Earnings Management and Tunneling through Related Party Transactions: Evidence from Chinese Corporate Groups

Abstract

From the U.S. accounting scandals to the emerging markets crisis of 1997-1998, there have been numerous examples of managers or large shareholders using related party transactions to manipulate earnings or divert resources away from their companies. This paper attempts to provide large sample evidence of these transactions in China where the corporate structure, economic institutions and weak legal system are conducive to the related party dealings. Using a sample of 131 Chinese listed firms in the basic materials industries such as mining, lumber, chemicals and building materials, we have found that firms that are controlled by a corporate group engage in more related party transactions than firms that are not. Among the group-controlled listed firms, the results show that they report abnormally high levels of related party sales, mainly to their controlling shareholders and other member firms in the group, when they have incentives to inflate earnings to avoid being delisted or prior to issuing new equity. Once the group-controlled listed firms have generated more free cash flows, they divert resources back to the group through providing other member firms generous trade credits. Our stock return results also confirm the conjectures that at least part of the related party transactions is perceived by the market as opportunistic. Investors view the reported sales figures to be less credible when they are generated from related party dealings than through arm's length transactions. Related party lending is negatively correlated with firm value, as measured by Tobin's Q and market-to-book equity.