REVit
At⫺1
⫹ ␤4
⌬REVit⫺1
At⫺1
⫹ ␧it

共 兲
DIS EXPit 1 REVit
⫽ ␤1 ⫹ ␤2 ⫹ ␧it
At⫺1 At⫺1 At⫺1

CFO is the cash flow from operations, REV is sales revenue, A is total assets, PROD is
the cost of production and DIS_EXP represents discretionary expenses. The abnormal
level of the cost of production (R_PROD), cash flow from operations (R_CFO) and
discretionary expenses (R_DISX) was calculated as the differences between actual
values and predicted values from those models mentioned above. Following Wu et al.
(2015), the final single proxy for RAM was calculated using the following equation:

RAMt ⫽ RPRODt ⫺ RCFOt ⫺ RDISXt

The results reported in Table VI show that PMC from existing rivals is not significantly Product
associated with RAM; however, the results show a strong link between PMC from market
potential entrants and RAM. This implies that the presence of an external governance
mechanism (market competition from potential entrants) discourages firms from
competition
engaging in RAM. However, the same cannot be said for competition from existing
rivals. In both cases, most of the control variables were significant at conventional
levels. 577
4.2.2 Product market competition, International Financial Reporting Standards and
earnings quality. The purpose of introducing IFRS was to improve the information
environment and reporting quality and to reduce information asymmetry to reduce the
costs of capital for firms. However, prior research showed that there had been mixed
results in this regard. For example, Dimitropoulos et al. (2013) and Pelucio-Grecco et al.
(2014) reported that IFRS adoption resulted in less earnings management, while
Doukakis (2014) suggested that IFRS adoption by 22 European countries had no
significant impact on real and accrual-based earnings management. Liu and Sun (2015)
also reported no significant change in EQ in Canada after IFRS adoption, while Kabir
et al. (2010) reported lower EQ under IFRS. Byard et al. (2011) argued that IFRS adoption
improved the information environment (i.e. reduced forecast dispersion and forecast
errors) but only in countries with strong enforcement regimes. They argued that
institutional settings played an important role in shaping the impact of IFRS adoption.
Accounting reforms in China started in 1993 with the introduction of Enterprise
Basic Accounting Standards and amendments in accounting laws that aligned the
Chinese accounting system with international accounting standards (Wu et al., 2014).
The convergence of Chinese accounting standards with IFRS was completed in 2007
when all listed companies were required to prepare their financial statements in
accordance with Accounting Standards for Business Enterprises. However, China’s

Variables PMC_EXIST PMC_POTN

PMC ⫺0.0371 (⫺0.59) ⫺0.0031*** (⫺2.71)

Size ⫺0.0081*** (⫺4.91) ⫺0.0096*** (⫺4.85)
ROA 0.0127 (1.31) 0.0121 (1.25)
Volatility 0.0716*** (5.11) 0.0890*** (5.04)
CFO_STD 0.3840*** (4.51) 0.3917*** (4.25)
LNOA ⫺0.0317* (⫺1.77) ⫺0.0309* (⫺1.78)
Growth ⫺0.0012 (⫺0.48) 0.0014 (⫺0.43)
LEV ⫺0.0140 (⫺0.55) ⫺0.0087 (⫺0.53)
IO ⫺0.0439*** (⫺4.09) ⫺0.0448*** (⫺4.11)
SOE ⫺0.0219*** (⫺3.91) ⫺0.0221*** (⫺3.92)
Constant 0.3158*** (6.35) 0.3285*** (6.94)
Year Yes Yes
Industry Yes Yes
R2 18.81 18.89
F-Statistics 16.45*** 16.68***

