The Impact of the Corporate Governance Code on Earnings Management – Evidence from Chinese Listed Companies

• Author: Jean J. Chen,Haitao Zhang
• Published date: 01 June 2014
• Date: 01 June 2014
• DOI: http://doi.org/10.1111/j.1468-036X.2012.00648.x

European Financial Management, Vol. 20, No. 3, 2014, 596–632

doi: 10.1111/j.1468-036X.2012.00648.x

The Impact of the Corporate

Governance Code on Earnings

Management – Evidence from Chinese

Listed Companies

Jean J. Chen

Surrey Business School, University of Surrey, UK

Email: j.j.chen@surrey.ac.uk

Haitao Zhang

Global Institute of Management and Economics, Dongbei University of Finance and Economics,

China

Email: h.zhang@dufe.edu.cn

Abstract

This study investigates the impact of the 2002 Chinese Code of Corporate

Governance for Listed Companies on earnings manipulations. We find that, in

general, the 2002 CODE had a positive effect on curbing earnings management

through the introduction of independent non-executive directors to the board of

directors and the audit committee, and accounting/financial experts to the audit

committee. Although such an impact was minimal when the firms were state-

controlled, it became significant once they were privately controlled. Overall,

we find regulatory reform on corporate governance plays an important role in

deterring the use of earnings management.

Keywords: earnings management ,corporate governance code

JEL classification: M4, G39, M52

1. Introduction

In recent years a major thrust of governance reforms has been to make the board of

publicly held corporations structurally and operationally more effective in alleviating

the opportunistic behaviours of management. One manifestation of such opportunistic

behaviours is widely recognised in the literature on accounting and finance is earnings

Wewould like to thank Professor John Doukas, two anonymous referees and Professor Weian

Li for their very helpful and constructive comments. Wealso acknowledge f inancial support

from the National Social Science Foundation of China (ID: 10zd&035) and the National

Natural Science Fundation of China (ID:G02).

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management, whereby the quality of financial information disclosed is distorted to

certain extent by managers to either mislead some stakeholders with respect to the

underlying economic performance of the company and/or to influence contractual

outcomes contingent on reported accounting numbers (Healy and Wahlen, 1999; Klein,

2002). In drawing out the procedures for improving quality of financial statements,

corporate governance codes worldwide have also emphasised the fiduciary role the

board can play in curbing opportunistic earnings management and in ensuring that

earnings figures convey accurate information about firm operations (Ananchotikul

et al., 2010; Peasnell et al., 2000).

Prior studies conducted in the UK and USA suggest that a company’s board influences

earnings management and the quality of financial statements, whereby the extent of such

influence depends on the board characteristics. In particular, studies have shown that

independent boards reduce the occurrences and extent of earnings management activities

and it is thus associated with better quality of financial reporting (e.g., Cornett et al.,

2009; Linck et al., 2009; Xie et al., 2003). Some authors, including DeFond et al. (2005),

Klein (2002) and Xie et al. (2003), have also considered the role of audit committee and

found earnings management to be related to the level of audit committee independence

and its financial expertise.

In China, according to Chung et al. (2002), Jiang et al. (2010) and Liu and Lu

(2007), evidence of prevalent earnings management practices in the listed firms has

recently been found. Fuelled by a series of high-profile corporate scandals for violating

provisionsrelated to f inancial reporting, such as Guangxia Co. Ltd., Lantian Co. Ltd., and

Sanjiu Co. Ltd., many corporate governance reforms took place in China at the beginning

of the 2000s with the aim of enhancing minority shareholders’ protection against the

expropriation by controlling shareholders (Ding et al., 2007). Among those reforms,

the most notable one was the implementation of the Code of Corporate Governance for

Listed Companies in China in 2002 (hereinafter, the 2002 CODE). The 2002 CODE,

with the quality of financial reporting laid at its heart, recommends, inter alia, that a

listed company shall establish a corporate governance structure sufficient for ensuring

fair treatment towards all shareholders, especially minority shareholders. It focuses on

the board’s monitoring responsibilities and highlights the contribution that independent

directors and audit committee can make to this process. In comparison with other rules

and/or regulations in China, the 2002 CODE provides explicit guidance relating to the

corporate governance requirements in practice. This is especially true with regard to the

board monitoring.

