Figure 1 Histogram of ROE for 698 Companies in Shanghai Stock ...
How Far Would Management Go to Manage Earnings?
---The Evidence from China
Guohua Jiang Liyan Wang
The Guanghua School of Management
Very preliminary, comments welcome.
The authors are assistant professor and professor, respectively, of the Guanghua
School of Management, Peking University, Beijing 100871, China. We thank Wenwen
Chen, Chen Li and Jingqi Lu for excellent research assistance. Please send comments
to firstname.lastname@example.org and email@example.com.
Earnings management has been one of the most widely studied corporate
behaviors in accounting literature. Basing on this large body of research, accounting
scholars have largely agreed that company management manages corporate earnings
to meet certain targets. The incentives for earnings management include bonus
contracts, debt covenants, initial public offerings and seasonal public offerings, etc. In
terms of the means of earnings management, although accounting scholars recognize
the possibility that management may manipulate real activities (company operation)
to meet earnings targets, the vast majority of studies identify accrued earnings as the
mean through which earnings management is achieved. One recent exception is
Earnings management (EM hereinafter) leads to misleading accounting
information being communicated to information users. Various groups of capital
market participants may suffer as a result, such as shareholders (bonus-driven EM),
creditors (debt covenant-driven EM), and potential shareholders (IPO-driven EM).
However, other than under its extreme form (accounting frauds or crimes), accrual-
based EM does not seem to do serious harm to its victims. The reason is that the
discretion on accruals is bounded by GAAP (Barton and Simko, 2002). Given the
underlying economic transactions of a firm, the management’s ability to report
accrued earnings is limited. Overtime, accruals will reverse as well, so management
has to consider the implications of their discretion on current accruals for future
earnings. This consideration in turns constraints accrual-based EM as well.
What if management can manipulate real activities (company operation) to
manage earnings? That is--- will managers go such a long distance to achieve their
EM targets? Will in this case myopic EM behaviors do significant harm to its
“victims”? Surveying the EM studies with U.S. firms as samples, we find little
research on these two questions. The reason is simple. The United States has one of
the best-developed capital markets in the world. The complexity of its institutions
guarantees that the market participants, including company management, do not
engage in self-serving activities that is beyond a certain acceptable limit.
However, what if the limit is loose? Will managers engage in more real activity-
based EM in this case? Our paper answers this question with data from China’s stock
China opened its current stocks markets at Shanghai and Shenzhen in early
1990’s. By September of 2003, there are more than 1,200 company stocks traded on
the two exchanges, with a total market capitalization of 1,266 billion RMB (153
billion US dollars).
In almost all aspects, China’s stock market is an emerging market. One
significant difference between China’s stock market and other world markets is in the
ownership structure of listed companies. When China embarked on economic reform
in the late 1970’s, its main purpose was to improve the operating efficiency of state-
owned enterprises (SOEs). The introduction of stock market was one step in this
reform. Therefore, China’s government involvement in the development of stock
market is instrumental and the government’s top priority was to list SOEs on the new
After a SOE went public, the government usually retained a controlling interest in
the listed company. Moreover, the shares retained by the government are not traded.
This practice in fact divides shareholders into two groups: one group with un-traded
shares who in most cases controls the listed company, and the other group with traded
shares who lacks control over the company.
Government regulation of the stock market is very strict. As in an emerging
market, the right to get listed on stock exchanges is a scarce commodity. China’s
government actually sets a very high standard and even a Quota System to list
companies. For example, the Quota System limits the book value of equity of the
tradable shares to a certain amount. As a result, most SOEs that would like to get
listed can’t actually list their whole company. In addition, the SOE itself may not be
able to meet the past profitability requirement of listing. To list at least a part of the
SOE, the SOEs usually carve out the best parts of the corporation to form a new
subsidiary and then apply to list the subsidiary. Therefore, most listed China’s
companies are actually subsidiaries of larger SOEs. SOEs hold controlling interests in
the listed companies, and government in turn controls SOEs. Central and local
governments also directly own listed companies through their Bureau of Asset
Management. As a result, Chinese government, through its various levels and
different branches, still retain controlling interests in most listed companies. And
listed companies, though nominally independent, face government interference in
their internal operation.