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represent significance level at 10%;
this table reports OLS results examining the impact of product market competition on earnings quality proxied for by RAM;
Table VI.
the dependent variable is a RAM proxy for real activity manipulation calculated following Roychowdhury (2006); both models Product market
include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by competition and
firms earnings quality
CMS convergence with IFRS has not resulted in higher information quality. Wang and
10,3 Campbell (2012) and Wu et al. (2014) argued that convergence with IFRS in China has
not resulted in an improvement in information quality. These studies supported the
argument of Byard et al. (2011) and Palea (2013) that the impact of IFRS depended upon
the institutional environment. Based on these premises, this study has examined how
IFRS adoption has affected the relationship between PMC and EQ. The IFRS variable in
578 this analysis is a dummy variable, which is equal to “one” for the post-IFRS period and
to “zero” for the pre-IFRS period.
Table VII reports the moderating role of IFRS on the association between PMC and
EQ. The PMC_IFRS variable, which represents the interaction between PMC and IFRS,
was significant in all models except for PMC_EXIST for earnings inflation. The results
show that IFRS has no significant impact on EQ which is in line with the findings of
Wang and Campbell (2012) and Wu et al. (2014), who argued that convergence with IFRS
has not resulted in improved EQ in China. However, the impact of IFRS on the
relationship between EQ and the varying kinds of PMC is quite interesting. The results
showed that PMC from existing rivals (PMC_EXIST) is a significant factor which
has influenced EQ before and after IFRS adoption in China. However, PMC_EXIST was
significant (and higher in magnitude) to discourage earning deflation only after IFRS
adoption. It was not statistically significant before IFRS adoption which implies that
IFRS adoption resulted in complementing the role of PMC_EXIST as an external
governance mechanism for reduce earnings suppressions. Furthermore, PMC_EXIST
has not seemed to play a significant role in reducing income inflation since IFRS
adoption. The results also show that PMC from potential rivals (PMC_POTN) has only
been significant since the adoption of IFRS, as PMC_IFRS was insignificant in all three
models representing overall EQ, earning inflation and earning deflation. This implies
that (threat of) PMC from potential entrants became a significant governance force only
after the adoption of IFRS. It also implies that the significant role played by PMC_POTN
on EQ in the overall sample as reported in Table III through to Table V may only have
been notable in the period after IFRS adoption.
4.2.3 Product market competition, state ownership and earnings quality. An
important characteristic of the Chinese institutional environment is the presence of a
large number of SOEs. The Chinese intuitional environment consists of SOEs and
NSOEs, so it suffers not just from agency conflict between managers and shareholders
(Jensen and Meckling, 1976) but also from (principal–principal conflict) between
majority and minority shareholders (Ali et al., 2007). The SOEs have different objectives
from NSOEs, as their primary aim is not the maximization of profit, but the attainment
of social and political goals. SOEs are regarded as less risky because they can get
financial support from the state in cases of need (Chen et al., 2010). Shen and Lin (2009)
have argued that state ownership and informal networks are the main governance
mechanisms in China. Chen et al. (2011) and Wang and Campbell (2012) reported a
negative relationship between state ownership and earnings management. On the basis
of these arguments, this study examined how state ownership affects the relationship
between PMC and EQ. Table VIII reports the result of the effect of state ownership on the
relationship between PMC and EQ. SOE was a dummy variable which represented state
ownership. SOE was equal to “one” if a company was state-owned, and it was “zero”
otherwise.
 EQ Earnings inflation Earnings deflation
Variables PMC_EXIST PMC_POTN PMC_EXIST PMC_POTN PMC_EXIST PMC_POTN

