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The effect of ownership-control earnings
disparity on the Chinese firm’s management
Abstract
Purpose – This paper aims to investigate the impact of the separation between control and cash flow rights
(control-ownership disparity) on the earnings management practices of Chinese firms. The notable features of
Chinese firms are those of concentrated ownership and the severe disparity that exists between the control
and cash flow rights of controlling shareholders.
Design/methodology/approach – This study measures the level of Chinese firms’ earnings management
by adopting two different methods of measurement: accrual-based earnings management (AEM) and real
activity earnings management (REM). The authors also consider the possible trade-off effects between these
two types of measurements. The data set in this study encompasses over 2,000 Chinese firms, using data from
2003 to 2015.
Findings – The results indicate that controlling shareholders are more likely to engage in AEM as their
cash flow rights are more concentrated, while they are less likely to use REM as the disparity of control-
cash flow rights increases. Further, this inverse relationship between REM and control-cash flow rights
disparity becomes more pronounced in the case of a low cash flow rights group. As REM generally causes
distortions in firms’ operations, it is possible that the controlling shareholders are more likely to constrain
the use of REM as the disparity is perceived to grow. This result may indicate a reduced agency problem
between controlling and minority shareholders due to the developing and/or existing ownership
dispersions, which are mainly driven by recent reforms applied to Chinese capital markets. However, we
do not entirely exclude the possibility of other types of expropriations by the controlling shareholders. It
appears that the controlling shareholders are still able to exert a significant level of control, even following
a substantial ownership dispersion, and they may seek alternative expropriation methods, including but
not limited to intercorporate loan or related party transactions as the disparity of control-cash flow rights
increases.
Originality/value – Although the Chinese economy is experiencing a series of reforms to infuse market
forces into capital markets, little has been known about the effects of ownership-control disparity in Chinese
firms. Our findings highlight the importance of the country specific context in this vein of research.
Keywords China, Agency problem, Controlling shareholder, Ownership-control disparity, Real ac-
tivity earnings management, State-owned enterprise
Paper type Research paper
expense of the wealth of minority shareholders (Demsetz, 1983; Morck et al., 1988). In fact,
Claessens et al. (2002) and Lemmon and Lins (2003) test the impact of agency problems on
firm value in line with the emerging country context. They conclude that disproportional
ownership has a significantly negative impact on a firm’s value in terms of Tobin’s Q and
stock returns, implying the prevalence of expropriation by controlling shareholders in
emerging markets.
This study examines the effects of the separation of control and cash flow rights (control-
ownership disparity) on the earnings management practices of Chinese listed firms using
panel data set. We measure the difference between control rights (also known as voting
right) and cash flow rights (also known as ownership right), to capture the control-cash flow
rights disparity. In addition, we adopt the notion of “real activity-based earnings management
(REM)” together with conventional “accrual-based earnings management (AEM)” to measure
the earnings management of Chinese firms. AEM relies on the manipulation of discretionary
accruals by managers (or controlling shareholders in the East Asian context). As accounting
standards sometimes allow several different accounting treatments for the same accounting
item, managers (or the controlling shareholders) can exert their discretion for the selection of
one specific method, thereby manipulating the reported earnings. Roychowdhury (2006);
however, demonstrates that the firm can manipulate accounting earnings through changes to
firm’s operations without adjustments in terms of discretionary accruals. For example,
offering a greater sales discount or more generous credit terms can boost sales revenue
substantially. As this approach requires changes in a firm’s real operations, it is referred to as
REM. A body of previous research investigates the relationship between control-cash flow
rights disparity and the earnings management (Cornett et al., 2008; Zhu et al., 2010; Leuz et al.,
2003; Kim and Yi, 2006). However, they have neither sufficiently investigated Chinese firms
nor paid special attention to the fact that a firm can manipulate earnings through operational
changes (i.e. REM).