Another feature of China’s stock market is that most management regards equity
capital raised from the stock market as cost-free, and rightly so. Because parent SOEs
and/or various government agencies still own the majority of the common shares, and
due to the lack of protection of minority shareholder rights, company management is
still only responsible to the parent SOEs and government, brushing aside the rights of
minority shareholders. In fact, equity capital raised on stock market is a substitute for
bank loans. In the case of bank loan, companies will have to answer to banks, but the
companies do not have to answer to minority shareholders at all.
Given these features of China’s stock market, there exist two strong incentives for
companies to manage earnings.
First, it is difficulty to get listed on the stock exchanges, and it is also easy to get
delisted from the exchanges. China’s SEC sets specific requirements for companies to
stay listed. Once any of these requirements are not met, companies would be put into
probation, and if the companies do not satisfactorily improve their performance, they
will be delisted at the end of the probation period. Section two of this paper provides a
chronicle of these requirements. Delisting is a big deal on any stock markets, but it is
a bigger deal for China’s listed companies. As discussed earlier, these listed
companies went through a very tough process to get listed, once they got listed, they
normally achieved star status in their respective local areas. Listing not only helps
these companies raise capital, which is basically cost-free in contrast to other
financing channels such as bank loans, it is also been regarded as a performance
measure of the local government heads. Therefore, companies, once facing the
possibility of delisting from the stock exchanges, have stronger than usual incentive to
find ways to meet requirements to stay listed. The SOEs behind the listed companies,
and the government agencies behind SOEs, also have strong incentive to support the
listed companies (Chen, Lee and Li, 2003).1
Second, most listed companies also raise additional capital from the stock market
through rights offerings. China’s SEC places even stronger constraints on the
privilege to do rights offering. A company must meet return-on-equity (ROE)
thresholds in the years prior to a rights offering. Section two of this paper provides a
chronicle of these requirements. Given that management regards equity capital raised
on stock market as cost-free, it is in their interest to pursue rights offering even that
means they have to manage company earnings. Plus, there is evidence that the parent
SOEs encourage and help listed companies to raise more capital and then tunnel the
money into the parent companies (Jian and Wong, 2003).
Compared to the incentives that prompt U.S. managers to engage in earnings
management (bond contracts, debt covenants, IPO and SEO, etc.), the incentives of
China’s company management to avoid delisting from the stock exchanges and to
raise more capital through rights offerings are much stronger. If accrual-based EM is
not enough to meet respective qualification requirements, we conjecture that with the
backing of SOEs and governments, China’s listed companies may engage in radical
On August 13, 2003, Sohu business news reports a story. Zong Heng Corporation of Jian Su province had two
consecutive loss years in 2001 and 2002. The stock exchange put the company stock under Special Treatment
(*ST, i.e., probation). If the company does not make profits in 2003, the stock will be delisted. Moreover, the
semiannual financial report to be released is going to report losses and predict a loss of the third quarter. To avoid
delisting of Zong Heng stock, it is reported that Jian Su government gets involved in restructuring of the company
in the hope to turn profit in 2003. One company insider was quoted as saying: “although time is short, if the
(government-backed) restructuring moves fast, it is entirely possible that we have a profit year and avoid
form of EM such as managing real activities of the company to meet these
requirements. There is no guarantee that this type of EM will benefit shareholders. It
only keeps the companies listed or helps them loot more capital, but potentially could
have damaged the company in the long run.
It is the purpose of this paper to examine real activity-based EM in China’s listed
This paper adds to the EM literature in the following ways. First, we identify two
EM incentives that have been less commonly studies before, managerial incentive to
avoid delisting from stock exchanges and to raise more capitals. Second, we identify
some real activities-based EM techniques in addition to conventional accrue-based
EM techniques, namely asset sales/purchase/exchanges and equity sales/purchase.
Third and most importantly, our paper shows that company management could go as
far as altering real activities to meet earnings targets. The evidence of EM in
accounting literature has been abundant, but how far would management go to do EM
is not clear. This paper provides evidence that management would go further than
accrual management to manage earnings.
A few recent papers also study earnings management in China’s stock market.
