Earnings Management, Asset Restructuring, and the Threat of Exchange Delisting in an Earnings‐based Regulatory Regime

• Author: Ann Jorissen,Peng Cheng,Walter Aerts
• Date: 01 September 2010
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00780.x
• Published date: 01 September 2010

Earnings Management, Asset Restructuring, and

the Threat of Exchange Delisting in an

Earnings-based Regulatory Regimecorg_780438..456

Peng Cheng*, Walter Aerts, and Ann Jorissen

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines the effect of an earnings-based listing regulation on corporate f‌inancial

reporting management. In 2001, China revised its listing standards requiring compulsory stock suspension for f‌irms

reporting three-year consecutive losses. Suspended stocks are further delisted if they continue to report losses in the year

of stock suspension.

Research Findings/Insights: Our results show that f‌irms approaching the delisting procedure use more earnings manage-

ment, although the effect is minor. Meanwhile, we observe that delisting risk induces extensive performance-enhancing

asset restructuring activities. For f‌irms turning losses into prof‌its, our evidence suggests a negative relationship between

earnings management and asset restructuring.

Theoretical/Academic Implications: This study extends the earnings management literature by suggesting that earnings

management to avoid losses is likely to increase with the severity of the losses and decline with asset restructuring activities.

In addition, this research adds to the literature on the economic consequences of the delisting process.

Practitioner/Policy Implications: The study provides evidence that an earnings-based delisting regulation is a double-

edged sword which leads to either earnings management or performance-enhancing asset restructuring activities. By

pointing out the earnings management and restructuring effects of the Chinese delisting regime, we may inform policy

makers of the economic consequences of an earnings-based regime. This adds to prior evidence on the effects of market-

based delisting thresholds. In addition, the study highlights that the earnings-based delisting regulation does not create a

level playing f‌ield, since state-controlled f‌irms are at an advantage to use more government-led asset restructurings through

state-owned shareholders in order to avoid delisting.

Keywords: Corporate Governance, Earnings Management, Asset Restructuring, Earnings-based Delisting Regulation,

China

INTRODUCTION

In this research, we investigate how Chinese consecutive

loss f‌irms react to the threat of earnings-based compul-

sory exchange delisting. The Chinese securities authority

(China Securities Regulatory Commission, CSRC) promul-

gated a Special Treatment (ST) policy in 1998 requiring that

a f‌irm reporting losses in two consecutive years would be

labeled “ST” in front of its stock name, with its daily stock

quotation f‌luctuation limited to 5 per cent. The stock trading

should be immediately suspended, once the f‌irm reports a

third-year loss. Additionally, the CSRC (2001) formallyintro-

duced an exchange delisting procedure, requiring a ST f‌irm

to be delisted if it fails to report positive earnings in the year

of stock suspension (see Appendix A), in order to protect

investors.1This delisting regulation may trigger consecutive

loss f‌irms to manipulate reported earnings in order to main-

tain their listing status. Prior literature (Jiang & Wang, 2008)

shows that the ST policy created a strong earnings manage-

ment incentive for Chinese f‌irms in general to avoid losses,

as the percentage of small-prof‌it f‌irms relative to small-loss

f‌irms increased signif‌icantly since 1998. However, Jiang and

Wang(2008) do not show whether the delisting regulation in

2001 created an incremental earnings management for ST

*Address for correspondence: Department of Accounting and Finance, University of

Antwerpen, 13 Prinsstraat,2000 Antwerpen, Belgium. Tel: 0032 03 220 4123; Fax: 0032

03 220 4064; E-mail: peng.cheng@ua.ac.be

438

Corporate Governance: An International Review, 2010, 18(5): 438–456

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00780.x

f‌irms to avoid the delisting procedure, as the percentage of

small-prof‌it f‌irms relative to small-loss f‌irms went down

after 2001.

We extend this research by examining to what extent loss

f‌irms engage in more earnings management when getting

closer to the delisting procedure (i.e., three-year suspended

loss f‌irms against two-year ST loss f‌irms). We f‌ind only

minor evidence that f‌irms successfullyavoiding the delisting

procedure (three-year suspended loss f‌irms) use more earn-

ings management than f‌irms successfully avoiding the sus-

pension procedure (two-year ST loss f‌irms).

On the other hand, the delisting regulation induces

massive performance-enhancing asset restructuring activi-

ties (e.g., asset sales, asset exchanges, and asset purchases).

We f‌ind that suspended f‌irms engage in a substantially

higher level of asset restructuring than ST f‌irms. This f‌inding

is consistent with prior corporate restructuring literature

that distressed f‌irms undertake restructuring activities to

counter poor performance (Denis & Kruse, 2000; John, Lang,

& Netter, 1992; Lang, Poulsen, & Stulz, 1995). International

evidence from Japan (Kang & Shivdasani, 1997) and the UK

(Hillier, McColgan, & Werema, 2009) also supports this

argument. Most importantly, for f‌irms successfully turning

losses into prof‌its, our results indicate a negative relation-

ship between asset restructuring and earnings management.