The results of this study demonstrate that controlling shareholders are more likely to
rely on AEM as they have more concentrated cash flow rights within Chinese firms. On the
contrary, they are more likely to refrain from REM as control-cash flow right disparity
increases. This negative relationship between the differences in control-cash flow rights and
REM may indicate a reduced agency problem between controlling and minority
shareholders, possibly due to recent reforms and regulatory changes pertaining to ownership
dispersion and improved protections afforded to minority shareholders in Chinese capital
markets. However, it is possible that the controlling shareholders are still capable of exerting
a significant level of control, and that they may seek alternative ways to make Activity
expropriations, such as related party transactions other than earnings management. earnings
Particularly, REM usually requires distortions in firms’ underlying economies; the
controlling shareholders may have fewer incentives to use REM for the expropriation of firm
management
wealth as control-cash flow right disparity increases. We also find that this negative
relationship becomes more pronounced in low cash flow rights groups. Although we find a
similar trend among state-owned Chinese firms, this is only marginally significant.
This study contributes to the extant literature in several ways. First, to the best of our
knowledge, this is the first study to investigate the relationship between control-cash flow
rights disparity and the earnings management practices of Chinese firms on a large scale,
including both state-owned firms and privately owned firms, from 2003 to 2015. Second, this
study measures the level of earnings management using two different methods – AEM and
REM (Kothari et al., 2005; Roychowdhury, 2006). As REM requires changes to the firm’s
operations, it is largely regarded as less detectable but more costly compared to AEM. As
such, a firm can opt for using one method instead of the other or for mixing of the two
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depending on their associated costs, as well as the firm’s operational characteristics (Cohen
et al., 2008; Zang, 2012; Kuo et al., 2014). Third, the results of this study also highlight the
impact of ownership dispersion and ownership type in line with a Chinese corporate
governance context. This paper proceeds in five sections. Section 2 reviews the previous
literature and develops hypotheses. In Section 3, the data and the model used in this study
are presented. Section 4 provides empirical results, followed conclusions in Section 5.
mitigated. A body of research still suggests that the controlling shareholders can exert a
great deal of influence on excess of their cash flow rights even after several reformative
changes driven by Chinese authorities (Liu and Lu, 2007; Kuo et al., 2014; Jiang and Kim,
2015; Liu, et al., 2015; Kim et al., 2018). First, the minority shareholders are largely buy-and-
sell (short-term) speculators who do not have a great incentive in monitoring the controlling
shareholders. In addition, the legal protection for them is still regarded as insufficient in
China. Second, the influence of institutional and foreign investors who used to be regarded
as more sophisticated investors compared with individual investors is still restrictive in
Chinese capital markets (Kim et al., 2018). Third, the controlling shareholders may involve
themselves in the firm’s decision-making process via various ways. For example, they can
appoint “board chairperson,” who actively controls and runs the firm than the general
manager or CEO does in most of Chinese firms (Jiang and Kim, 2015). On the contrary, the
effectiveness of independent directors who are supposed to monitor and check the
controlling shareholders is still uncertain. As a result, it is probable that the controlling
shareholders may still exercise a great deal of control power in excess of their ownership,
thereby facilitating the expropriation of firm wealth even after the substantial ownership
dispersion. Therefore, the question of whether higher control-cash flow right disparity
mitigates or deteriorates the agency problem necessitates an empirical test. Thus, our first
set of hypotheses is:
H1a. The cash flow rights are significantly associated with earnings management.
H1b. The separation of control and cash flow rights is significantly associated with
earnings management.
2.3 The moderating effects of high and low cash flow rights
The divergence between control and cash flow rights affects the firms’ corporate governance
and influences the ability to monitor earnings management. The conflicts of interests
existing between controlling and minority shareholders are likely to motivate controlling
shareholders to engage in opportunistic earnings management practices to hide their private
control benefits from the minority shareholders (Leuz et al., 2003; Haw et al., 2005). Further,
Nguyen and Xu (2010) and Zhu et al. (2010) posit that the controlling shareholders would
PAR have less incentives to manipulate earnings under a low cash flow rights concentration
compared with high cash flow rights concentration. They argue that the private benefits
gained from earnings management are smaller compared to the financial risks involved as
the cash flow right deceases, thereby restraining the controlling shareholders from earnings
management practices. In fact, Zhu et al. (2010) document that the low cash flow rights
negatively moderate the relationship between the control-cash flow right disparity and the
earnings management in Chinese privately owned firms. Thus, our second hypothesis is as
follows:
H2. The separation of control and cash flow rights is negatively associated with firm’s
earnings management when cash flow right is low.