PMC ⫺0.1223*** (⫺3.88) ⫺0.0004 (⫺0.61) ⫺0.1893*** (⫺4.68) ⫺0.0007 (⫺0.70) 0.051 (1.14) ⫺0.0002 (⫺0.15)
IFRS 0.0006 (0.14) 0.0035 (0.90) 0.003 (0.45) 0.0022 (0.37) 0.0023 (0.40) ⫺0.0044 (⫺0.92)
PMC_IFRS ⫺0.0658** (⫺2.17) ⫺0.0019*** (⫺2.61) ⫺0.0163 (⫺0.39) ⫺0.0020** (⫺2.12) 0.1110** (2.51) 0.0019* (1.66)
Size ⫺0.0069*** (⫺7.69) ⫺0.0067*** (⫺7.46) ⫺0.0034*** (⫺2.62) ⫺0.0033*** (⫺2.59) 0.0103*** (8.56) 0.0100*** (8.42)
MTB1 0.0069 (0.09) 0.008 (0.11) 0.0742 (0.40) 0.0741 (0.40) 0.0103 (0.15) 0.0071 (0.10)
Volatility 0.0017 (0.27) 0.0024 (0.37) ⫺0.016 (⫺1.47) ⫺0.0152 (⫺1.39) ⫺0.0214*** (⫺2.97) ⫺0.0219*** (⫺3.04)
CFO_STD 0.0812*** (3.34) 0.0820*** (3.37) 0.0937** (2.10) 0.0941** (2.11) ⫺0.0660*** (⫺3.70) ⫺0.0666*** (⫺3.74)
LNOA ⫺0.003 (⫺0.69) ⫺0.0028 (⫺0.65) ⫺0.0145** (⫺2.34) ⫺0.0142** (⫺2.30) ⫺0.0048 (⫺1.07) ⫺0.0047 (⫺1.06)
Growth 0.0003*** (5.08) 0.0003*** (4.98) 0.0005*** (5.25) 0.0005*** (5.20) ⫺0.0001 (⫺0.90) 0.0000 (⫺0.77)
LEV 0.0616*** (4.11) 0.0614*** (4.10) 0.0473*** (2.64) 0.0467*** (2.59) ⫺0.0646*** (⫺3.21) ⫺0.0646*** (⫺3.23)
SOE ⫺0.0042*** (⫺2.89) ⫺0.0040*** (⫺2.74) ⫺0.0064*** (⫺2.86) ⫺0.0062*** (⫺2.75) 0.0014 (0.74) 0.0012 (0.66)
Constant 0.1769*** (8.43) 0.1932*** (9.37) 0.0958*** (2.98) 0.1229*** (4.04) ⫺0.2558*** (⫺9.71) ⫺0.2612*** (⫺10.02)
Year Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes
R2 11.43 11.58 16.45 16.63 9.64 9.7
F-Statistics 13.87*** 13.96*** 9.65*** 9.80*** 9.04*** 9.00***

Notes: *** represent significance level at 1%; ** represent significance level at 5%; * represent significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality and the moderating role of IFRS adoption on this relationship; the dependent variable is earnings quality as defined earlier. all models include
industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms

Product market
Table VII.
579
competition
market
Product

earnings quality
competition and
 10,3

580
CMS

Table VIII.
Product market
competition and
earnings quality
EQ Earnings inflation Earnings deflation
Variables PMC_EXIST PMC_POTN PMC_EXIST PMC_POTN PMC_EXIST PMC_POTN

PMC ⫺0.1502*** (⫺4.25) ⫺0.0019*** (⫺4.64) ⫺0.1907*** (⫺4.31) ⫺0.0024*** (⫺4.63) 0.1030* (1.92) 0.0013* (1.86)
SOE ⫺0.0040** (⫺2.16) ⫺0.0041*** (⫺2.78) ⫺0.0076*** (⫺2.76) ⫺0.0061*** (⫺2.73) ⫺0.0002 (⫺0.08) 0.0016 (0.83)
PMC_SOE 0.0024 (0.18) 0.0000 (0.00) ⫺0.0148 (⫺0.79) 0.0002 (0.44) ⫺0.0203 (⫺0.98) 0.0003 (0.59)
Size ⫺0.0069*** (⫺7.64) ⫺0.0068*** (⫺7.46) ⫺0.0033*** (⫺2.60) ⫺0.0033*** (⫺2.60) 0.0102*** (8.53) 0.0100*** (8.40)
MTB1 0.0085 (0.11) 0.0081 (0.11) 0.0742 (0.40) 0.0775 (0.41) 0.006 (0.09) 0.0077 (0.11)
Volatility 0.0018 (0.28) 0.0023 (0.36) ⫺0.016 (⫺1.46) ⫺0.0152 (⫺1.39) ⫺0.0214*** (⫺2.98) ⫺0.0218*** (⫺3.04)
CFO_STD 0.0811*** (3.34) 0.0816*** (3.35) 0.0938** (2.10) 0.0934** (2.10) ⫺0.0657*** (⫺3.64) ⫺0.0666*** (⫺3.73)
LNOA ⫺0.003 (⫺0.69) ⫺0.0028 (⫺0.64) ⫺0.0145** (⫺2.34) ⫺0.0142** (⫺2.30) ⫺0.0048 (⫺1.07) ⫺0.0049 (⫺1.09)
Growth 0.0003 (5.07) 0.0003*** (4.98) 0.0005*** (5.26) 0.0005*** (5.19) 0.0000 (⫺0.88) 0.0001 (⫺0.78)
LEV 0.0615*** (4.11) 0.0616*** (4.09) 0.0472*** (2.63) 0.0470*** (2.60) ⫺0.0646*** (⫺3.21) ⫺0.0646*** (⫺3.21)
Constant 0.1749*** (8.27) 0.1956*** (9.40) 0.0953*** (2.95) 0.1254*** (4.12) ⫺0.2522*** (⫺9.61) ⫺0.2635*** (⫺9.97)
Year Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes
R2 11.4 11.52 16.45 16.57 9.56 9.63
F-Statistics 13.88*** 13.89*** 9.65*** 9.66*** 8.98*** 8.98***

