The impact of corporate governance and ownership structure reforms on earnings quality in China

• Published date: 05 May 2015
• Pages: 169-198
• Date: 05 May 2015
• DOI: https://doi.org/10.1108/IJAIM-05-2014-0035
• Author: Xu_Dong Ji,Kamran Ahmed,Wei Lu
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

The impact of corporate

governance and ownership

structure reforms on earnings

quality in China

Xu_Dong Ji and Kamran Ahmed

Department of Accounting, La Trobe University, Melbourne, Australia, and

Wei Lu

Department of Accounting, Monash University, Clayton, Australia

Abstract

Purpose – The purpose of this paper is to investigate the effect of corporate governance and

ownership structures on earnings quality in China both prior and subsequent to two important

corporate reforms: the code of corporate governance (CCG) in 2002 and the split share structure reform

(SSR) in 2005.

Design/methodology/approach – This study utilises informativeness of earnings (earnings

response coefcient), conditional accounting conservatism and managerial discretionary accruals to

assess earnings quality using 12,267 rm-year observations over 11 years from 2000 to 2010. Further,

two dummy variables for measuring the changes of CCG and SSR are employed to estimate the effects

of CCG and SSR reforms on earnings quality via OLS regression.

Findings – This study nds that the promulgation of the CCG in 2002 has had a positive impact, but

the SSR reform in 2005 has had little effect on listed rms’ earnings quality in China. These results hold

good after controlling for a number of ownership, governance and other variables and estimating

models with multiple measures of earnings’ quality.

Research limitations/implications – Future research could focus on how western style corporate

governance mechanisms have been constrained by the old management systems and governmental

dominated ownership structures in Chinese listed rms. The conclusion is that simply coping Western

corporate governance model is not suitable for every country.

Practical implications – The results will assist Chinese regulators in improving reporting quality,

ownership structure and governance mechanisms in China. The results will help international investors

better understand quality of nancial information in China.

Originality/value – This is the rst to our knowledge that addresses the effects of major governance

and ownership reforms together on accounting earnings quality and, thus, makes a signicant

contribution on understanding the effect of regulatory reforms on improving earnings quality. In doing

so, it also indirectly assesses the effectiveness of western-style corporate governance mechanisms

introduced in China.

Keywords Accounting conservatism, Discretionary accruals, China, Earnings informativeness,

Governance reforms, Ownership reforms, Governance reform, Split-share structure reform

Paper type Research paper

1. Introduction

In this paper, we examine whether corporate earnings quality has improved following

two major reforms on corporate governance and ownership structure in China. In 2002,

The current issue and full text archive of this journal is available on Emerald Insight at:

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Earnings

quality in

China

169

Received 11 May 2014

Revised 29 May 2014

Accepted 29 May 2014

InternationalJournal of

Accounting& Information

Management

Vol.23 No. 2, 2015

pp.169-198

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-05-2014-0035

China implemented the code of corporate governance (CCG) for listed companies to

protect investors’ rights and interest, and to articulate behavioural rules and moral

standards for directors, supervisors and other senior managers of listed companies

(CSRC, 2002). This was followed by the split share structure reform (SSR) in 2005, which

required all companies, including state-owned, to convert non-tradable shares into

tradable shares, allowing them to be traded on the stock market in the same way as

shares held by private shareholders and become more sensitive to share price

movements. These two reforms were in response to criticisms that Chinese securities are

too restrictive for investors and the country has a negligible market control mechanism,

weak corporate governance structure, an inefcient managerial labour market and a

lack of credibility of nancial information (Firth et al., 2011;Peng et al., 2010). Prior to

these reforms, boards of directors in Chinese state-owned and private companies were

dominated by insiders, particularly Communist Party members, and ownership was

highly concentrated (Aharony et al., 2000). This situation created a serious problem

whereby a lack of proper monitoring of rm operations allowed dominant shareholders

to expropriate the wealth of other shareholders. Further, the high concentration of

shareholding created entrenchment problems in Chinese rms, resulting in lower

governance quality and nancial transparencies (Gul et al., 2010). For example, Peng

et al. (2010) estimated that in some years, more than 80 per cent of rms were involved

in related-party transactions. They found that controlling shareholders had

manipulated earnings and assets in listed companies through tunnelling or propping

mechanisms.

By implementing changes in board composition, such as appointing independent

directors through the implementation of CCG and allowing shares owned by state

enterprises to be oated on the market under SSR, it is expected that entrenchment

problems embedded in Chinese rms would be mitigated and, thus, reduce agency

conicts among the parties involved. Prior research has established the positive effect of

better governance and diversied ownership on nancial reporting quality through

mitigating agency conicts (Morck et al., 1988;Farinha, 2003;Brown and Caylor, 2006;

Firth et al., 2007;La Porta et al., 1999,2000). It has also been suggested that concentrated

share ownership has implications for the level of information asymmetry between

managers and investors, and that this inuences the informativeness of accounting

earnings and managers’ accounting choices (Bhagat et al., 1999;Fan and Wong, 2002;

Firth et al., 2007).

Firth et al. (2007) explored these unique ownership and corporate governance

structures in Chinese rms and examined their effect on the earnings quality in China.

They found that ownership concentration, the presence of foreign shareholders, the

percentage of tradable shares, the type of dominant shareholders, the supervisory board

and independent directors, all affected the earnings quality of listed rms. Later, Cho

and Rui (2009) examined the effect of corporate governance quality on earnings

informativeness and found that board independence was not signicant, but such a

relation improved one year (2003) after CGC implementation. With regard to ownership

structure, Yuan et al. (2007), using data from 273 companies in 2002, found a higher level

of earnings management in state-owned enterprises (SOEs) which they interpreted as

being due to a greater entrenchment effect in these enterprises. Similarly, Chen et al.

(2010) found SOEs in China practice less quality reporting (as measured by conservative

accounting) compared with non-SOEs when they borrow funds from state-owned

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