manage earnings compared with privately owned firms. Wang and Yung (2011) find that
the Chines state-owned firms are less likely to manage earnings compared with non-state-
owned firms. They argue that Chinese SOEs are not likely to face the same level of pressure
pertaining to the firms’ performance compared with privately owned firms because they
have a strong political tie with the government. On the contrary, Noronha et al. (2008)
document that Chinese public ownership firms[1] have stronger incentives to manipulate
earnings for the management compensation compared with privately owned firms. Still,
many top managers found in SOEs are government officials (Noronha et al., 2008; Jiang and
Kim, 2015). To be promoted as high-ranking officials, they may need to show an outstanding
firm performance where the firm performance measurements are usually based on
accounting figures such as income level and/or growth rate. Therefore, the third hypothesis
is to investigate the moderating effects of state-ownership on the relationship between the
control-cash flow right disparity and the earnings management in Chinese firms. In this
study, we classify a firm as a state-owned firm if its controlling shareholders are SOEs, state
institution such as the ministry of finance or local government. All other firms are classified
as privately owned firms:
H3. The separation of control and cash flow rights is more significantly associated with
a firm’s earnings management in state-owned firms compared with privately owned
firms.
3. Methodology
3.1 Data and the control-cash flow right disparity
All financial data are retrieved from the Chinese Stock Market and Accounting Research
(CSMAR) database. CSMAR database is a comprehensive data set including the information
of Chinese firms’ financial statements, stock exchanges and firm’s shareholders and
corporate governance. To be more specific, CSMAR provides the first observation of the
control and cash flow rights data from 2003. At the same time, it identifies the controlling
shareholders by either firms’ annual report or equity chain. We select the equity chain
approach with the aim of identifying the controlling shareholders, in accordance with the
previous studies (La Porta et al., 1999; Claessens et al., 2000; Claessens et al., 2002). Also,
CSMAR adopts the calculation methods of La Porta et al. (1999) and Claessens et al. (2000) to
provide three key variables:
the control right percentage (also known as voting rights); Activity
the cash flow right percentages (also known as ownership rights); and earnings
the degree of separation between two rights. management
That is, the control right comprises shareholding relation chain or the weakest layer among
all shareholding relation chains, or the total weakest layers alternatively. In addition, the
cash flow right is the property of listed company possessed by the controlling shareholder
by means of acting in concert, multi-layer pyramid shareholding, cross-shareholding, etc. As
a result, the data set in this study encompasses the period from 2003 to 2015 for a total of
2,405 Chinese firms with 17,517 observations.
the difference between net income and net cash flow from operations. Then, these total
accruals are assumed to be comprised of non-discretionary accruals and discretionary
accruals. To estimate the non-discretionary accruals, we first run the following cross-
sectional regression model for each year and industry:
Accrualst 1 DSalest DARt PPEt
¼ a0 þ a1 þ a2 þ a3 ROAt1 þ « t
At1 At1 At1 At1
(1)
where Accruals (total accruals) are calculated as the difference between net income and net
cash flow from operation; A is firm’s total asset; DSales is the change in the sales; DAR is the
change in net receivables; PPE represents the property, plant and equipment; and ROA is
defined as net income divided by the lagged total asset.
For industry classification, we use the industry classification code that was published by
Chinese Securities Regulatory Committee in 2012. Consistent with previous studies, we do
not estimate industry-year coefficients if there are less than ten observations in one
industry-year group (Kothari et al., 2005; Kim et al., 2012; Kuo et al., 2014). Then, the firm-
specific non-discretionary accruals (NDA) are estimated as follows:
!