Notes: *** represent significance level at 1%; ** represent significance level at 5%; * represent significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality and the moderating role of state ownership on this relationship; the dependent variable is earnings quality as defined earlier; all models include
industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms
The interaction term PMC_SOE represented the effect of state ownership on the Product
relationship between PMC and EQ. The results suggested that there was a negative market
relationship between PMC and EQ. State ownership also reduced income inflation but
had no significant impact on income deflation. Importantly, the main variable, IE_SOE,
competition
was statistically insignificant, suggesting that state ownership has no impact on the
relationship between PMC and EQ, which implies that PMC plays no role in increasing
(decreasing) the EQ of SOEs. 581
5. Robustness tests
5.1 Alternative measures of product market competition
To test the robustness of the results gathered, this study used some other measures of
PMC. The first measure (PMC_A) was an assets-based HHI following Guo et al. (2015).
A second measure used in this study was a natural log of HHI, which had been used in
prior research (Akdoğu and MacKay, 2009) when the distribution of HHI was skewed.
Lower PMC_HHILog values indicated the presence of many rival firms (high
competition), while higher values indicated the presence of few rival firms (lower
competition). A third measure of PMC was based on industry concentration. The
measure of industry concretion was calculated as the aggregate sales of the four largest
firms in the industry. A higher share for the four largest firms described the market
power of large firms and hence indicated that a market with lower competition existed.
The variable PMC_C4 was obtained by dividing the total sales of the four largest firms
in an industry to the total sales of the industry and then multiplying the result by
negative one. Higher values of PMC_C4 represented higher competition. This measure
has been used extensively in other preceding research (Haushalter et al., 2007; Valta,
2012; Ali et al., 2014). A fourth measure of competition was based on the number of firms
in an industry (PMC_FN). The measure of PMC_FN was one minus the inverse of the
total number of firms operating in an industry. Following previous research (Dhaliwal
et al., 2014; Li, 2010b), this study also used another measure of competition from
potential rivals (PMC_MKTS), which was the natural log of aggregate industry sales
multiplied by negative one. PMC_MKTS has multidimensional implications for PMC.
Product market competition is negatively associated with market size (PMC_MKTS) as
high entry barriers are associated with larger market size (Li, 2010b). Large market size
also indicates higher customer demand, as higher demand attracts potential entrants. A
higher value of PMC_MKTS indicated weaker competition from potential entrants and
vice versa. Definitions of alternative measures of PMC have been provided in
Appendix I. The results for all the alternative measures showed that PMC plays a
significant role in improving EQ (Table IX).

