Journal of Accounting in Emerging Economies

Does ownership structure affect the degree of corporate financial distress in

China?
Dan Hu Haiyan Zheng
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Dan Hu Haiyan Zheng , (2015),"Does ownership structure affect the degree of corporate financial
distress in China?", Journal of Accounting in Emerging Economies, Vol. 5 Iss 1 pp. 35 - 50
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Does ownership structure affect DOFD in

China
the degree of corporate financial
distress in China?
Dan Hu 35
Graduate School of Economics, Nagoya University, Nagoya, Japan, and
Haiyan Zheng
School of Economics and Management,
Shanghai Institute of Technology, Shanghai, China
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Abstract
Purpose – The purpose of this paper is to investigate the degree of corporate financial distress
(DOFD) and relationship between ownership structure and the DOFD in China.
Design/methodology/approach – The authors estimate the DOFD across a sample of 378 Chinese-
listed companies that got into financial distress between 2000 and 2008. The DOFD reflects long-term
solvency capability, short-term liquidity capability, development capability, risk level, profitability
capability, operating capacity, and cash flow capability. The authors analyze the relationship between
ownership structure and the DOFD in these companies, using the panel data analysis method.
Findings – The authors find that a concentrated ownership structure is negatively related to the
DOFD. Further, the results indicate that a state-owned status helps firms in decreasing their DOFD and
that the separation of cash-flow rights and control rights is positively related to the DOFD. The authors
also found that the Chinese special treatment (ST) system needs further improvement. The reason is
that ST firms can be classified into “value” ST firms and “garbage” ST firms. They have different DOFD
and change trend, so they should not be treated equally.
Originality/value – This paper find that Chinese ST system and previous research are not helpful for
risk-seeking investor to distinguish and evaluate “value” ST firms and “garbage” ST firms. It is unfair
to warn and punish this two kinds of firms equally, so ST system should be improved. The authors
also suggest that risk-seeking investor can choose ST firms that have a concentrated ownership
structure and are controlled by the state or local government. These findings are not observed in
previous studies.
Keywords Degree of corporate financial distress, Ownership component, Ownership concentration,
Ownership structure, Separation of cash-flow rights and control rights, Special treatment
Paper type Research paper

1. Introduction
On March 16, 1998, the Chinese Securities Regulatory Commission (CSRC) issued the
special treatment (ST) Warning Rules. These rules stated that listed firms must be
entitled to ST once they enter into financial distress or other abnormal situations.
Since this notice was issued, the number of ST firms increased sharply (see Figure 1).
In addition, the number of ST investors increased by 75 percent; however, more than 65
percent of individual Chinese investors in ST firms incurred huge losses in 2010. The
resulting investment paradox shows that despite increased losses, high investment
enthusiasm continues among distressed firms. On July 27, 2012, the Shanghai Stock
Journal of Accounting in Emerging
Exchange issued Stock Transaction Risk Warning Rules (Draft) and limited the change Economies
rate of stock prices from −5 to 1 percent. This rule exposed ST investors to more Vol. 5 No. 1, 2015
pp. 35-50
pressure. Previous studies are insufficient because they focus on constructing financial © Emerald Group Publishing Limited
2042-1168
prediction models to explain financial reasons that a firm gets into financial distress. DOI 10.1108/JAEE-09-2011-0037
 2,500 300
JAEE 260
2,063
5,1 2,000
228 250

202 204 199 1,718

1,625
200
1,500 1,434 1,399
1,367 1,380 172
1,187 1,200 150
136
36 1,000
124 130 100

500
50

0 0
2002 2003 2004 2005 2006 2007 2008 2009 2010

Number of listed companies

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Number of companies in financial distress

Notes: In China, 1,570 listed companies published their annual financial reports for
2010 by April 17 2011, of which 1,454 (or 92.61%) companies received government
Figure 1. subsidies. The total amount of subsidies was RMB 46.34 billion (www.nbd.com.cn),
Number of Chinese an important reason for the sharp decline in the number of firms in distress in 2010
firms in financial Source: Shanghai Stock Exchange (www.sse.cn/sseportal/ps/zhs/home.html)
distress (2002-2010) and Shenzhen Stock Exchange

