Can Stock Exchange Front-Line Supervision Identify Capital Market Risks? Evidence from the Annual Report Inquiry Letter

Abstract

The corporate earnings management behavior will reduce the efficiency of capital market pricing, resulting in the accumulation of bubbles”, which is an important factor influencing risk hazards. In recent years, strengthening the front-line supervision of the exchange is an important action for China’s capital market to fill shortcomings. Therefore, it is of great significance to explore whether the front-line supervision of the exchange can identify the corporate earnings management behavior and to verify its active prevention and mitigation of risks. Based on the evidence of the annual report inquiry letter, this study uses Heckman’s two-stage approach to further explore whether the exchange has the whistleblower” risk screening ability on listed companies’ earnings management behavior. The results of the study show that: First, the higher the corporate accrued earnings management level is, the higher the probability of acceptance of the inquiry letter is, and in the sample of companies receiving the annual report inquiry letter, the higher the higher the accuracy of the inquiry letter is, which shows that the inquiry letter has a precise recognition function. Second, the cross-section grouping finds that the inquiry letter identifies more obviously in non-state-owned companies, Shenzhen Stock Exchange listed companies, and the media’s earnings management with high degree of concern and good legal environment. Third, the scalability test finds that the inquiry letter also has a screening effect on the relatively hidden real earnings management, and the inquiry letter mainly plays the role of reducing market information asymmetry by reducing companies’ future accounting performance for positive earnings management. This paper has the following contributions: First, the existing domestic literature mainly explores the economic consequences of the inquiry letter from the aspects of market reaction, audit quality, stock price crash risk and earnings management, but has not yet begun to pay attention to the influencing factors of the inquiry letter. Different from Chen, et al. （2019）, whether the inquiry letter can reduce the future earnings management behavior from the perspective of economic consequences, this paper mainly studies whether the current corporate earnings management can trigger the identification and supervision of the exchange annual inquiry letter from the perspective of influencing factors. The risk identification function of the inspection inquiry letter is precisely the important premise of the exchange’s governance role. It enriches and supplements the research on the effectiveness of the front-line supervision of the exchange by Chen, et al. （2019）, and also expands the study perspective of the domestic inquiry letter to a certain extent. According to the literature that the author has mastered, the existing research on the influencing factors of the inquiry letter abroad is mainly based on profitability, audit quality, corporate governance, tax evasion, political connections, etc. However, it has not yet paid attention to whether the corporate earnings management behavior can be accurately identified by the inquiry letter, which enriches the research on the influencing factors of the inquiry letter to a certain extent. Second, the existing literature mainly focuses on the impact of earnings management from the perspective of banks, firms and auditors, but lacks the perspective of public law enforcement to explore the economic consequences of earnings management. As a front-line of supervision, whether the exchange is sensitive to earnings management is of great significance to prevent the occurrence of risks. Third, different from the SEC comment letter in US, the main body of the Chinese inquiry letter is mainly a lower-level exchange. Exploring the effectiveness of the inquiry letter with Chinese characteristics can complement the literature in this field. It is also a test of the effect of the deepening the reform of the regulatory system” of the 19th National Congress and the reform of the information disclosure through the train policy in 2013.