5.2 Alternative measures of earnings quality

We re-estimated our results for the impact of PMC on EQ using an information quality
measure described by Francis et al. (2005). Following Francis et al. (2005), this study
estimated the following model cross-sectionally with at least ten observations:

TAit ⫽ ␣0 ⫹ ␣1CFOit⫺1 ⫹ ␣2CFOit ⫹ ␣3CFOit⫹1 ⫹ ␣4⌬REVit ⫹ ␣5PPEit ⫹ ␧it

TAit represented total current accruals; OCFit⫺1 represented operating cash flows;
⌬REVit represented a change in revenues; and PPEit represented property, plant and
equipment. The residuals from the above equation represented the estimation errors in
 10,3

582
CMS

Table IX.
Product market
competition and
earnings quality
Variables PMC_A PMC_HHILog PMC_C4 PMC_FN PMC_MKTS

PMC ⫺0.0685*** (⫺3.240) 0.0137*** (4.00) ⫺0.1253*** (⫺5.65) ⫺1.1649*** (⫺4.19) 0.0070** (2.04)
Size ⫺0.0086*** (⫺7.41) ⫺0.0070*** (⫺7.72) ⫺0.0033*** (⫺3.48) ⫺0.0069*** (⫺7.65) ⫺0.0044*** (⫺5.03)
MTB 0.0050 (0.07) 0.0086 (0.11) 0.3139* (1.64) 0.0077 (0.10) 0.3695** (2.51)
Volatility 0.0016 (0.26) 0.0018 (0.28) ⫺0.0108 (⫺1.55) 0.002 (0.31) ⫺0.0013 (⫺0.20)
CFO_STD 0.0814*** (3.34) 0.0812*** (3.34) 0.1459*** (3.61) 0.0815*** (3.36) 0.0767*** (3.32)
LNOA ⫺0.0026 (⫺0.60) ⫺0.003 (⫺0.69) 0.0021 (0.34) ⫺0.003 (⫺0.69) ⫺0.0019 (⫺0.5)
Growth 0.0003*** (5.08) 0.0003*** (5.07) 0.0003*** (4.42) 0.0003*** (5.06) 0.0003*** (5.47)
LEV 0.0612*** (4.07) 0.0615*** (4.11) 0.0239* (1.70) 0.0608*** (4.06) 0.0317*** (2.71)
SOE ⫺0.0036*** (⫺2.42) ⫺0.0043*** (⫺2.9) ⫺0.0037* (⫺1.930) ⫺0.0043*** (⫺2.92) ⫺0.0041** (⫺2.56)
Constant 0.2243*** (8.93) 0.2246*** (10.09) 0.0286 (1.13) 1.3052*** (4.92) 0.3023*** (3.78)
Year Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes
R2 11.27 11.38 13.67 11.35 10.92
F-Statistics 13.96*** 14.05*** 10.39*** 13.89*** 10.80***

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represents significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality for the sample firms spanning 2000-2014 that met our data requirements; the dependent variable is earnings quality as defined earlier; PMC_A is
an assets-based HHI; PMC_HHILog represents the log of a sales-based HHI; PMC_C4 represents market concentration which represents the share of the four largest firms in an industry,
thus describing the market power of those four large firms; PMC_MKTS represents market competition from potential rivals; and PMC_FN represents a competition measure based on the
number of firms in an industry; all models include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms
the current accruals that were not related with operating cash flows and that could not Product
be described by the change in revenue and the level of PPEit. All the variables in the market
equation above were scaled by lagged total assets. The proxy for information quality competition
was the standard deviation of firm-level residuals over the past five years. A higher
standard deviation meant lower information quality and a lower standard deviation
meant higher information quality.
Table X reports the results for the impact of PMC on EQ using the information 583
quality measure as described by Francis et al. (2005). The results were consistent with
prior results except that the assets-based PMC measure (PMC_A) was insignificant but
had the expected sign. All the results for other measures of PMC showed that
information quality improves with an increase in competition from both existing rival
and potential entrants and vice versa. To test the robustness of the results, we also used
Dechow and Dichev’s (2002) measure for EQ and our results, as reported in Table XI,
remained consistent. Details of Dechow and Dichev’s (2002) measure of EQ have been
provided in Appendix II.