These models include the univariate statistical model, multiple discriminate analysis
(Chen, 1999), the linear probability model (Wu and Lu, 2001), the back propagation
neural network model (Liang and Wu, 2005), the evolution-based approach
with modularized evaluations model (Ko and Lin, 2006), and the support vector
machine model (Ding and Song, 2008). These methods and ST system are useful to
risk-averse investors interested in non-ST firms. However, for the risk-seeking
investor interested in ST firms, they cannot distinguish and evaluate “value”
ST firms from “garbage” ST firms. Our study contributes to previous studies in
three ways.
First, we classify ST firms into “value” ST and “garbage” ST firms and measure the
degree of financial distress (DOFD) of ST firms by integrating 32 financial ratios. Value
ST firms refer to non-deteriorating companies (NDCs) that undergo a positive change
when returning to normality after experiencing financial distress, garbage ST firms
refer to deteriorating companies (DCs) that undergo a negative change, which reflects
worsening financial distress.
Second, our results suggest that the Chinese ST system needs to be improved
because NDCs and DCs are both labeled ST according to the ST system.
However, NDCs, whose performance improves gradually, are different from DCs,
so it is unfair to warn and punish them equally.This finding is not observed in
previous studies. We should adopt a comprehensive index such as the DOFD to
distinguish these two types of distressed companies and take different supervision
methods.
Third, we find that a concentrated state ownership structure helps in reducing
the DOFD of firms. Further, the separation of cash-flow rights and control
rights is positively related to the DOFD. These findings are helpful to distinguish
distressed firms with different change trend and improve their performance.
 We contribute to previous literature that just distinguish healthy firms and DOFD in
distressed firms. China
Our paper is organized as follows: Section 2 reviews the literature on corporate financial
distress and ownership structure and presents our hypotheses. Section 3 describes the
sample and methodology. Section 4 presents the major discussions and conclusion.

2. Literature review and hypotheses 37

We investigate the relationship between the DOFD and ownership structure. After
reviewing literatures related to our study, we developed five hypotheses.

2.1 Ownership structure and the DOFD

The definition of ownership structure involves ownership concentration, ownership
component, and separation of ownership. Ownership component refers to the identity
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of the shareholder; ownership concentration refers to the number of shares that a

shareholder owns; separation of ownership refers to the separation of control rights
and cash-flow rights of a large shareholder.
2.1.1 Definition of financial distress. Lau (1987) defined corporate financial distress
as occurring in three stages: incubation of financial distress, deficit funds flow, and
financial distress. In general, research in the west mainly uses bankruptcy criteria to
define financial distress ( Jaffe, 2006). However, the bankruptcy code is not prevalent in
China. Most listed companies in China are state-owned enterprises (SOEs) which cannot
declare bankruptcy, because bankruptcy is disadvantageous to social stability and
sustainable development. To both warn and induce distressed firms to improve their
performance, the CSRC introduced the system of ST. Once listed companies enter into
the situations described below, they are labeled “ST” and face termination of their
listing qualifications on the Chinese stock market. From 2002 to 2010, the number of ST
firms increased rapidly in China (see Figure 1), suggesting that more attention should
be paid to firms in financial distress.
A company that meets one of the following criteria would be labeled ST by the CSRC:
(1) External auditors express a negative opinion or are unable to state an audit
opinion in a listed company’s annual report.
(2) The company’s financial conditions are considered abnormal by the stock
exchange or the CSRC.
(3) The company suffers from negative net income over two consecutive years, or
its net asset value per share falls below its par value.
(4) The auditor’s report shows that shareholder equity is lower than registered
capital. Criteria (3) and (4) are the most common reasons for a company to be
labeled ST, with 94 percent of the companies labeled ST under these criteria
(Bai et al., 2006).
Listed companies labeled ST face negative consequences, for example, stricter limits; being
required to audit their mid-term reports; and having a 5 percent limit placed on the daily
fluctuation of their stock price, unlike healthy companies that face a 10 percent limit.
2.1.2 Ownership concentration. According to the alignment effects theory[1], large
shareholders are strongly motivated to maximize their firms’ values. They are able to
collect information and oversee managers, but are mindful of potential principal-agent
problems (Elstona and Yang, 2010). However, according to the entrenchment theory,
 JAEE large shareholders may represent their own interests, which need not coincide with the
5,1 interests of minority shareholders, employees, and managers. Under this theory, a
firm’s financial status influences the behavior of large shareholders. Tunneling and
propping behavior are commonly observed in firms with concentrated ownership
(Cheung, 2009). The controlling shareholders in healthy firms have the power to
expropriate minority shareholders but can also use their private wealth to prop up
38 distressed firms. With respect to a healthy firm, related-party transactions may provide
opportunities for controlling shareholders to extract cash from listed companies
through tunneling activities. However, when a firm becomes distressed, controlling
shareholders must face the risk and pressure of bankruptcy from creditors, investors,
the government, and other related parties. A sharp decline in share prices dramatically
shrinks the wealth of large shareholders and influences the sustainable development of
firms; thus, related-party transactions of large shareholders are often used to prop up
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distressed firms. For example, in order to inject cash into publicly listed Thai
companies, the controlling shareholders in CP Group sold assets in Thailand and China.
The Salim group sold private assets in the Netherlands in order to bail out publicly
listed operations in Indonesia. Evidence suggests that, in many countries, controlling
shareholders use private funds to provide temporary support to a firm that is facing
financial trouble. Moreover, in order to maintain individual interests (such as position,
reputation, and non-monetary income), managers tend to cooperate with large
shareholders in carrying out the gamble for resurrection. Concentrated ownership
helps to increase the efficiency of decision making. Based on the above reasoning, we
formulate our first hypothesis:

H1. Ownership concentration is negatively related to the DOFD.