The remainder of the paper is organized as follows.

Section 2 presents a literature review. Sections 3 and 4 intro-

duce the hypotheses and research design. Sections 5 and 6

present and discuss results. Section 7 concludes.

LITERATURE REVIEW

Earnings Management of Loss Firms

Firms trying to avoid delisting are typically in f‌inancial dis-

tress. Prior literature shows that earnings management of

f‌inancially-distressed f‌irms is mixed (Bradbury, 2007)–

distressed f‌irms may engage in income-increasing accruals

manipulation to reduce the impact of negative signals from

f‌inancial distress (Burgstahler & Dichev, 1997; DeFond &

Jiambalvo, 1994; Sweeney, 1994), or engage in income-

decreasing accruals manipulation for renegotiating debt

contracts with lenders (DeAngelo, DeAngelo, & Skinner,

1994; Saleh & Ahmed, 2005). Jaggi and Lee (2002) further

argue that the choice of income-increasing (or -decreasing) is

inf‌luenced by the severity of f‌inancial distress. In line with

Jaggi and Lee (2002), we examine how earnings manage-

ment choice of Chinese loss f‌irms differs according to the

severity level of losses (number of loss-reporting years).

Earnings Management Behavior of Chinese Firms

A number of studies document earnings management

behavior in the Chinese capital market. For example,

Chinese B-share2IPOs manage earnings through f‌inancial

packaging in the pre-IPO period (Aharony, Lee, & Wong,

2000). Moreover, Chinese f‌irms execute transactions involv-

ing non-operating items to meet regulatory Returns on

Equity (ROE) targets for rights issues (Chen & Yuan, 2004;

Haw, Qi, Wu, & Wu,2005). Consistent with Garcia-Meca and

Sanchez-Ballesta (2009), Liu and Lu (2007) conjecture that

earnings management in Chinese listed f‌irms maybe largely

due to concentrated ownership3and weak corporate gover-

nance.4Whereas these studies concentrate on incentives to

manage earnings in order to meet the earnings thresholds of

China’s earnings-based listing regulation (both IPO and

on-going standards), we investigate the impact of the

earnings-based delisting counterpart. Whereas Jiang and

Wang (2008) investigate the impact of the earnings-based

regulation by examining earnings histograms, we focus on

f‌irm-level evidence on earnings management and alterna-

tive performance-enhancing activities.

Compulsory Delisting Process

Prior literature on the role of accounting information in

involuntary security exchange delisting is limited. Involun-

tary delisting research in western markets tends to empha-

size market-based delisting thresholds: e.g., market

capitalization, closing stock price, public f‌loat (Chen &

Schoderbek, 1999; Clyde, Schultz, & Zaman, 1997; Leuz, Tri-

antis, & Wang,2006). However, several delisting regulations

use a mix of market-based and earnings-based delisting

thresholds (e.g., NASDAQ5). Firms listed in China are con-

fronted with both market-based and earnings-based contin-

ued listing criteria, but the earnings-based criteria tend to

dominate the delisting process in China.6

Prior western evidence shows that the delisting process

may be f‌lawed as it engenders signif‌icant costs (Macey,

O’Hara, & Pompilio, 2005) and tends to induce manipulative

market practices (Aggarwal & Wu, 2006; SEC (US Securities

Exchange Commission) Litigation Release No. 20828, 20087).

Our study examines a delisting incentive for earnings-based

manipulative practices.

HYPOTHESES

Consecutive losses and compulsory delisting would nor-

mally damage all three parties of a listed f‌irm – managers,

shareholders, and the f‌irm itself. First, consecutive losses

negatively affect managers’ reputation and performance-

based remuneration, and further jeopardize managers’ job

security (XihuaNews, 2008).8Second, involuntary delisting is

not at the best interest of shareholders. Once their shares are

delisted, their shares are often transferred to the less regu-

lated OTC markets, in which the liquidity for their shares is

very limited. Third, compulsory exchange delisting is gener-

ally a bad sign for the f‌irm itself as delisting may trigger the

f‌irm’s creditors to call in loans, the f‌irm’s credit rating might

be downgraded, and its interest expenses may increase sub-

stantially. Once removed from the exchange, it takes at least

three years to restore the exchange listing status.9

Hypothetically, Chinese f‌irms are highly inclined to avoid

consecutive losses and delisting procedure through earn-

ings management. Loss f‌irms may take measures to reduce

earnings in loss years and/or enhance earnings in the turn-

into-prof‌it year, in order to ensure that the compulsory

delisting process is not triggered. Whenreporting three-year

losses, the delisting risk increases signif‌icantly and it is more

likely that f‌irms avoid further losses through earnings man-

agement. Therefore, we hypothesize that:

EARNINGS MANAGEMENT, ASSET RESTRUCTURING, AND EARNINGS-BASED EXCHANGE DELISTING 439

Volume 18 Number 5 September 2010© 2010 Blackwell Publishing Ltd