1 DSalesi;t DARi;t PPEi;t
NDAi;t ¼ a ^0 þa^1 þa ^2 þa^ 3 ROAi;t1
Ai;t1 Ai;t1 At1
(2)
Therefore, the discretionary accruals (DA) are defined as the difference between total
accruals and non-discretionary accrual estimates (i.e. DA = total accruals – NDA). Then, an
individual firm’s DA is converted to an absolute value as a proxy for AEM. In short, higher
AEM indicates more earnings management through discretionary accruals.
3.2.2 Real activity earnings management. REM methods detect the level of a managers’
engagement in earnings through real activities other than the adjustment in discretionary
accruals (Roychowdhury, 2006). The basic three measurements of REM are as follows. First,
firm’s sales manipulation methods, such as price discounts or more lenient credit terms, lead
to an abnormally low cash flow from operations (CFO). This unusual gap can be captured by
PAR “abnormal CFO” (ab_CFO), the shortfall below the normal level of cash flow from
operations. Similar to AEM, we run the following cross-sectional regression model for each
year and industry to estimate the normal level of cash flow from operation (Roychowdhury,
2006; Kim et al., 2012; Kuo et al., 2014):
CFOt 1 St DSt
¼ b0 þ b1 þ b2 þ b3 þ «t (3)
At1 At1 At1 At1
where CFO is cash flow from operations, A is total assets, S is net sales and DS is the change
in sales.
Again, we do not estimate when there are less than ten observations in one industry-year
group. Therefore, “abnormal” cash flow from operation (ab_CFO) is equal to the difference
between the actual CFO and the normal level of CFO’ (i.e. ab_CFO = actual CFO – normal
CFO).
Second, the management can manipulate reported earnings by determining the production
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level. Usually, the higher production level lowers the fixed costs per unit (Roychowdhury,
2006)[2]. In this case, the cost of goods sold (COGS) is abnormally low and operating margin
increases accordingly. Therefore, production costs (PROD) is defined as the sum of COGS
and change in inventory during the period. Firm’s normal production costs can be estimated
using the following cross-sectional regression model for each year and industry
(Roychowdhury, 2006; Kim et al., 2012; Kuo et al., 2014):
PRODt 1 St DSt DSt1
¼ b0 þ b1 þ b2 þ b3 þ b4 þ «t (4)
At1 At1 At1 At1 At1
4. Empirical results
4.1 Basic statistics
Panel A of Table I presents the descriptive statistics of sampled firms. All continuous
variables are winsorized at the 1 and 99 percentiles. The mean and median AEM values are
0.085 and 0.049, while those of REM are lower at 0.004 and 0.001, respectively. This
implies that AEM is more prevalent than REM among the sampled Chinese firms, possibly
because of the loose accounting regulations and the low levels of investor protection in
China (Kuo et al., 2014). Control rights (CONT) and cash flow rights (CASH) show means of
0.39 and 0.33, respectively, indicating that the control right is slightly greater than the
ownership rights in Chinese firms. The separation between the control and cash flow rights
(SEP) has a median of 0.000, meaning that most of the listed Chinese firms are still closely
PAR N Mean Median SD Minimum Maximum
AEM 8,405 0.0803 0.046 9,112 0.090 0.051 0.010 <0.000 <0.000
REM 8,405 0.0075 0.002 9,112 0.002 0.005 0.006 0.194 0.023
SIZE 8,405 22.054 21.845 9,112 21.587 21.515 0.467 <0.000 <0.000
ROA 8,405 0.049 0.039 9,112 0.033 0.030 0.016 <0.000 <0.000
LEV 8,405 0.486 0.494 9,112 0.518 0.510 0.032 <0.000 <0.000
BM 8,405 0.597 0.587 9,112 0.561 0.549 0.036 <0.000 <0.000
CONT 8,405 0.511 0.505 9,112 0.279 0.268 0.232 <0.000 <0.000
CASH 8,405 0.483 0.464 9,112 0.192 0.198 0.291 <0.000 <0.000
SEP 8,405 0.028 0.000 9,112 0.086 0.063 0.058 <0.000 <0.000
Panel C – private vs non-private
State-owned firms Privately owned firms t-test Wilcoxon
test
N Mean Median N Mean Median Mean p-value p-value
diff.