6. Conclusion
This study examined the association between PMC and EQ in the Chinese settings. The
analysis for this study produced several interesting findings. We documented that two
important dimensions of market competition, i.e. competition from existing rivals and
competition from potential entrants, were significant determinants of EQ. Our results
indicated that PMC is positively associated with EQ. Higher PMC results in higher EQ.
These results supported the argument that PMC acts as a governance mechanism and
curtails the opportunistic behavior of managements and lessens agency conflict. Our
study also added that market competition reduces both earning inflation and earning
deflation, but it has a higher impact on earnings inflation which suggests that PMC
reduces opportunistic behavior. This study also documented that not only PMC from
existing rivals (PMC_EXIST) but PMC from potential entrants also improves the
quality of earnings reported by firms. Our results also suggested that market
competition from potential rivals improves EQ by reducing RAM, which distorts
accounting outcomes. Our study further documented that PMC from existing rivals is
associated with higher EQ in both the pre-IFRS and the post-IFRS periods, but
competition from potential entrants was associated with higher EQ only after China
converged its accounting standards with IFRS. This study has also suggested that PMC
does not play any statistically significant role in improving the EQ of SOEs. The results
of this study are robustly supported by a series of alternative measures of PMC and of
EQ.
Our study supported the argument that PMC (from existing rivals and potential
entrants) acts as an external governance mechanism. These results are consistent with
He (2012) and Laksmana and Yang (2014). Our study also supported the external
disciplinary mechanism hypothesis that PMC acts as a governance mechanism in China,
as has been suggested by Chen et al. (2014). However, this study has contested the
argument that competitive pressure increases managerial opportunism and (or)
proprietary cost and results in the maintenance of opaque information environments (or
lower-quality disclosures) because firms retain proprietary information (Verrecchia,
1983; Clinch and Verrecchia 1997; Stivers, 2004; Ali et al., 2014).
 10,3

584
CMS

Table X.
Product market
competition and
earnings quality
Variables PMC_EXIST PMC_POTN PMC_A PMC_MKTS PMC_C4 PMC_HHILog PMC_FN

PMC ⫺0.3386*** (⫺4.92) ⫺0.0017** (⫺2.75) ⫺0.0176 (⫺0.71) 0.0305*** (2.96) ⫺0.2067*** (⫺8.83) 0.0225*** (5.76) ⫺2.4249*** (⫺3.36)
Size ⫺0.0067*** (⫺4.84) ⫺0.0066*** (⫺4.75) ⫺0.0073*** (⫺3.80) ⫺0.0064*** (⫺4.64) ⫺0.0068*** (⫺4.87) ⫺0.0064*** (⫺6.67) ⫺0.0067*** (⫺4.81)
MTB1 0.7367** (2.22) 0.7685** (2.21) 0.7594** (2.19) 0.7692** (2.19) 0.7451** (2.22) 0.0497 (0.95) 0.7542** (2.22)
Volatility 0.0049 (0.79) 0.0051 (0.85) 0.0047 (0.77) 0.0056 (0.91) 0.0041 (0.67) 0.0227*** (4.54) 0.0052 (0.84)
CFO_STD 0.0922*** (3.010) 0.0907*** (2.95) 0.0914*** (2.96) 0.0905*** (2.94) 0.0925*** (3.03) 0.0186*** (2.72) 0.0905*** (2.92)
LNOA ⫺0.0360*** (⫺3.97) ⫺0.0355*** (⫺3.89) ⫺0.0358*** (⫺3.91) ⫺0.0361*** (⫺3.94) ⫺0.0365*** (⫺4.02) ⫺0.0051* (⫺1.93) ⫺0.0360*** (⫺3.93)
Growth 0.0000 (0.51) 0.0000 (0.42) 0.0000 (0.49) 0.0000 (0.45) 0.0000 (0.53) 0.0000** (⫺2.08) 0.0000 (0.46)
LEV 0.0052 (0.43) 0.0066 (0.54) 0.007 (0.57) 0.0073 (0.60) 0.0047 (0.38) 0.0684*** (4.35) 0.0062 (0.51)
SOE 0.0025 (0.78) 0.0028 (0.86) 0.0029 (0.88) 0.0025 (0.78) 0.0024 (0.74) ⫺0.0062*** (⫺4.15) 0.0026 (0.79)
Constant 0.1441*** (4.46) 0.1948*** (6.01) 0.2023*** (4.86) 0.9081*** (3.63) 0.6295* (1.77) 0.2232*** (10.22) 2.5059*** (2.61)
Year Yes Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes Yes
R2 27.66 27.29 27.16 27.56 27.83 7.15 27.48
F-Statistics 11.45*** 11.49*** 11.57*** 11.50*** 11.79*** 14.84*** 11.49***

