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

Published date01 June 2014
Date01 June 2014
DOIhttp://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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The Impact of the Corporate Governance Code on Earnings Management 597
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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2012 Blackwell Publishing Ltd
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Jean J. Chen and Haitao Zhang
598
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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2012 Blackwell Publishing Ltd
© 2012 John Wiley & Sons Ltd

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