AEM 9,993 0.078 0.046 7,522 0.095 0.053 0.017 <0.000 <0.000
REM 9,993 0.005 0.006 7,522 0.017 0.005 0.022 <0.000 <0.000
SIZE 9,993 22.090 21.904 7,522 21.440 21.358 0.650 <0.000 <0.000
ROA 9,993 0.036 0.030 7,522 0.047 0.041 0.011 <0.000 <0.000
LEV 9,993 0.536 0.541 7,522 0.459 0.449 0.077 <0.000 <0.000
BM 9,993 0.634 0.636 7,522 0.504 0.478 0.130 <0.000 <0.000
CONT 9,993 0.416 0.413 7,522 0.355 0.325 0.061 <0.000 <0.000
CASH 9,993 0.373 0.360 7,522 0.277 0.245 0.096 <0.000 <0.000
SEP 9,993 0.043 0.00 7,522 0.078 0.054 0.035 <0.000 <0.000
Table I.
Descriptive statistics Note: CONT = control right (also known as voting right); all other variables are the same as previous. All
for variables continuous variables are winsorized at 1% and 99%
held and the ownership structures are not well dispersed yet despite the recent development
in Chinese capital market such as SSSREF in 2006 (Kuo et al., 2014).
Panels B and C of Table I present the descriptive statistics of the sub-sampled firms
depending on the level of cash-flow right and state ownership with t-test and Wilcoxon
rank-sum test results. First, we split the total sample into two sub-groups in Panel B: “high”
cash flow rights (firms whose cash flow rights are greater than median cash flow rights of
full sample) and “low” cash flow rights (firms whose cash flow rights are smaller than the
median). Then, we further reclassify the total sample according to the levels of state or
private ownership (i.e. state-owned firms vs privately owned firms) in Panel C. As results
show, there are significant differences between sub-sampled groups in terms of all test Activity
variables except for REM in Panel B, supporting further investigations among these earnings
classification groups. The low cash flow right firms and state-owned firms are more than
half of each classification. The number of low-cash-flow firms and state-owned firms are
management
9,112 and 9,993, respectively, out of total 17,514 observations. Overall, the results confirm
the perceived highly concentrated ownership and the prevalence of state ownership
among the sampled Chinese firms.
Table II provides Pearson correlation coefficients matrix of test variables with their
significance. AEM is positively correlated with REM, which is consistent with previous
studies. Kuo et al. (2014) explain that the weak level of investor protection and lack of
effective corporate governance make it possible to mix both AEM and REM in Chinese
firms. Firm size (SIZE) is negatively correlated with AEM and REM, implying that the
bigger firms are likely to avoid both AEM and REM. While ROA is positively correlated
with AEM on the one hand, negatively with REM on the other hand, indicating the firms
with a higher accounting performance tend to increase AEM, but reduce REM. Similarly,
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book-to-market value (BM) shows the same trend: the firms with the higher growth rate (i.e.
lower BM ratio) tend to rely more on AEM in lieu of REM.
The level of control rights (CONT) is negatively correlated with both AEM and REM.
Given the ownership is closely held, these negative correlations imply that the controlling
shareholders may be less likely to engage in earnings management as their control power
increases. Similarly, a higher cash flow right (CASH) is negatively correlated with both
AEM and REM although the correlation between CASH and REM is not statistically
significant. We did not find a specific correlation between the separation of control and cash
flow rights (SEP) and both AEM and REM.
AEM 1
REM 0.034*** 1
SIZE 0.112*** 0.027*** 1
ROA 0.078*** 0.223*** 0.148*** 1
LEV 0.166*** 0.107*** 0.221*** 0.368*** 1
BM 0.149*** 0.089*** 0.472*** 0.209*** 0.239*** 1
CONT 0.032*** 0.022*** 0.237*** 0.139*** 0.059*** 0.098*** 1
CASH 0.033*** 0.012 0.217*** 0.118*** 0.076*** 0.088*** 0.883*** 1
SEP 0.011 0.019 0.008 0.017 0.049*** 0.002 0.039*** 0.434*** 1
Table II.