2.1.3 Ownership component and corporate financial distress. Ownership component

refers to the identity of shareholders, including state shares and legal shares in the
Chinese stock market. State shares are held by state asset management departments
and institutions directly authorized by the government. SOEs easily obtain government
support when facing financial distress for the following reasons.
First, SOEs are often burdened with public responsibilities such as promoting
employment and maintaining social stability. Their bankruptcy may cause significant
unemployment and social unrest, and banks would then face large amounts of bad loans
and bad debt. Therefore, whether SOEs go bankrupt mainly depends on government
decisions rather than their financial situation (Vickers and Yarrow, 1991). Second,
according to the soft budget constraint theory, an SOE has access to subsidies from the
government up to a maximum amount. If an investment fails, the government may bail
out a bankrupt SOE, allowing the SOE to remain solvent and enjoy private benefits
(Clement et al., 2005). As long as the subsidies are lower than the cost of bankruptcy, the
government can continue to provide subsidies. Liu found that the number of subsidies
shows a significant positive relation to the ratio of state-owned shares. SOEs easily obtain
favorable financing arrangements, such as bank loans and government subsidies, and are
less subject to liquidity constraints posed by lending agreements (Sapienza, 2004;
Khawaja and Mian, 2006). Li found that local governments actively provide tax benefits
and financial subsidies to firms.
There are many examples confirming that distressed state-owned firms obtain local
government support. Luoyang Glass Company Ltd is a state-owned listed firm controlled
 by the government of Henan Province. In August 2001, the firm’s debt-to-equity ratio was DOFD in
higher than the industry median and its return on equity. However, it received a RMB 28 China
million loan and a timely bank loan guarantee from its non-listed state-owned parent
company. In another example, Nan Hua Co Ltd, a state-owned listed company, suffered
cumulative net losses of RMB 139 million and RMB 297 million in 2008 and 2009,
respectively. However, it received a government subsidy of RMB 335 million in 2010.
De Mian Co. Ltd. received a subsidy of RMB 53.61 million in 2010[2]. Therefore, it can be 39
inferred that state-owned status helps in bailing out distressed firms.
Legal person shares refer to shares owned by domestic institutions that are
independent of the central or local government[3]. Compared to SOEs, firms controlled
by legal shareholders face more competitive pressure and have clearer property rights,
since their main objective is to earn higher profits (Qi et al., 2000; Sun and Tong, 2003).
Controlling shareholders pay more attention to the long-term enhancement of firm
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value. Institutional owners are active in monitoring management (Han, 1998). Based on
the above analysis, we state the following hypotheses:

H2. State-owned shares are negatively related to the DOFD.

H3. The DOFD is lower when the controlling shareholder is a state-owned entity.

H4. Legal person shares are negatively related to the DOFD.