Jian and Wong (2003) find that listed companies manage earnings through related-
party sales, and parent SOEs of listed companies tunnels resources into or away from
the listed companies to extract benefits from the listed companies. Liu and Lu (2002)
find that corporate governance is an important factor in deciding whether companies
manage earnings. Weak corporate governance companies with a large controlling
shareholder tend to manage earnings to exceed regulatory thresholds and at times
tunnel resource away from the listed companies. Chen, Lee and Li (2003) find that
local government uses its tax and fiscal policies to help listed companies from its
jurisdiction manage earnings to circumvent central government regulatory
Our study differs from the three papers in that we look at more dramatic forms of
earnings management. That is, we look at real activities that in essence change the
operation of the listed companies. Our study presents a striking phenomenon of
earnings management at high costs.
II. A chronicle of CSRC requirements on stock listing and rights offering
In this section, we provide a chronicle of CSRC requirements on stock listings
and rights offering. During the short history of Chinese stock markets, regulation has
to change frequently to keep pace with the fast development of the markets.
In terms of delisting policy, the Chinese Company Act of 1993 mandates that if a
listed company suffers three consecutive loss years, its stock will be suspended from
trading on the exchanges and put into probation. If the company does not make
satisfactory improvement during the probation period, its stock will be delisted. From
February 2001, the probation period is one year and during the probation period, the
company stock is up under Particular Transfer (PT) status. However, after January 1,
2002, CRSC removed PT status and installed Special Transfer (ST) status instead.
CSRC also shortened the probation period to half-a-year. It is clear that CRSC
monitors closely those firms who do not show profitability in consecutive years and
deal with them with the punishment of delising.
In terms of rights offering, in 1993, CSRC requires two years of profits for
companies to be eligible for rights offering. In September 1994, CSRC stops to
require profits only, but require the average return on equity (ROE) of the previous
three years not below 10 per cent. In January 1996, CSRC further tightens the
requirements to require ROE not below 10 per cent in each of the previous three
years. In March 1999, the requirements change to average ROE not below 10 per cent
AND ROE not below 6 per cent in EACH of the previous three years. In March 2001,
CSCR requires weighed-average ROE not below 6 per cent in the previous three
The CSRC requirements create two critical thresholds for listed companies, one is
zero profit and the other is 6 per cent or 10 per cent ROE. If possible, a company will
prefer to report small profit instead of small loss to avoid getting into a delising trap,
or to report a ROE above 6 per cent or 10 per cent instead of slightly fall short in case
the company needs to raise more capital from stock market in the next few years.
Prior studies have documented out-of-proportion number of firms reporting small
profits, or reporting ROE slightly higher than 6 per cent or 10 per cent, depending on
which year’s data was used.
Prior literature has ably documented that once a company is going to miss all
meaningful earnings thresholds (zero profit, analysts’ forecast, earnings of the same
period in the previous year), management tends to “take a big bath” to earnings
(Abarbanell and Lehavy, 2001). A “big bath” to current earnings creates earnings
reserve for future years.
Therefore, in this paper, we identify three scenarios where earnings management
is suspected: big loss firms whose ROE fall below negative 10 per cent (big loss
group), small profit firms whose ROE fall between zero per cent and 2 per cent (small
profit group), and rights offering firms whose ROE fall between 6 per cent and 8 per
cent (rights offering group). All other firms are put into one group: other firms group.
III. Identifying real activity-based earnings management techniques
We identify five real activities that we suspect were used to manage earnings,
equity sales, equity purchase, asset sales, asset purchases, and asset exchanges. For
the sake of this paper, we call these activities earnings management activities.
Equity sales refer to companies selling ownership in another firm, sometimes a
subsidiary. Equity purchases refer to companies buying ownership in another firm. If
these transactions are purely based on fair market prices, the room for earnings
management is limited. However, as discussed earlier, a parent SOE usually controls
the listed company, and the SOE tends to control a net of other companies.