Note: CONT = control right. All other variables are the same as previous; Pearson correlations are Pearson correlation
presented; ***denote the significance at 1% matrix
PAR Panel B: The separation of
Panel A: Cash flow rights control and cash flow rights
and earnings management and earnings management
Dep. Var. (1) AEM (2) REM (1) AEM (2) REM
F-statistics (p-value) 2.31 (0.000) 3.00 (0.000) 2.31 (0.000) 3.01 (0.000)
and cash flow rights Obs. 17,517 17,517 17,517 17,517
on earnings
management Note: t-statistics are in the parentheses; **and ***denote the significance at 5% and 1%, respectively
with each other as expected, a trend which does not change throughout the entirety of the
test results, consistent with Kuo et al. (2014). Cash flow rights (CASH) are significantly and
positively associated with AEM (t-statistic = 3.52 with p < 0.000a1) in Model (1), while there
is no significant relationship between cash flow right and REM found in Model (2). This
indicates that the controlling shareholders are more likely to use AEM as their cash flow
rights increases. This positive relationship between AEM and ownership concentration is
somewhat consistent with previous studies (Cheng and Warfield, 2005; Nguyen and Xu,
2010; Zhu et al., 2010).
On the other hand, the variable of interest, SEP (control-cash flow rights disparity) shows
the opposite relationships in Panel B of Table III. SEP is not significantly associated with
AEM in Model (1), but significantly and negatively associated with REM (t-statistics =
2.28 with p < 0.05) in Model (2). In many East Asian countries, the controlling
shareholders are found to be exerting a level of power in excess of their cash flow rights to
expropriate the minority shareholders (Claessens et al., 2000; Claessens et al., 2002; Lemmon
and Lins, 2003). Thus, it is probable that the controlling shareholders are more likely to
engage in earnings manipulations although there is a significant divergence between control
rights and cash flow rights (Joh, 2003; Kim and Yi, 2006; An, 2015; An, 2017). However, the
results in this study suggest that those Chinese firms with a higher level of control-cash
right disparity are less likely to manage earnings through REM. This trend is somewhat
consistent with the US setting as demonstrated in Nguyen and Xu (2010), but opposite to the
context found in other Asian countries such as the Korean setting in Kim and Yi (2006).
Particularly, we pay special attention to the negative relationship between SEP and
REM. Unlike AEM, REM requires a distortion of a firm’s underlying economy, such as the
sacrifice of real cash flows or abandonment of a positive net present value project
(Roychowdhury, 2006; Graham et al., 2005; Bozzolan et al., 2015). Further, Liu et al. (2015)
documents that family firms with excessive control rights tend to prefer high cash holding
strategy for their tunneling purpose in China. From the controlling shareholder’s
viewpoints, the operational distortions driven by using REM may make it more difficult to Activity
expropriate firm value as the disparity between control and cash flow rights increases earnings
(Nguyen and Xu, 2010). Therefore, this negative relationship may indicate a reduced agency
issue between the controlling and minority shareholders, possibly due to a series of recent
management
reformative changes driven by Chinese authorities (Kuo et al., 2014; Jiang and Kim, 2015).
Thus, H1a accepted in AEM and H1b is accepted in REM.
Nonetheless, we are cautious in interpreting these results. Despite the recent rapid
development of Chinese capital markets, it is somewhat untimely to conclude that the
agency problem between controlling and minority shareholders is effectively mitigated for
several reasons (Kuo et al., 2014). First, the sample period in this study (i.e. a period of 2003-
2015) actually overlaps with the subsequent periods of many reformative actions by Chinese
authorities such as market liberalization (2003), SSSREF (2005), mandatory appointment of
independent directors (2003), the introduction of principle-based Chinese Accounting
standards (2006), Shanghai-Hong Kong Stock exchange connect (2014) and Shenzhen-Hong
Kong stock exchange connect (2016). This series of measures have combined to affect
Chinese firms’ corporate governance and helped narrow the agency gap between controlling
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and minority shareholders. However, it may take some time to realize the entirety of the
effects of all of these measures[3]. Second, recent studies suggest that the controlling
shareholders still have a great level of influence over the firm even after those reformative
changes in Chinese capital markets (Jiang and Kim, 2015). Most minority shareholders are
short-term investors, and the legal protections afforded to them are still weak in China.