2.1.4 Separation of ownership and corporate financial distress. Separation of ownership

refers to the separation of control rights and cash-flow rights[4]. Control rights of
ownership refer to an owner’s ability to influence the way a firm operates, while cash-
flow rights refer to the fraction of a firm’s profits or losses that an owner possesses
( Jeremy et al., 2009). In East Asian corporations, firms are increasingly adopting a
pyramid ownership structure (La Porta et al., 1999). Ownership is highly concentrated
and the separation between control rights and cash-flow rights is large. By pyramiding,
controlling shareholders gain control rights that are greater than their cash-flow rights
(La Porta et al., 1999). Pyramiding is defined as the ultimate ownership of a firm
running through a chain of ownership of intermediate corporations. For example, firm
A holds certain shares of firm B, firm B holds certain shares of firm C, and so on. The
ultimate controlling shareholder is firm D, who controls firm A and, thereby, the “lower-
level” firm B and firm C. Firm D can exert control over lower-level firms belonging to
the pyramidal chain without holding the majority of cash-flow rights. That is, firm D
has control over subsidiaries without making much of an investment. Excess control
rights increase the likelihood of expropriation from other investors (Lin, 2011). Many
studies use the separation of cash flow from control rights as a proxy for the likelihood
of expropriation.
The following reasons explain why the separation of control rights and cash-flow
rights influence the DOFD. First, according to negative entrenchment effect theory, the
non-matching of significant voting rights with lower cash-flow rights encourages large
shareholders to pursue private benefits at the expense of others. Second, according to
the incentive effect theory, the amount of cash-flow rights controlled by large
shareholders is an important incentive. The greater the concentration of cash-flow
rights in the hands of the largest shareholder, the greater is his incentive to ensure that
the firm runs properly. This, in turn, lowers his/her motivation to reduce the value of
 JAEE the firm by extracting private benefits, because his/her own wealth would decrease.
5,1 When a firm goes into distress, shareholders with greater cash-flow rights are
burdened with greater bankruptcy risk than are other shareholders. They have enough
financial incentive to support distressed firms. Third, according to the asset specificity
theory, unlike debt capital, companies need not repay equity capital. It is difficult for a
large shareholder to take back his investment. When a firm goes into financial distress,
40 the greater the funds a shareholder invests, the higher the risk and cost that he/she
faces during the process of share transfer. Controlling shareholders have greater
motivation and ability to help firms out of financial distress if the separation between
cash-flow rights and control rights is minimal. Controlling shareholders usually engage
in related-party transactions, including internal asset sales, equity sales, and transfer
pricing contracts, to transfer their funds to distressed firms ( Johnson et al., 2000).
The greater the cash-flow rights of the controlling owner, the more closely his/her
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incentives will be aligned with those of the other owners, and hence, the lower his/her
incentives will be to pursue costly policies which divert profits from non-controlling
owners. Thus, the conflict of interest is likely to be more severe when the divergence
between the controlling owner’s control and cash-flow rights are greater. Based on the
above theoretical analysis, we propose the following hypothesis:

H5. The degree of separation of cash-flow rights from control rights is positively
related to the DOFD.

3. Methodology
Our study measures the DOFD of firms using the method of principal component
analysis. The DOFD reflects solvency, growth, profitability, operational capability,
and cash flow of distressed firms. After measuring the DOFD, we investigate the
relationship between ownership structure and the DOFD using panel data analysis.
In this section, we describe the sample, data sources, and ownership structures of
the sample firms and test the hypotheses proposed in the previous section.

3.1 Sample selection

As previously discussed, most listed companies in China are SOEs. Since listed
bankrupt firms are lower in number, we selected Chinese companies that were ST-listed
between 2000 and 2008 (see Table I).

Number of ST firms
Year Number Ratio (%)

2000 26 6.9
2001 24 6.3
2002 48 12.7
2003 57 15.1
2004 41 10.8
2005 34 9.0
2006 63 16.7
Table I. 2007 60 15.9
Distribution of firms 2008 25 6.6
in financial distress Total 378 100.0
 We obtained our data set from the WIND database and the China Stock Market DOFD in
Accounting Research (CSMAR) database. For data unavailable on the WIND and China
CSCMAR databases, we manually collected data from the sample companies’
audited annual reports. The industries in our sample included agriculture, medicine,
chemistry, home appliances, metallurgy, mechanics, mobile manufacturing, travel,
textile, construction, telecommunications, traffic, energy, and manufacturing. The
research period is illustrated in Figure 2. T−2 refers to two years before being 41
labeled ST. T−1 refers to two years before being labeled ST. T refers to the year of
being labeled ST. T+1 refers to one year after being labeled ST. T+2 refers to two
years after being labeled ST.
Our sample meets the following four criteria: observations were conducted on listed
companies that recently experienced financial distress and were labeled ST on the
Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE) between
2000 and 2008. We excluded firms labeled ST for special reasons, such as natural
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disasters and other serious accidents. (Firms with missing data were excluded. To
ensure the consistency of samples, we chose firms that had just issued A shares,
eliminating firms that had also issued B shares and H shares[5]. Based on the above
criteria, we confirmed 378 observations during 2000-2008 (see Table I).

3.2 Variables
3.2.1 Dependent variable. 3.2.1.1 Financial ratios selection. We used the DOFD as a
dependent variable. A review of the literature showed that Tobin’s Q is often used to
evaluate firm performance. However, Tobin’s Q is not suitable for evaluating distressed
firms, because it is affected by the pessimistic psychology of investors. The evaluation
of the DOFD is less prevalent in current research. We chose 32 financial ratios that
have proved effective in performance evaluations and risk warning systems in
previous studies. These financial ratios reflect long-term solvency, short-term liquidity,
development capability, risk level, profitability, operating capacity, and cash flow.
All variables are defined in Table II. As 32 is a large number of ratios, we found it
necessary to replace them with fewer measurements with minimal loss of information.
Therefore, we used the method of principal components analysis to measure the DOFD.
3.2.1.2 DOFD measurement. We measured the DOFD from year T−2 to T+2. Let us
consider the calculation process of the DOFD in T−2 as an example. First, we used
Bartlett’s test of sphericity and obtained a KMO of 0.527 and a significance level of
o 0.05, making it feasible to use the principal factor analysis method for measuring the
DOFD. Second, we extracted ten main factors whose accumulated contribution rate
was 80.426 percent (see Table III). We constructed the equation as follows:
F j;ðt2Þ ¼ bj1 x1 þ bj2 x2 þ . . .bj32 x32 j ¼ 1; 2; . . .; 10 (1)
where Fj(t−2) represents the score of factor j in year T−2. βj1, βj2, …, βj32 denote the
separate weights of the initial 32 variables. According to the component matrix