Furthermore, The local government behind the SOE controls more companies. This
complex net of connections offer listed company opportunities to engage in equity
sales and equity purchases that generate profits. Surveying the news reports on these
so called “restructuring transactions”, it at first appears that the “restructuring
transactions” do not make economic sense for at least one party in the transactions,
but tracing the roots of each party, quite often, will lead to the controlling
shareholders of the listed company or local government. It is not rare that ownership
sold (purchased) by the listed companies in one year was purchased back (sold) in
There are a few ways equity sales/purchases would affect earnings and ROE. For
equity sales, the earnings the sold equity generates from beginning of the year to the
date of sales could be recognized; for equity purchases, the earnings the purchased
equity generates would be recognized. Assuming companies have a good idea about
the earnings-generating ability of the equity, they would certainly pick subsidiary to
sell, or other company to purchase so that their earnings target is met. Also, for equity
sales, gains may be generated because selling price is higher than book value of the
sold equity. A more subtle impact of equity sales/purchases is that equity
sales/purchases may change the consolidation base of financial reporting. A subsidiary
which was consolidated in financial reporting may not need to be consolidated after
the listed company sold a certain portion of its holding in this subsidiary. After equity
purchase, the listed company may need to consolidate a new subsidiary.
Therefore, we believe listed companies, with the backing of parent SOE and local
government, may “strategically” use equity sales/purchases to manage earnings.
Similar arguments can be made for asset sales, asset purchases and asset
exchanges. Therefore, in this paper, we examine whether Chinese listed companies
use these five activities to manage earnings.
IV. Empirical results
We hand-collect earnings management activities for 704 listed companies on the
Shanghai Stock Exchange which had announced their 2002 annual results before
April 30, 2003. Seven companies with negative ROE are removed from the sample.
Our final sample consists of 698 companies.
We first plot a histogram of ROE of these 698 companies. It is shown in figure 1.
Figure 1 plot the number of firms whose ROE fall into each one-per cent interval.
Firms whose ROE fall below negative 10 per cent are put into one group, so are firms
whose ROE are above 20 per cent.
As documented by earlier studies, it is apparent from figure 1 that there is an out-
of-proportion clustering of companies in the ROE intervals (0, 1) and (6, 7). There are
very few companies with ROR between negative 10 per cent and zero percent, but
there are 46 companies with ROE between zero percent and one per cent—that is,
these firms managed to report a small profit. There are 106 companies with ROE
between 6 per cent and 7 per cent—that is, they slightly meet the CSRC rights
offering requirement on ROE. In contrast, the two adjacent intervals contain much
fewer companies, with 36 companies in the interval (5, 6) and 60 companies in the
interval (7, 8). We believe that the out-of-proportion clustering of companies in the
ROE intervals (0, 1) and (6, 7) indicates possible earnings management by these
Figure 2 plots number of earnings management activities by ROE intervals.
Similar to figure 1, firms in the ROE interval (0, 1) report 49 cases of earnings
management activities, while firms in with ROE between negative 10 per cent and
zero percent reports only a few. Firms in the ROE interval (6, 7) reports 170 such
cases, while those in the ROE intervals (5, 6) and (7, 8) only report 51 cases and 78
A more meaningful statistic is the average number of earnings management cases
in each ROE interval. Figure 3 shows this. Apparently, in terms of average number of
earnings management activities, ROE intervals (0, 1) and (6, 7) do not exhibit a
higher frequency than their adjacent intervals.
Table 1 gives a detailed analysis of earnings management activities. We show in
this table number and average number of earnings management activities by group,
and number and percentage of firms in each group reporting earnings management
activities by zero time, one-to-three times and more than three times. We use other
firms group as a benchmark to analyze whether big loss group, small profit group, and
rights offering group report higher frequency of earnings management activities.
Out of 698 firms, 58 are big loss firms, 88 are small profit firms, 168 are rights
offering firms, and 384 are other firms. From the top panel of table 1, these 698 firms
in year 2002 reported 951 cases of earnings management activities, 1.36 cases per
firm on average. Only rights offering group reported a higher average number of
earnings management activities than the benchmark other firms group (1.48 versus
1.34), while small profit group actually reported a smaller average (1.25). In terms
number and percentage of firms in each group reporting earnings management
activities by zero time, one-to-three times, and more than three times, there is still no
clear difference between big loss group, small profit group, rights offering group and
other firms group.
