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With the international accounting convergence in real terms after the earnings quality will change? Empirical data from Chinese

Author: GuoRenJie
Tutor: ZhouHong
School: Fudan University
Course: Business management
Keywords: Earnings quality IFRS Threshold
CLC: F233
Type: Master's thesis
Year: 2011
Downloads: 170
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Abstract

Coming into effect on January 1st,2007, the new Chinese Accounting Standards have realized substantial convergence with International Accounting Standards (IAS and IFRS), leaving only minor divergence. IFRS is considered by scholars as a set of accounting standards, limiting opportunistic discretion by managers and hence increasing accounting quality (Barth et al.,2008). However, former researches have revealed that Chinese listed companies not only manipulate earnings to exceed thresholds, but also change their behavior of earnings management, given improvements of accounting standards (Yu et al.,2006). In addition, concerns have been raised about the effective implementation of the new accounting standards. Therefore, this paper is dedicated to detect whether earnings quality of Chinese listed companies, in particular, the pervasiveness of earnings management, changed after the transition to this IFRS-cored set of standards.The investigation of this paper is concentrated on earnings management to exceed threshold zero. The logic is firstly to detect the existence of earnings management among listed companies; if so, the second step is to compare the pervasiveness of earnings management before and after the adoption of the 2007 new standards. In the study, I choose year 2004 and 2005 as representatives of the years before the transition to the new standards, while year 2007 and 2008 as that of post transition years.1211 listed companies, from both Shanghai and Shenzhen Stock Exchanges are involved in the study. Following the logic of the research, the variable IBEXt/LTAt-1 (IBEX stands for income before extraordinary items and LTA stands for lagged total assets) is developed as the measure of earnings in the histograms of earnings distributions, where we pay extra attention to the observations in the two intervals adjacent to the zero point, namely ’small profits’ and ’small losses’. As a matter of fact, obvious discontinuities appear between these two intervals, in all the four years examined. The number of observations in the ’small losses’ area is extremely small, and whereas the number of observations in the ’small profits’ area is abnormally large. Given the fact that normal earnings distribution should be quite smooth, I conclude that Chinese listed firms, as a whole, heavily engage in earnings management, moving the earnings upwards to exceed the zero threshold. More importantly, I would like to test whether the adoption of the new accounting standards could change this phenomenon. A ratio of number of observations of small profits/observations of small losses, i.e. the asymmetry of small profits and small losses observations, is thereby adopted as the measure of the pervasiveness of earnings management. The greater the asymmetry, the more pervasive is earnings management. I run a chi square test to examine whether this ratio varies in the four years. The statistical test cannot prove that there is a change in the ratio during the years, pre and post the transition. Therefore, I detect no evidence to suggest the pervasiveness of earnings management change after the transition of standards.There are possible explanations for this result. First, IFRS per se may provide greater opportunity for firms to manage earnings (Barth et al.,2008). The inherent flexibility of IFRS offers more space for firms to manipulate their reported earnings. The second possible reason is the competence of Chinese accountants and auditors in complying with the new accounting standards. Their capability have been doubted by Tang (2000), not to mention that IFRS is a set of accounting standards that require frequent judgment of accounting professionals. The last explanation, and the most important one, is the strong motivation of managers to avoid loss reporting. Chinese securities laws and regulations mandate that if a listed firm reports negative earnings in two consecutive years, its stock will be put under’Special Treatment’status (ST) (Jiang& Wang,2008). Various trading and financial restrictions are imposed on an ST stock. Moreover, if the firm reports one more loss in the third consecutive year, it will be suspended from trading on the stock exchanges; after a fourth annual loss the stock will be delisted. In this policy, the recognition of loss is independent on the extent of the loss. Once a loss occurs, no matter how slight it is, it is recorded as a qualified loss. Under such a circumstance, managers have strong motivation to move small losses upwards to become small profits in order to avoid complying with stricter rules. Yu et al. (2006) find out that Chinese listed not only heavily engaged in earnings management, but also changed their behavior in response to changes in regulatory requirements. We may infer that with the improvement of accounting standards, managers would still discover new techniques to manage earnings. Therefore, under such a strong incentive, changing standards alone seems not that effective.Given the consensus that IFRS is of higher accounting quality than most of the domestic accounting standards in the world, including the former Chinese accounting standards, my opinion is that accounting standards in themselves are not sufficient to guarantee higher earnings quality, based on the result of this paper. Other factors, such as enforcement of the standards, management incentives, authorities’regulations, and even accountants and auditors’competence, are of vital importance in producing financial information that accurately reflects the performance of companies. Therefore, when the Chinese Ministry of Finance are striving to improve the quality of financial information, extra efforts are suggested to be devoted to these aspects, other than hastily looking for the most advanced accounting standards in the world alone. Not only accounting standards, but also every aspect of the accounting reporting system needs to be improved, before earnings quality can be increased.

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