Two years One year The year One year Two years
before ST before ST of ST after ST after ST

Figure 2.
Sample period
T –2 T –1 T T +1 T +2
 JAEE Capacity Calculation formula Variable
5,1
Long-term Asset-liability ratio ¼ total debt/total assets x1
solvency Interest protection multiples ¼ (total profits+financing expenses)/ x2
financing expenses
Fixed expenditures pay multiples ¼ (pre-tax profit+fixed expenses)/fixed x3
42 expenditures
EBIT to liability ratio ¼ earnings before interest and tax/total debt x4
Debt equity ratio ¼ total debt/total equity x5
Owner’s equity ratio ¼ total equity/total assets x6
Long-term assets matching rate ¼ (long-term debt+equity)/ x7
(fixed assets long-term investment)
Short-term Current ratio ¼ current assets/current liabilities x8
liquidity Acid test ratio ¼ (current assets-inventory)/current liabilities x9
Operating funds ratio ¼ (current assets-current liabilities)/current assets
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x10
Operating funds to assets ratio ¼ operating funds/total assets x11
Development Accrued items ¼ (current assets change-cash equivalents change) x12
capability Fixed assert increasing rate ¼ (final fixed assets-initial fixed assets)/initial x13
fixed assets
Total assert increasing rate ¼ (final assets-initial assets)/initial assets x14
Operating income increasing rate ¼ (operating income this year-operating x15
income last year)/operating income last year
Risk level Degree of operating leverage ¼ (operating income-operating costs)/ x16
(total profit+financial cost)
Profitability Earnings per share ¼ net profit/shares x17
Net assets per share ¼ total equity/shares x18
Operating income per share ¼ operating income/shares x19
Book-to-market ratio ¼ equity/market value x20
Income before interest and tax per share ¼ income before interest and x21
tax/shares
Undistributed profits per share ¼ undistributed profit/shares x22
Retained earnings per share ¼ (surplus reserves+undistributed profits)/ x23
shares
Operating Accounts receivable turnover ¼ operating revenue/accounts receivable x24
capacity Current asset turnover ¼ operating revenue/current asset x25
Long-term asset turnover ¼ operating revenue/average long-term asset x26
Total asset turnover ¼ operating revenue/average asset x27
Cash flow Cash flow ratio ¼ operating net cash flow/current liabilities x28
Debt coverage ratio ¼ operating net cash flow/total liabilities x29
Table II. Total assets to cash ¼ operating net cash flow/total assets x30
Financial ratios Free cash flow to equity ¼ after-tax profits–(net investment–liabilities x31
used to measure net increase)
the DOFD Cash flow per share ¼ operating net cash flow/shares x32

(see Table AI in the appendix), the score of every factor (Fj) can be calculated
as follows:
F 1;ðt2Þ ¼ 0:765x1 þ 0:089x2 þ 0:088x3 0:108x4 þ UUU0:121x31 þ 0:009x32 (2)

F 2;ðt2Þ ¼ 0:337x1 0:205x2 þ 0:205x3 0:721x4 þ UUU0:100x31 0:191x32 (3)

F 3;ðt2Þ ¼ 0:057x1 0:061x2 0:060x3 0:166x4 þ UUU0:020x31 0:499x32 (4)

 Initial eigenvalues Rotation eigenvector DOFD in
Indicator Total % of variance Cumulative % Total % of variance Cumulative % China
1 6.658 20.807 20.807 5.185 16.202 16.202
2 4.327 13.521 34.329 4.508 14.088 30.290
3 3.215 10.048 44.376 3.161 9.877 40.168
4 2.860 8.939 53.315 2.558 7.994 48.162 43
5 1.829 5.717 59.032 2.502 7.819 55.981
6 1.659 5.183 64.215 2.045 6.390 62.371
7 1.586 4.955 69.170 1.628 5.087 67.459
8 1.347 4.210 73.380 1.546 4.830 72.289 Table III.
9 1.202 3.755 77.134 1.350 4.219 76.507 Total variance
10 1.053 3.291 80.426 1.254 3.918 80.426 explained
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F 4;ðt2Þ ¼ 0:088x1 þ 0:024x2 þ 0:023x3 0:237x4 þ UUUþ 0:091x31 þ 0:048x32 (5)