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represent significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality for the sample firms spanning 2000-2014 that met our data requirements; the dependent variable is earnings quality as defined by Francis et al. (2005);
all models include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms
Variables PMC_EXIST PMC_POTN PMC_A PMC_MKTS PMC_FN PMC_C4 PMC_HHILog

PMC ⫺0.1451*** (⫺3.849) ⫺0.0016*** (⫺4.01) ⫺0.0673*** (⫺4.29) 0.0028 (0.61) ⫺0.8642*** (⫺4.90) ⫺0.1585*** (⫺6.86) 0.0225*** (5.76)
Size ⫺0.0062*** (⫺6.50) ⫺0.0062*** (⫺6.38) ⫺0.0082*** (⫺6.75) ⫺0.0061*** (⫺6.09) ⫺0.0063*** (⫺6.62) ⫺0.0064*** (⫺6.55) ⫺0.0064*** (⫺6.67)
MTB 0.0491 (0.94) 0.0476 (0.89) 0.0447 (0.86) 0.054 (0.92) 0.0473 (0.90) 0.0555 (0.94) 0.0497 (0.95)
Volatility 0.0224*** (4.44) 0.0231*** (4.59) 0.0226*** (4.52) 0.0242*** (4.66) 0.0230*** (4.60) 0.0239*** (4.67) 0.0227*** (4.54)
CFO_STD 0.0186*** (2.73) 0.0192*** (2.79) 0.0191*** (2.79) 0.0195*** (2.69) 0.0192*** (2.82) 0.0187*** (2.6) 0.0186*** (2.72)
LNOA ⫺0.0051* (⫺1.92) ⫺0.0047* (⫺1.78) ⫺0.0045* (⫺1.72) ⫺0.0063* (⫺1.85) ⫺0.0049** (⫺1.85) ⫺0.0066* (⫺1.94) ⫺0.0051* (⫺1.93)
Growth 0.0000* (⫺1.94) 0.0000** (⫺2.23) ⫺0.0000* (⫺2.03) ⫺0.0001*** (⫺2.73) 0.0000* (⫺2.07) ⫺0.0001** (⫺2.66) 0.0000** (⫺2.08)
LEV 0.0682*** (4.30) 0.0682*** (4.26) 0.0676*** (4.25) 0.0664*** (4.00) 0.0677*** (4.26) 0.0662*** (4.08) 0.0684*** (4.35)
SOE ⫺0.0060*** (⫺4.05) ⫺0.0059*** (⫺3.95) ⫺0.0054*** (⫺3.54) ⫺0.0060*** (⫺3.83) ⫺0.0063*** (⫺4.14) ⫺0.0064*** (⫺4.09) ⫺0.0062*** (⫺4.15)
Constant 0.1541*** (7.04) 0.1799*** (8.56) 0.2083*** (8.17) 0.2341** (2.51) 0.9967*** (5.97) 0.0914*** (3.58) 0.2232*** (10.22)
Year Yes Yes Yes Yes Yes Yes Yes
Industry Yes Yes Yes Yes Yes Yes Yes
R2 7.15 7.16 7.00 6.8 7.13 7.6 7.15
F-Statistics 14.84*** 15.15*** 15.71*** 13.71*** 15.09*** 12.90*** 14.84***

Notes: *** Represent significance level at 1%; ** represent significance level at 5%; * represents significance level at 10%; this table reports OLS results examining the impact of product
market competition on earnings quality for the sample firms spanning 2000-2014 that met our data requirements; the dependent variable is earnings quality as defined by Dechow and
Dichev (2002); all models include industry and year dummies; t-values reported in the parentheses are calculated with standard errors clustered by firms