The other panels of table 1 report similar statistics for each individual earnings
management activity. Once again, significant differences between groups are not
evident. However, it appears that small profit group and rights offering group report
higher average number of earnings management activities in December, the last
month of a fiscal year. Small profit group reports 0.4 cases per firm, rights offering
group reports 0.45 cases, while other firms only reports 0.29 cases. This is a
preliminary indication that small profit firms and rights offering firms, trying to meet
ROE threshold, engage in more earnings management activities right before fiscal
In table 2, we test whether there are significant differences in the percentage of
firms reporting at least one earnings management activities. The lower panel reports
the differences between big loss group, small profit group, rights offering group, and
other firms group. We use a K-squared test to test whether the differences are
Statistically significant differences are few. Small profit group reports
significantly higher percentage of firms reporting asset sales (by 6 per cent), higher
percentage of asset exchanges (by 7 per cent), but lower percentage of asset purchase
(by 8 per cent). Big loss group reports a significantly lower percentage of firms
reporting equity purchase (by 18 per cent).
Overall, table 1 and table 2 indicate that contrary to our expectation, big loss
firms, small profit firms, and rights offerings firms do not report earnings
management activities more often than other firms.
One possibility to explain the lack of differences in table 1 and table 2 is that
number of earnings management activities may not be as important as the amounts of
earnings these transactions generate if firms were to use these activities to manage
earnings—for example, to turn a loss year into a profit year, a small profit firms might
have used only one earnings management activity which generates a larger amount of
earnings than more activities of another company combined.
To explore this possibility, we hand-collect the impact of earnings management
activities on earnings. A better approach is to examine the impact on ROE. However,
firms do not report the impact of these activities on equity, so we could not determine
the impact on ROE.
Firms usually report the following items in their annual reports: the contributions
to current year earnings of sold assets or sold equity; the contributions to current year
earnings of purchased assets or purchased equity; and the gains on asset sales or
equity sales. So we separate the contributions to current year earnings into these three
types. Table 3 reports the results. The numbers reported are contributions to current
year earnings standardized by total equity.
Other than in one case, we can see earnings management activities contribute
larger amounts to earnings of big loss firms, small profit firms, rights offering firms
than to other firms. The only case where other firms group report a larger contribution
from equity/asset sales than small profit group is due to one extreme observation.
Getting rid of this extreme observation small profit group would report a larger
contribution than other firms group by 0.027.
However, using a t-test, all these differences in contributions to earnings are not
Nevertheless, table 3 indicates that small profit firms and rights offerings firms
might have used earnings management activities to increase their ROE above the
zero-profit, and 6 per cent ROE thresholds. Contrary to our expectation, these
earnings management activities also increase earnings for big loss group, instead of
decreasing earnings to take a big bath.
Our final test is a probit regression analysis to detect whether big loss firms, small
profit firms, and rights offering firms report higher frequency of earnings
management activities after controlling other variables that might influence the
engagement of such activities. The dependent variable takes value one if a company
reports more than one earnings management activities, and zero otherwise. One is the
median number of earnings management activities reported by our sample firms.
The independent variables include the following items. The variable Earnings
Management Group takes value one if a firm belongs to big loss group, small profit
group, or rights offering group, and zero otherwise. Although table 2 indicates
earnings management group firms do not report significantly higher frequency of
earnings management activities, the probit regression will add a robustness check
after controlling other variables that might affect the frequency of these activities.
% controlling shareholder ownership is the percentage of common shares owned
by controlling shareholders. If shareholder ownership is concentrated, the controlling
shareholders will have more leeway to manipulate the internal operation of the firms
without sufficient monitoring. We conjecture that the larger the controlling
shareholder ownership, the more likely a firm may engage in earnings management
activities. Liu and Lu (2002) documents that firms with weak corporate governance
engages in more earnings management activities, and the existence of a controlling
shareholder is frequently cited as an indication of weak corporate governance.
% government ownership is the percentage of common shares owned by various
levels and branches of Chinese government. As Chen, Lee and Li (2003) shows,
governments are involved in helping listed companies in their own jurisdictions to
meet CSRC requirements through tax benefits, we conjecture governments may also
help companies engage in the earnings management activities identified in this paper
through their administrative power.
Market-to-Book ration is market capitalization divided by total equity. High
market-to-book stocks are routinely regarded as glamour stocks and even small
negative news would have significant consequences for the stock prices (Sloan and
Skinner, 1999). So high market-to-book firms may tend to manage earnings to meet or
Finally, we also include total assets as a control variable. Companies’ ability to use
asset sales or asset purchases depend on how much asset they control.
