Earnings Management, Tunnelling Behaviour and Corporate Governance: The Case in China

Abstract

This thesis explores three aspects of minority shareholder protection in the Chinese stock market, where earnings management depends on the split share structure reform (SSSREF) and mergers and acquisitions (M&As), as well as impact of mutual fund ownership on controlling shareholders’ tunnelling behaviour and firm performance.

More precisely, Chapter 2 empirically shows that China’s SSSREF has not fundamentally improved the quality of firm financial information. However, the reform exogenously created an incentive alignment effect that influences firm’s earnings management behaviour. Specifically, the use of discretionary accruals by firm`s has been constrained since the reform and has consequently shifted to less detectable and underscrutinized real earnings activities after the SSSREF. This shift is similar to that seen with the passage of the Sarbanes–Oxley Act (SOX) and International Financial Reporting Standards (IFRS) on firm earnings behaviour in developed countries with a strong investor protection environment. The results also suggest that the shift between firm’s accrual-based and real earnings methods is an overlooked area for investors in the Chinese stock market and may require regulatory attention.

Chapter 3 explore fully the role of mutual funds in corporate governance in Chinese listed firms through examining whether mutual fund ownership can effectively reduce controlling shareholders’ tunnelling behaviour and improve firms’ performance. The corresponding results find a non-linear association between mutual fund ownership and firm performance. In particular, a higher level of mutual fund ownership is associated with better firm performance, which indicates that mutual funds could serve as sophisticated investors to provide useful accounting information to outsiders, and are also capable of monitoring to improve the corporate governance mechanism. When the mutual fund ownership reaches a certain level, the negative relation between high mutual fund ownership and firm performance may imply that mutual fund managers are more likely to expropriate value from minority shareholders when they have dominant controlling power. In addition, the non-linear relation between mutual fund ownership and firm performance is still observable when controlling shareholders implement tunnelling behaviours. At last, mutual fund ownership can effectively reduce controlling shareholders’ tunnelling behaviour. Therefore, in order to realize fully the benefit of mutual fund ownership in improving corporate governance, it is necessary to further liberalize the mutual fund industry and to decentralize regulation by government agencies.

Chapter 4 extends the study of Chapter 2 and examines the environment of investor protection in the Chinese stock market by looking at the relation between earnings management and M&As. In details, the findings reveal M&As in China have a positive effect on promoting real earnings management and a negative effect on limiting accrual-based earnings management during the year of M&As. This finding indicates acquirers in China prefer to engage in more real earnings management mainly because of strict regulatory supervision by CSRC and the high percentage of deals paid by cash. However, accrual-based earnings management yields a significantly positive correlation with both real earnings proxies and their interaction with M&As instead of a substitution effect between accrual-based and real earnings management around M&As. This further reflects the absence of effective corporate governance and weak investor protection for the Chinese stock market. In addition, the results show a decline in earnings informativeness in the year of the M&A, and this further supports that the adjustment of earnings upwards around M&A can lower firm’s informational quality. Finally, due to the increase in real earnings management activities around M&As, the market is more likely to react negatively to such earnings strategy, especially in the year of the M&A.

Consequently, the empirical evidence in this thesis contributes to the current literature and related policy making by expanding our understanding of the Chinese stock market and paying more attention to protecting minority shareholder interests.