Controlling Shareholder’s Share Pledging and Accounting Manipulations

Abstract

A controlling shareholder can pledge shares to secure personal loans while retaining control of the firm, but share pledging increases the risk of a margin call and the possibility of losing control of the firm. We investigate how share pledging by controlling shareholders influences the financial reporting of the firm. Considering the different pledgor ‘types’, incentives and institutions across countries, we detail and take advantage of these differences and data availability to focus on China-listed firms. We find that firms with controlling shareholders pledging their shares are more likely to manipulate accounting numbers of the firm to avoid such margin call risks. Specifically, we find that firms with controlling shareholders pledging their shares have more positive discretionary accruals, more income-increasing real earnings management, and a higher propensity of using non-recurring items to avoid losses. We find that the level of accrual-based earnings management declines while levels of real earnings management and non-recurring items continue as the controlling shareholder repeatedly pledges his\her shares. Such manipulations reverse when controlling shareholders cease their pledge. Firms with controlling shareholders who pledge their shares exhibit more restatements, worse audit opinions, and more sanctions by regulators, which implies financial reporting quality suffers. Collectively, our evidence is consistent with the view that with shares pledged as collateral, the controlling shareholder responds to the incentives and institutions in place by exerting influence over the firm’s financial reporting to defend the value of the share price.