Does Foreign Ownership Restrict Earnings Management? The Case of China

Sang Ho Kim,Prabu Udawatte,Yohan An

doi:10.21315/aamjaf2020.16.1.4

Abstract

This study examines the effects of foreign ownership on Chinese firmsâ€™ earnings management practices. Given that foreign shareholders are expected to increase the transparency of the firmâ€™s management, this study anticipates that foreign ownership would restrict earnings management of both the accrual-based earnings management (AEM), and real activity-based earnings management (REM). Using the panel dataset of the B-share and H-share firms from 2003 to 2015, this study finds that the H-share firms which cross-listed on both the mainland China and Hong Kong Stock Exchanges are more likely to manage earnings through the discretionary accruals as well as the changes in the firmsâ€™ operations. In contrast the B-share firms are less likely to manage earnings by using the discretionary accruals. This study also finds that state control and large shareholdings of foreigners can restrict the B-share firmsâ€™ earnings management through the discretionary accruals. The findings noted in this study imply that foreign investors who want to invest in Chinese firms must be more cautious about market inefficiency and the information asymmetry problem in the Chinese stock markets.

Highlights

This study investigates the effect of foreign ownership on Chinese firms’ earnings management practices
This means that there is considerable market inefficiency, and information asymmetry problems in the Chinese stock markets, for foreign investors Chinese firms primarily operate in mainland China, and foreigners can trade their shares at restricted locations such as Shanghai, Shenzhen, or Hong Kong
The results generated in this study showed that the H-share firms which cross-listed their shares on both mainland stock exchanges, and the Hong Kong Stock Exchange (HKSE), were more likely to engage in earnings management by using the accrual-based earnings management (AEM) and the real activitybased earnings management (REM) methods

Summary

Introduction

This study investigates the effect of foreign ownership on Chinese firms’ earnings management practices. Qualified firms can issue B-shares for foreign investors They can opt to cross-list their shares on the Hong Kong Stock Exchange (HKSE) by issuing H-shares (Su, 2003). There is a constant price discount of B-shares and H-shares that are open to foreign investments (Su, 2003; Mei, Scheinkman, & Xiong, 2005) This means that there is considerable market inefficiency, and information asymmetry problems in the Chinese stock markets, for foreign investors Chinese firms primarily operate in mainland China, and foreigners can trade their shares at restricted locations such as Shanghai, Shenzhen, or Hong Kong. The insiders of such firms (such as the managers and the domestic investors) may have a strong incentive to pursue their own agenda, thereby jeopardising the interests of the outsiders (such as the foreign investors’ interests)

Methods

Results

Conclusion