Furthermore, the controlling shareholders are able to appoint the board chairperson and the
influence of independent directors is still insufficient. Third, a body of research points out
that Chinese firms have various subtle ways to expropriate firm wealth other than earnings
management such as intercorporate loans, loan guarantees for related companies, favorable
transfer pricing for related companies and dilution of new shares (La porta, 1999; Liu and
Lu, 2007; Liu et al., 2015; Jiang and Kim, 2015). In this regard, we do not entirely exclude the
possibility of other types of expropriation by the controlling shareholders when they can
still exercise significant influence over the firms, despite a substantial disparity between
control and cash flow rights.
Turning to the control variables, firm size (SIZE) and book to market ratio (BM) are
negatively associated with AEM, but are positively associated with REM in both Panels A
and B. A large firm is usually subject to a greater surveillance and monitoring from outside
stakeholders compared with small firm. Thus, such a firm is more likely to rely on REM, a
less detectable earnings management method rather than AEM, more detectable one. In
addition, the results demonstrate that a firm with low growth rate is more likely to engage in
AEM rather than REM, which is consistent with previous studies (Wang and Yung, 2011;
Kuo et al., 2014). Firms with higher ROA (ROA) and leverage (LEV) are also more likely to
engage in AEM over REM as expected. Overall, the results are consistent with those
produced by previous studies.
4.2.2 The separation and earnings management in high and low cash flow rights.
Table IV shows the high and low cash flow rights groups. Although no specific relationship
between the separation (SEP) and AEM is found in Model (1) of both Panels A and B, the
relationship between the separation (SEP) and REM are consistently negative in high and
low cash flow rights groups in the model (2) of both Panels. These relationships are
marginally significant at 10 per cent levels in high cash flow rights group (t-statistics =
1.82 with p < 0.10) in Model (2) of Panel A, and becomes even more significant in low
cash flow rights group at 5 per cent level (t-statistics= 2.53 with p < 0.05) in Model (2) of
Panel B. It is interesting to note that the avoidance of REM is more pronounced in low cash
PAR Panel A: High cash flow rights Panel B: Low cash flow rights
(cash flow rights > median) (cash flow rights < median)
Dep. Var. (1) AEM (2) REM (1) AEM (2) REM
and low cash flow Note: t-statistics are in the parentheses *, **and ***denote the significance at 10% 5% and 1%,
rights groups respectively
flow rights group. Zhu et al. (2010) find that the low cash flow right negatively moderate on
the relationship between control-cash flow right disparity and earnings management. They
argue that as the disparity grows larger, the controlling shareholders’ private benefit from
earnings management becomes smaller. Particularly, the results indicate that the controlling
shareholders with low cash flow right are more likely to constrain REM as the difference
between control and cash flow right becomes larger possibly because REM cause a change
in firm’s real operations. Thus, H2 is also accepted, as had been expected.
4.2.3 The separation and earnings management in state-owned and privately owned
firms. Table V shows the difference between state-owned groups and privately owned
groups. In Panel A, both AEM and REM are negatively but marginally associated with the
degree of separation (SEP) (AEM; t-statistics = 1.90 with p < 0.1 and REM; t-statistics =
1.84 with p < 0.1, respectively). On the other hand, there is no specific relationship between
SEP and AEM or REM in Panel B. Therefore, the results indicate that state-owned firms are
less likely to engage in earnings management as the difference between the control and cash
flow rights increases.
The results are somewhat consistent with Wang and Yung (2011)’s findings, in that
state-owned firms are more likely to refrain earnings management because they have less
incentives to manipulate earnings due to their strong political tie with the state compared
with the privately owned firms. However, this relationship (H3) is only marginally accepted
at a 10 per cent significance level.