F 10;ðt2Þ ¼ 0:043x1 þ 0:004x2 þ 0:004x3 þ 0:049x4 þ UUU0:393x31 0:284x32 (6)

After all the factors (Fj) were obtained, we took the variance contribution rate of each
factor (see Table III) as the weight to estimate the DOFD in year T−2, which is labeled
Zt−2. The equation is as follows:
Z t2 ¼ 16:202F 1;ðt2Þ þ 14:088F 2;ðt2Þ þ 9:877F 3;ðt2Þ þ 7:994F 4;ðt2Þ
þ 7:819F 5;ðt2Þ þ 6:390F 6;ðt2Þ þ 5:087F 7;ðt2Þ þ 4:830F 8;ðt2Þ
þ 4:219F 9;ðt2Þ þ 3:918F 10;ðt2Þ (7)
Finally, using the above method and process, we measured the DOFD in years T−1, T,
T+1, and T+2.
3.2.1.3 Description of the DOFD. To describe the DOFD, we utilized a new
classification method according to the changing trend of corporate financial distress
(i.e. from distress to normal and from distress to worse). This classification method
differed from the classification used in previous research. We classified distressed
firms into NDC and DC.
Deteriorating refers to delisting or keeping the ST label for two years after being
labeled ST. Non-deteriorating refers to the reactivation in the stock market or the
cancellation of the ST label within two years of being labeled.
According to ST standards, both DCs and NDCs had negative net profits, meaning
that they were both labeled ST. However, if we consider the DOFD rather than net
profits, different changes in trends between NDCs and DCs were observed. The DOFD
is a more comprehensive index than net profits and reflects long-term solvency, short-
term liquidity, development, risk, profitability, and operating cash flow. However, net
profit is just an index of profitability. Although the difference was not significant, the
concomitant probability was o 5 percent in year T−2. Significant differences existed
in the next four years (from T−1 to T+2), and the concomitant probability was o 1
percent every year (see Table IV) (Figure 3):
(1) The mean DOFD of NDCs was less than that for DCs from year T−2 to year T
+2; thus, NDCs and DCs could not be placed in the same category.
 JAEE (2) From year T−2 to T, the mean DOFD of DCs was on the rise, but that of NDCs
5,1 decreased continuously, implying that it must change its trend to improve
performance. From year T to T+2, if deterioration continued, DCs would be
delisted; therefore, large shareholders support firms to improve their DOFD.
For NDCs, although the DOFD decreased from year T+2 to T, they were
labeled ST as their net profits were negative. The ST label forces firms to fall
44 into a passive state where they are confronted with many constraints, such as a
5 percent limit on stock price fluctuations and an increase in financing costs
that lead to a loss of investment opportunities. These constraints increased the
DOFD of the sample firms from year T to T+2. To further improve firm
performance on a continual basis, the ST system must be improved in order to
give NDCs an advantageous environment.
3.2.2 Independent variables. The independent variables are grouped into three
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categories: ownership concentration, ownership component, and separation of ownership.

All variables are defined in Table V.
Based on the theoretical and empirical evidence, we hypothesize the signs of the
coefficients (see Table V).

Year mean
DOFD
Trend T−2 T−1 T T+1 T+2

Non-deteriorating company –0.74013 −8.54701 −9.43609 −8.96160 −4.32409

Table IV. Deteriorating company 0.38122 8.61613 11.71076 17.13906 9.66196
Descriptive statistics Concomitant probability 0.735 0.000 0.000 0.000 0.004
and mean check Significant differences No Yes Yes Yes Yes

20

15

10

5
DOFD

0
T–2 T–1 T T–1 T–2
–5

–10

Figure 3. –15
Change trend of Year
corporate financial Poly. (Non-deteriorating Company)
distress
Poly. (Deteriorating Company)
 Expected
DOFD in
Classification Calculating formulae sign China
Ownership ZH1 ¼ the first shareholder’s shares/the second shareholder’s shares −
concentration
Ownership GYGB ¼ state-owned shares ratio ¼ state-owned shares/total −
component shares × 100 percent 45
FRGB ¼ legal persons shares ratio ¼ Legal persons shares/total −
shares × 100 percent
TOP1X ¼ the first shareholder identity properties (TOP1X ¼ 1 means +
state-owned shareholder) (TOP1X ¼ 2 means non-state-owned
shareholder)
SKGX ¼ controlling shareholder identity properties (SKGX ¼ 1 means +
state-owner shareholder) (SKGX ¼ 2 means non-state-owned Table V.
Definitions of
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shareholder)
Separation of LQFL ¼ deviation of control right from cash-flow right ¼ control right/ + ownership structure
ownership cash-flow right variables