Other than ROE, variables mentioned above are measured at beginning of year.
Table 4 reports descriptive statistics of these variables. Only big loss firms show
differences from the other three groups with lower controlling shareholder ownership,
lower government ownership, and smaller amount of assets.
Table 5 reports the probit regression results. Consistent with table 2, even after
controlling for these other variables, earnings management group still show no
deterministic power for earnings management activities. The sign of the coefficient is
actually negative. The coefficient on % controlling shareholder ownership is 0.026
and significant, indicating firms with larger controlling shareholder ownership engage
in more earnings management activities. This result is consistent with the Liu and Lu
(2002) conjecture. Contrary to our expectation, the coefficient on % government
ownership is –0.007 and significant. After controlling for the impact of controlling
shareholder ownership, more government ownership actually decreases the likelihood
of earnings management activities.
Finally, the coefficients on market-to-book ratio and on total assets are not
In summary, the empirical analysis does not support the notion that big loss firms,
small profit firms, and rights offering firms engage in more frequent earnings
management activities identified by this paper, but with weak evidence, these firms
report larger amounts of income-increasing contributions to current year earnings
from earnings management activities to meet or exceed important thresholds.
Our purpose in this paper is to test whether Chinese companies use real activities
such as asset sales/purchase/exchange and equity sales/purchase to manage earnings
to meet or exceed CSRC regulatory thresholds. Different from earnings management
through accrued earnings, real activity-based earnings management may cause more
harm to investors.
Our results in this paper are weak. We do not observe significant difference in the
frequency of earnings management activities between big loss firms, small profit
firms, rights offering firms (firms we suspect would engage in more earnings
management) and the other firms (firms we use as benchmark). However, there is
indeed indication that these activities of big loss firms, small profit firms, rights
offering firms generate more earnings than other firms, helping companies to meet or
exceed earnings thresholds.
We believe there are a few things we can do to enrich this paper. One is to expand
our sample to include companies on the Shenzhen Stock Exchange. Second, since
CSRC delisting and rights offering requirements are both for three consecutive years,
we should further identify firms who have missed these thresholds in the past two
years. These firms should have stronger incentive to manage earnings. Third, we can
identify firms who in fact do rights offering in the next two years. Assuming firms
decide early whether to do rights offering in the future, they would engage in earnings
management to make sure their current earnings meet CSRC requirement. We will
collect more data to further explore these possibilities.
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Figure 1 Histogram of ROE for 698 Companies in Shanghai Stock Exchange, 2002
Histogram of ROE for 698 Companies in Shanghai Stock
Figure 2 Histogram of Earnings Management Activities of 698 Companies in Shanghai Stock
Exchange, 2002, by ROE Groups
Histogram of Earnings Management Activities of 698
Companies in Shanghai Stock Exchange, 2002, by ROE Groups
Figure 3 Histogram of Average Number of Earnings Management Activities of 698 Companies in
Shanghai Stock Exchange, 2002, by ROE Groups
Histogram of Average Number of Earnings Management Activities
of 698 Companies in Shanghai Stock Exchange, 2002, by ROE Groups
Table 1 Summary of Earnings Management Activities
Big Loss Firms Small Profit FirmsRights Offering Other Firms All Firms
# of firms 58 88 168 384 698
# of All Activities 78 110 249 514 951
Average per firm 1.34 1.25 1.48 1.34 1.36
Number and Percentage of Firms Reporting Earnings Management Activities by
Zero times 27 47% 36 41% 75 45% 163 42% 301 43%
One to three times 24 41% 46 52% 69 41% 180 47% 319 46%
More than three times 7 12% 6 7% 24 14% 41 11% 78 11%
# of Equity Sales 45 39 81 154 319
Average per firm 0.78 0.44 0.48 0.4 0.46
Zero times 45 78% 66 75% 135 80% 299 78% 545 78%
One to three times 9 16% 20 23% 25 15% 77 20% 131 19%
More than three times 4 7% 2 2% 8 5% 8 2% 22 3%