Notes: t-statistics are in the parentheses *, **and ***denote the significance at 10%, 5% and 1%,
respectively owned firms
relationship becomes more pronounced in low cash-flow rights firms compared with high
cash-flow rights firms. Also, we find that state-owned firms are less likely to engage in
earnings management as the separation of control and cash flow rights increases. Despite
that, this negative relationship is only marginally significant. Overall, these results may
indicate the agency problem between the controlling and minority shareholder is not severe
as much as other Asian countries, possibly because of recent developments in Chinese capital
markets such as SSSREF, which infuse market forces and help to mitigate the agency
problem.
Nonetheless, we do not entirely exclude the possibility of other types of expropriation by
the controlling shareholders for several reasons. First, the sample period in this study overlaps
with the subsequent period of many reformative actions taken by Chinese authorities. Thus,
more time may be necessary to understand the effects of these developments on Chinese firms’
corporate governance and institutional environments. Second, previous literature suggests
that the controlling shareholders can still exert a great deal of control over a firm, even after a
series of reforms and regulations (Jiang and Kim, 2015). Third, a body of study finds that the
controlling shareholders can expropriate firm wealth in various subtle ways other than
through earnings management, such as through intercorporate loans, loan guarantees for
related companies, favorable transfer pricing for related companies, and/or share dilution (La
porta, 1999; Liu and Lu, 2007; Liu et al., 2015; Jiang and Kim, 2015). Therefore, it is plausible
that the controlling shareholders may seek an alternative way to expropriate firm value other
than earnings management, even while under a substantial control-ownership disparity.
Taken together, it appears that the corporate governance and ownership structure reforms are
still in a transitional stage in China, and it may be premature to conclude that recent reforms
have effectively remedied the agency gap existing between the controlling and minority
shareholders in Chinese capital markets.
Despite the above findings, we would like to suggest future research directions in several
aspects. First, as Chinese capital markets have been rapidly developing, the assumptions in
this study should be carefully re-examined in the future. According to the changes in
Chinese capital markets, researchers can extend the arguments in this study into the future.
Second, although previous literature suggest various types of expropriation channels, such
PAR as intercorporate loans or related party transactions, these methods are examined separately
rather than comparatively. Therefore, future studies can analyze the effects of control-cash
flow rights disparity on various expropriation methods. The comparison made between
relative costs and benefits of different expropriation methods will give more comprehensive
insight into the control-cash flow rights disparity in the Chinese context. Third, the majority
of previous studies measured the level of earnings management based on discretionary
accruals without paying specific attention to firms’ operational changes. Therefore, future
research need to revisit the relationship between control-ownership disparity and earnings
management in terms of REM. Fourth, for the aforementioned reasons, special caution
should be extended to the findings in this study in connection with other Asian countries
where the institutional environment is found to be significantly different. For example, the
family-owned firm is quite common in other Asian countries, while the state-owned firm is
more dominant in the Chinese capital markets. In addition, the market reforms that have
been consistently imposed by Chinese authorities may generate greater differences between
Chinese capital markets and those of other Asian countries in the future.
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Notes
1. Public ownership firms comprise of state-owned enterprises (that usually locate in urban areas)
and collectively-owned enterprises (that usually locate in rural areas) (Noronha et al., 2008).
2. As long as the reduction in fixed costs per unit is not offset by any increase in marginal cost per
unit, total cost per unit declines. (Roychowdhury, 2006, p. 340)
3. For example, the percentage of non-tradable shares was slightly higher than 60% in 2003. It fell
to around 28% in 2010 due to the implementation of SSSREF (Jiang and Kim, 2015, p. 195).
However, this level of non-tradable shares percentage may affect the results in this study as the
dataset period is from 2003 to 2015. Similarly, the percentage of one large shareholder started
with over 42%, and still sustained over 38% until 2012 (Jiang and Kim, 2015, p. 196). The
percentage of top 5 shareholders were more than 50% until 2012, which implies highly
concentrated ownership in Chinese firms (Jiang and Kim, 2015, p. 196).
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