However, to the best of our knowledge, there was no prior study examined the impact

of the 2002 CODE on restraining the level of earnings management in Chinese listed

companies, particularly with respect to the changes to the board independence and the

audit committee characteristics (its existence, independence, and financial expertise)

exclusively stipulated by the CODE for the listed firms. Our research aims to fill this

gap.

Drawing upon a panel data of 447 non-financial Chinese listed companies over the

period of 2000–2006, we provide evidence that the magnitude of earnings management

measured by discretionary accruals decreased over time. We also f ind a negative

relationship between earnings management and the independence of the board, inde-

pendence of the audit committee, and presence of financial/accounting experts on the

audit committee. Thus, it appears that the 2002 CODE had a positive impact on the

effectiveness of these corporate governance mechanisms. However, although significant

for privately controlled companies, such an impact becomes minimal when listed firms

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have state-controlling shareholders. We also f ind that the establishment of an audit

committee, the percentage of shares held by institutional investors,and the Big 4 auditors

do not have a significant impact on the extent of earnings management.

Our results contribute to the existing literature in earnings management and corporate

governance in the following ways. First, this is the f irst study to investigate the effec-

tiveness of Chinese Corporate Governance Code on constraining earnings management.

It is different from prior research on corporate governance codes, which is largely based

on the Western economies (e.g., Cohen et al., 2008; Linck et al., 2009; Peasnell et al.,

2000), as it focuses on China where the incentives of earnings management as well as

the ownership structure of the listed companies are largely different from the Western

experiences. Moreover, our findings are useful for policy-makers aiming to identify

and devise key corporate governance mechanisms that are effective in constraining

opportunistic earnings management behaviours.

The reminder of this study is organised as follows. Section 2 providesthe backg round

of ownership structure in China and reviews the literature on earnings management and

corporate governance. Section 3 presents hypotheses development, followed by research

design, discussed in Section 4. Finally, empirical results are presented in Section 5,

followed by Section 6 that concludes the study.

2. Institutional Setting and Literature Review

Wewill start with a brief demonstration of the characteristics of Chinese listed f irms from

the agency theory perspective, and then review the literature on earnings management

and corporate governance respectively.

2.1 Ownership characteristics of Chinese listed companies

As stated by the Chinese government, the original purpose of developing China’s

stock market was to help state-owned enterprises (SOEs) raise funds and improve their

operating performance (Sun and Tong, 2003; Wang et al., 2004). For historical reasons,

the majority of Chinese listed companies originate from restructured SOEs. This leads

to a unique feature of ownership structure, whereby the state has retained controlling

stake in all former SOEs. In particular, over 50% of a firm’s shares have been held

directly by the governments at the central and local levels or by the legal entities, which

are ultimately controlled by the state (Chen et al., 2006; Wang et al., 2004). Thus, the

state and legal entities are typically the largest stakeholders, who often control the firms

as they have substantially larger investment stakes than the other investors (Chen et al.,

2008).

From the agency perspective,this highly concentrated ownership determines the nature

of agency problem in Chinese listed companies. More generally, when ownership is in

the hands of a single owner (or a small number of owners) that has effective control

of the firm’s management, it results in the conflict of interests between controlling

shareholder(s) and minority shareholders. According to Sun and Tong (2003) and Ding

et al. (2007), the agency cost is manifested through insiders’ control of the firm, as they

pursue their private benefits at the costs of outsiders. In addition, China’s incomplete

legal infrastructure and lack of stock market discipline further entrench controlling

shareholders’ opportunistic behaviours (Cull and Xu, 2005). In fact, helped by the

government, for almost a decade, the controlling shareholders were largely insulated

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