# of Equity Purchase 8 27 90 174 299
Average per firm 0.14 0.31 0.54 0.45 0.43
Zero times 53 91% 70 80% 116 69% 283 74% 522 75%
One to three times 4 7% 18 20% 49 29% 95 25% 166 24%
More than three times 1 2% 0 0% 3 2% 6 2% 10 1%
# of Asset Sales 12 19 16 56 103
Average per firm 0.21 0.22 0.1 0.15 0.15
Zero times 49 84% 73 83% 152 90% 345 90% 619 89%
One to three times 9 16% 15 17% 16 10% 37 10% 77 11%
More than three times 0 0% 0 0% 0 0% 2 1% 2 0%
# of Asset Purchase 7 13 46 100 166
Average per firm 0.12 0.15 0.27 0.26 0.24
Zero times 51 88% 78 89% 134 80% 309 80% 572 82%
One to three times 7 12% 10 11% 33 20% 74 19% 124 18%
More than three times 0 0% 0 0% 1 1% 1 0% 2 0%
# of Asset Exchange 6 12 16 30 64
Average per firm 0.1 0.14 0.1 0.08 0.09
Zero times 53 91% 76 86% 157 93% 356 93% 642 92%
One to three times 5 9% 12 14% 10 6% 28 7% 55 8%
More than three times 0 0% 0 0% 1 1% 0 0% 1 0%
# of December 16 35 76 111 238
Average per firm 0.28 0.4 0.45 0.29 0.34
Zero times 49 84% 67 76% 127 76% 307 80% 550 79%
One to three times 8 14% 20 23% 38 23% 76 20% 142 20%
More than three times 1 2% 1 1% 3 2% 1 0% 6 1%
# of Activities With 20 27 85 132 264
Average per firm 0.34 0.31 0.51 0.34 0.38
Zero times 48 83% 73 83% 121 72% 296 77% 538 77%
One to three times 9 16% 14 16% 44 26% 83 22% 150 21%
More than three times 1 2% 1 1% 3 2% 5 1% 10 1%
This table summarizes earnings management activities by groups. It presents average number of each
activity by groups, and number and percentage of firms reporting zero time, one-to-three times, and
more-than-three times such activities. For 698 2002 Shanghai Stock Exchange companies who reported
a valid ROE, those with ROE less than –10% are classified into Big Loss Group, those with ROE
between 0% and 2% into Small Profit Group, and those with ROE between 6% and 8% into Rights
Offering Group. All others are classified into Other Firms Group. Equity sales and equity purchases
refer to companies selling or buying ownership of other companies; asset sales, asset purchase, and
asset exchange refer to selling, buying, and exchanging of fixed assets; December activities refers to
any equity activities that occur in December of calendar year (all Chinese companies have December as
fiscal year end); activities with subsidiary refer to dealings with a subsidiary.
Table 2 Differences in Reporting Earnings Management Activities among ROE Groups
---Number of Firms Reporting At Least One Earnings Management Activity
Earnings Management Activities
Equity Sales Equity Asset Sales December With Subsidiary
Asset Purchase Asset Exchange Any Activities
Freq. % Freq. % Freq. % Freq. % Freq. % Freq. % Freq. % Freq. %
Big Loss 13 9% 9
Firms (1) 23% 5 16% 7 12% 5 9% 31 53% 9 16% 10 18%
Small Profit Firms 22 20% 15
25% 18 17% 10 11% 14% 52 59% 21 24% 15 17%
Rights Offering 33 31% 16
20% 52 10% 34 21% 11 7% 93 55% 41 25% 47 28%
Other Firms (4) 85 27% 39
22% 101 11% 75 19% 28 7% 221 58% 77 20% 88 23%
Difference in Frequency of Earnings Management Activities Between Groups
(1) – (4) 1% -18% 5% -7% 2% -5% -4% -5%
(2) – (4) 2% -7% 6% -8% 7% 1% 4% -6%
(3) – (4) -2% 4% -1% 2% 0% -3% 5% 5%
This table presents differences in frequency of occurrence of earnings management activities. For all 2002 Shanghai Stock Exchange companies who reported a valid ROE, those with ROE less
than –10% are classified into Big Loss Group, those with ROE between 0% and 2% into Small Profit Group, and those with ROE between 6% and 8% into Rights Offering Group. All others are
classified into Other Firms Group. This table for each group reports the number of firms and percentage of firms in respective group reporting at least one activity of equity sales, equity
purchase, asset sales, asset purchase, and asset exchanges. We use K-squared test to test the difference of the percentages between groups. Statistically significant differences are highlighted in
Table 3 The Impact of Earnings Management Activities on Earnings by Group
Impact on Earnings of Earnings Management Activities
Equity and Gains on Total
Asset Equity or
Equity and Purchase Asset Sales
Big Loss Firms (1) 0.030 0.006 0.020 0.029
Small Profit Firms (2) -0.004* 0.015 0.028 0.024
Rights Offering Firms (3) 0.050 0.004 0.020 0.027
Other Firms (4) 0.002 -0.013 0.014 -0.001
(1) – (4) 0.028 0.019 0.005 0.029
(2) – (4) -0.007 0.027 0.014 0.024
(3) – (4) 0.047 0.017 0.006 0.028
*The magnitude of this number is mainly due to one extreme observation. After getting rid of this
extreme observation, it is 0.0029.