3.3 Regression analysis

3.3.1 Model constructing. We use the general least squares (GLS) method to test the
proposed hypotheses and construct a panel regression model. Using a cross-sectional
time series sample as the data set of this study, the pooled GLS technique allows for
cross-sectional heterogeneity and serial correlation. Based on our research hypotheses
mentioned above, we construct the following fixed-effects model:

DOFD ¼ b0 þb1 Z H 1 þ b2 GY GB þ b3 FRGBþ b4 SKGX þ b5 TOP1X þ b6 LQFL þ e (8)

DOFD is the dependent variable, ZH1 represents the ratio of shares owned by the first large
shareholder, GYGB represents the ratio of shares of the state-owned shareholder, FRGB
represents the ratio of shares of legal persons, SKGX and TOP1X stand for the identity
controlling shareholder and the first shareholder, respectively, LQFL refers to the deviation
of control rights from cash-flow rights, β0 is a constant term, and ε is the error term.
3.3.2 Regression results. The regression results are shown in Table VI.
The regression coefficient of ZH1 is −0.018453, indicating that a concentrated
ownership structure is helpful in decreasing the DOFD, which supports H1.
The regression coefficient of state-owned shares and legal person shares are
−25.69128 and −23.85015, respectively, indicating that state-owned shares and legal
person shares are negatively related to the DOFD. This result supports H2 and H4.
The regression coefficients of the first large shareholder’s identity (TOP1X) is
5.188404 and the real controlling shareholders’ identity (SKGX) is 12.10381; these
results show that the DOFD of state-owned firms is less than that of firms controlled by
non-state-owned entities. This result supports H3.
The regression coefficient of LQFL means that the separation of control rights and
cash-flow rights is positively related to the DOFD. This result supports H5.

4. Conclusion and discussion

We document the relationship between ownership structure and the DOFD. We find
that the ST regulation, the most important regulation in the Chinese Stock Exchange,
needs further improvement.The reason is that ST firms can be classified into “value”
 JAEE Dependent variable: DOFD; method: GLS (cross-section weights); total panel observations: 823
5,1 Expected Actual Coefficient
Classification Variables sign sign (t-statistic) Research results

Ownership ZH1 − − −0.018653**

Ownership concentration is
concentration (−2.286929)
negatively related to the degree of
46 corporate financial distress (H1)
Ownership GYGB − − −25.6912*** State-owned shares are negatively
component (−6.889770) related to the degree of corporate
SKGX + + 12.10381*** financial distress and the degree of
(6.128796) financial distress is lower when
TOP1X + + 5.188404*** the controlling shareholder is a
(3.137679) state-owned entity (H2, H3)
FRGB − − −23.8501*** Legal shares are negatively related
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(−19.51412) to the degree of corporate financial

distress (H4)
Table VI. Separation of LQFL + + 0.41795*** The separation degree of cash-flow
Panel data ownership (6.585538) rights from control rights is
regression: positively related to the degree of
relationship between corporate financial distress (H5)
ownership structure Notes: The model R2 is 0.556424. ***,**,*Significance at the o0.01, o 0.05, and o0.10 levels,
and DOFD respectively, for the two-tailed test

ST firms and “garbage” ST firms. They have different DOFD and change trend, so they
should not be treated equally. Or else, the stock price and other restrictions of ST
regulation may adversely affect the performance of “value” ST firms.
We document that concentrated ownership helps in decreasing the DOFD and that
SOEs (SOEs) can easily obtain financial support from the local government. As a result,
the risk-seeking investor can choose ST firms that have a concentrated ownership
structure and are controlled by the state or local government.
Finally, we find that the separation between control rights and cash-flow rights
aggravates the DOFD. Investors should pay more attention to distressed firms that
have adopted a pyramid ownership structure with many levels, which may increase the
separation between control rights and cash-flow rights and increase the DOFD.

Notes
1. The alignment effects theory was proposed by Shleifer and Vishny (1986). It provides an
explanation of the effect of entrenchment. The entrenchment effect refers to expropriation
from firms by the controlling shareholder; that is, the controlling shareholder can pursue his
benefits instead of maximizing firm profits. Alignment is one way of mitigating the problem
of entrenchment. Cash flow rights provide the controlling shareholder with not only rights
but also risk, and therefore, help in aligning the controlling shareholder s benefits with the firm’s
objectives.
2. Data taken from www.nbd.com.cn/newshtml/20110422/20110422151043845.html (2011.8.22).
3. Legal person share is analogous to the institutional shareholder in the USA.
4. There are no universally agreed upon terms for these concepts in the literature: control rights
and cash flow rights are alternatively called control and ownership or voting rights and cash
flow, respectively (Porta et al., 1999).
 5. A Shares refer to shares sold to domestic investors in China; A B Shares refer to shares sold DOFD in
to foreign investors (Hu, 2003); and H Shares refer to stocks issued by listed companies in
Hong Kong.
China
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Corresponding author
Dr Haiyan Zheng can be contacted at: yanziboshi@126.com

(The appendix follows overleaf.)