Product market
Table XI.
585
competition
market
Product

earnings quality
competition and
CMS Our research has several policy implications. First, while analyzing the disclosure
10,3 practices of a firm, industry structure and the competitive position of the firm should be
given importance. This study also has policy implications for standard-setters, as they
should focus on uncompetitive industries more, applying different sets of rules to reduce
the information asymmetry and improve the transparency of financial reporting. Our
study may also help investors and creditors understand PMC and EQ, and its findings
586 may augment their decisions. The results also imply that regulators ought to focus on
improving industry competitiveness (by deregulation etc.) to promote overall
improvements in the information environment at firms.
However, this study is not without limitations. First, an important limitation of this
study was its use of listed firms only. There are a large numbers of private firms in China
as well as those to which this study exclusively referred. The measure of PMC based on
listed companies has been used extensively in prior literature, but this is a noisy
measure that may not be representative of the actual state of competition in Chinese
industry (Ali et al., 2009). Second, China has a unique institutional environment. Despite
being a developing economy, it differs greatly from other developing nations. So the
results, based as they are, on Chinese settings may not be generalized for other
developing economies. Future research in other developing countries with different
institutional environments could potentially help engender an understanding of the role
of PMC in improving EQ elsewhere.

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Appendix 1
Alternative measure of product market competition
• PMC_A: The assets-based Herfindahl–Hirschman Index (HHI) (PMC_A) has also been used in
other literature previously (Hou and Robinson 2006). The measurement of PMC_A is the same
as a sales-based HHI, as is explained in Section 3.
• PMC_HHILog: PMC_HHILog is a natural log of HHI. This measure has been used in prior
research (Akdoğu and MacKay, 2009) when the distribution of HHI was skewed. Lower
PMC_HHILog values indicate the presence of many rival firms (high competition), while higher
values indicate the presence of few rival firms (lower competition).
• PMC_C4: PMC_C4 represented the market shares of the four largest firms within an industry
and is also known as a four-firm concentration ratio. A four-firm concentration ratio (PMC_C4)
is obtained by dividing the total sales of the four largest firms in an industry by the total sales of
the industry, and then multiplying the result by negative one. This method is commonly applied
by government agencies (Datta et al., 2013).
• PMC_FN: The number of firms in an industry also indicates the severity of competition within
an industry. As the number of firms in an industry increases, the competition among firms also
surges, not only because of the quest for economic profits but also because of limited resources
(e.g. funds from capital markets). PMC_FN is one minus the inverse of the total number of firms
operating in an industry.
• PMC_MKTS: Product market size is associated with competition from potential entrants. If the
market size is large, then there should be high entry barriers, as entry may require higher
investment in fixed assets or technology. However, large market sizes also indicate higher
demand, and higher demand means higher profits, which would ultimately attract more
potential entrants. The PMC_MKTS is a natural log of aggregate industry sales multiplied by
negative one. Large values of PMC_MKTS exhibit weaker competition from potential entrants
and vice versa.
CMS Appendix 2
Alternative measures of earnings quality
10,3
Dechow et al. (2010) assessed numerous proxies for earnings quality and concluded that these proxies
did not appear to substitute each other. They argued furthermore that none of the earnings quality
proxies was superior in all scenarios. Therefore, we used alternative measures of earnings quality, as
these proxies of earnings quality measured different underlying constructs:
592 • The information quality measure as proposed by Francis et al. (2005) was a modified version of
Dechow and Dichev’s (2002). This measure also included sales revenues and plant, property and
equipment (PPE) which led to “better specified residuals” and also enhanced the explanatory
power of the measure.
• We used Dechow and Dichev’s (2002) model as a measure of earnings quality as expressed by
the following equation:

TAit ⫽ ␣0 ⫹ ␣1CFOit⫺1 ⫹ ␣2CFOit ⫹ ␣3CFOit⫹1 ⫹ ␧it

TAit represented total current accruals and CFO represented operating cash flows. The higher
absolute values of residuals represented lower earnings quality. In this measure, accruals have
been modeled as a function of former, current and future cash flows. All the variables in the
equation above were scaled by lagged total assets.

Corresponding author
Xian-zhi Zhang can be contacted at: zxz@dufe.edu.cn

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