This table presents the impact of earnings management activities on earnings by groups. For all 2002
Shanghai Stock Exchange companies who reported a valid ROE, those with ROE less than –10% are classified
into Big Loss Group, those with ROE between 0% and 2% into Small Profit Group, and those with ROE between
6% and 8% into Rights Offering Group. All others are classified into Other Firms Group. The second column
reports contributions to earnings from beginning of the year to the date equity or asset is sold. The third column
reports the contributions to earnings from the date of equity purchase or asset purchase to fiscal year end. The
fourth column reports gains on equity or asset sales. The last column reports the combined effects.
Table 4 Descriptive Statistics
Big Loss Small Rights All Firms
Firms Profit Offering
Firms Firms Other Firms
Number of observations 58 88 168 698
ROE -110.16 1.03 6.83 -2.82
(-36.01) (0.98) (6.67) 8.27 (6.3)
% Controlling Ownership 36.50 45.38 44.48 44.99
(33.02) (45.74) (44.19) 46.56 (44.90)
% Government Ownership 21.81 29.91 30.03 30.32
(19.09) (31.33) (31.58) 32.00 (30.49)
Market-to-Book Ratio 6.60 4.89 4.80 6.95
(5.16) (4.47) (4.04) 8.44 (4.29)
Total Assets (millions) 1242.47 2235.76 2168.09 2717.79
(933.52) (1247.90) (1307.65) 3324.68 (1217.09)
This table presents summary statistics of our sample. For 698 2002 Shanghai Stock Exchange
companies who reported a valid ROE, those with ROE less than –10% are classified into Big Loss
Group, those with ROE between 0% and 2% into Small Profit Group, and those with ROE
between 6% and 8% into Rights Offering Group. All others are classified into Other Firms Group.
ROE is return on equity; % controlling ownership is the percentage of common shares owned by
controlling shareholders; % government ownership is the percentage of common shares owned by
various levels and branches of Chinese government; Market-to-Book ration is market
capitalization divided by total equity. Other than ROE, variables are measured at beginning of
Table 5 Probit Regression of Companies Reporting Earnings Management Activities on
Predicted Parameter P-value
Intercept -0.190 0.58 0.44
Earnings Management Group + -0.049 0.08 0.78
% Controlling Ownership + 0.026 18.68 <0.01
% Government Ownership + -0.007 3.82 0.05
Market-to-Book Ratio + 0.002 0.32 0.57
Total Assets + -0.000 0.75 0.39
Log Likelihood Ratio: -384.41
Number of Observation: 617
This table reports Probit regression results. The dependent variable takes value one if a company
reports more than one earnings management activities, and zero otherwise. For 617 2002
Shanghai Stock Exchange companies who reported a valid ROE, those with ROE less than –10%
are classified into Big Loss Group, those with ROE between 0% and 2% into Small Profit Group,
and those with ROE between 6% and 8% into Rights Offering Group. All others are classified into
Other Firms Group. Earnings Management Group includes big loss group, small profit group and
rights offering group. ROE is return on equity; % controlling ownership is the percentage of
common shares owned by controlling shareholders; % government ownership is the percentage of
common shares owned by various levels and branches of Chinese government; Market-to-Book
ration is market capitalization divided by total equity. Other than ROE, variables are measured at
beginning of year.