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5,1

50
JAEE

Table AI.
Component matrix
Component
1 2 3 4 5 6 7 8 9 10
Appendix

(x1) 0.765 0.337 0.057 0.088 −0.331 −0.072 0.096 −0.068 −0.128 0.043
(x2) 0.089 −0.205 −0.061 0.024 0.009 −0.963 −0.032 −0.014 0.001 0.004
(x3) 0.088 −0.205 −0.060 0.023 0.009 −0.963 −0.032 −0.014 0.001 0.004
(x4) −0.721 −0.108 −0.166 −0.237 0.062 −0.262 0.006 −0.119 −0.061 0.049
(x5) −0.799 −0.052 −0.082 −0.357 0.188 −0.059 0.045 0.024 −0.070 −0.050
(x6) −0.767 −0.341 −0.059 −0.087 0.328 0.071 −0.089 0.068 0.127 −0.037
(x7) −0.353 −0.095 −0.057 0.287 −0.251 −0.016 0.117 0.032 0.420 0.005
(x8) −0.939 0.004 −0.080 0.019 −0.066 0.059 0.046 −0.017 −0.065 0.042
(x9) −0.897 0.003 −0.029 0.021 −0.020 0.008 0.040 −0.039 −0.158 0.024
(x10) −0.749 −0.160 0.114 0.259 −0.226 0.048 −0.055 −0.022 0.083 0.086
(x11) −0.809 −0.174 0.096 0.277 −0.207 0.085 −0.029 −0.025 0.142 0.095
(x12) −0.115 −0.133 0.242 0.058 −0.068 −0.032 0.189 0.103 −0.153 0.778
(x13) −0.078 −0.074 −0.088 0.041 0.060 0.002 −0.047 −0.006 −0.783 −0.012
(x14) 0.028 −0.428 0.056 0.051 −0.174 −0.023 −0.045 −0.743 −0.206 −0.093
(x15) −0.013 0.056 0.056 −0.020 0.034 −0.029 0.042 −0.841 0.108 0.060
(x16) 0.041 −0.096 0.015 0.099 −0.152 −0.037 0.217 0.076 −0.408 −0.593
(x17) −0.132 −0.883 −0.100 −0.002 −0.055 −0.172 0.223 −0.104 −0.009 0.039
(x18) −0.349 −0.391 0.001 −0.009 0.013 0.033 −0.727 −0.038 −0.024 −0.074
(x19) 0.092 −0.109 0.002 −0.314 −0.822 −0.001 −0.229 −0.044 −0.042 −0.012
(x20) 0.164 0.106 −0.064 −0.064 −0.166 −0.085 −0.797 0.081 −0.086 0.044
(x21) −0.064 −0.889 −0.120 0.006 −0.135 −0.192 0.169 −0.110 −0.042 0.046
(x22) −0.192 −0.886 −0.037 −0.029 −0.019 −0.001 −0.220 0.028 0.023 −0.052
(x23) −0.206 −0.860 −0.049 −0.043 −0.030 0.005 −0.318 0.024 0.026 −0.045
(x24) 0.054 −0.190 −0.163 −0.736 −0.085 0.011 −0.056 −0.004 0.050 0.018
(x25) 0.026 −0.023 −0.022 −0.940 −0.166 0.015 −0.010 0.025 −0.061 0.018
(x26) −0.057 −0.088 0.030 −0.133 −0.882 0.018 0.031 −0.018 0.134 −0.018
(x27) −0.039 0.017 0.071 −0.736 −0.560 0.038 −0.015 0.013 0.015 0.005
(x28) −0.072 −0.092 −0.954 −0.058 0.031 −0.095 −0.054 0.036 −0.039 −0.036
(x29) −0.080 −0.073 −0.963 −0.027 0.013 −0.041 −0.038 0.038 −0.047 −0.030
(x30) 0.063 −0.111 −0.924 −0.088 0.001 −0.021 −0.022 0.045 0.015 −0.062
(x31) −0.121 −0.100 0.020 0.091 0.410 0.005 0.135 0.052 −0.393 0.413
(x32) 0.009 −0.191 −0.499 0.048 0.015 0.062 0.160 −0.446 −0.082 −0.284