Corporate governance and accounting scandals

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An empirical study on the ownership structure and earnings quality of the listed companies in Zhejiang Province in China

Introduction

Nowadays, many major scandals happened around the word which significantly influenced investors' faith in published company accounts. Top executives have been found to manage their earnings aggressively. They present high earnings quality to show their companies' good apparent performance. As in Chinese stock market many studies provide strong evidence that Chinese listed companies will provide high earnings quality in order to gain authorization for an IPO, to issue new shares or to avoid being delisted. It means that company has the incentives to manage earnings to achieve high earnings quality to meet the regulatory requirements. (Aharony et al., 2002; Liu and Lu,2002; Chen and Yuan, 2004; Jian and Wong,2004). From the agency perspective, we consider the earnings quality management structure as one signal of the agency problem confronted with modern corporations. Because ownership structure is the primary determinant of agency cost, this study attempts to link Company's ownership structure and earnings quality. Ownership structure can be defined as two dimensions: ownership concentration and ownership mix. The former refers to the percentage of majority of shareholders' shares while the latter is related to the identity of the major shareholder. In this study, I will investigate that how the ownership concentration influence the earnings quality and the relationship between ownership identity and earnings quality.

Literature Review

earnings quality

Previous researchers gave various definitions of earnings quality which emphasized on the quality, profits, persistent and predictability, steady and value relativity.

The Hawkins (1998) thinks that high earnings quality should be stable, predicted and reflect the trend of the income level in the future. Meanwhile, the earnings quality not only involves the income, finance activity, the management characteristic will be set to income quality as a sequence creation influence. Moreover, the outside factors such as the economic environment, tax policy etc. also play important roles in deciding the company's earnings quality.

Penman and Zhang (2002) claims that before the company discloses abnormally items, if the earnings can present the future earning level, then the earning quality is high.

In 2002, American accountancy's master (AAA) defines earnings quality from the cash perspective: earnings quality is inversely related to the amount of time elapsed between revenue (income) recognition and cash collection.

This paper agree with Dechow and Schrand (2004) 's view. Three conditions should be satisfied if a company is considered to have high earning quality. Firstly, if reflects current operating conditions. Secondly, it well predicts future operating condition. Thirdly, it really reflects the company's intrinsic value.

Ownership structure

Shleifer and Vishny (1997) define the ownership structure as the concentration in a firm's ownership and the identity of a firm's owners. It influences a firm's corporate governance, its strategies and its performance.

Jensen and Meckling (1976) consider that ownership structure concerns "the relative amounts of ownership claims held by insides (management) and outsides (investors with no direct role in the management of the firm)".

Borbosa and Louri (2002) think that ownership structure is an incentive device for reducing the agency costs, which can be used to protect property rights, which cannot be fully contracted out.

How to evaluate earnings quality?

There are two main methods to evaluate the earnings quality.

The first method is the accrual quality model. This model first suggested by Dechow and Dichev (2002). In his approach, "the estimated residuals from firm specific regressions of working capital accruals on past, present, and future cash flow from operation capture total accruals estimation error by management and are viewed as an inverse measure of earnings quality". Francis et al. (2005) add two extra variables which are "change in revenue and property, plant and equipment (PPE) for more complete characterization of the relation between accruals and cash flow" to the Dechow and Dichev's accrual quality model.

The other model is ESC (earnings response coefficient) model. This model is under efficient market hypothesis. ESC measures and evaluates the earning quality from the market's aspect. It can use the information supported in a company's announcement to estimate of the change in a stock price. (Hotchkiss & Strickland ,2003)

Ownership concentration, ownership mix and earnings quality

Ownership structure can be defined as two dimensions: ownership concentration and ownership mix.

Hill and Snell (1988) show that ownership structure affect firm's performance as the ownership concentration motivates innovation that leads to value maximization. Fan and Wong (2002) find out East Asian firms that higher concentration is associated with lower earnings infromativeness, consistent with the entrenchment hypothesis that controlling shareholders have higher incentives to manipulate earnings in order to hide outright expropriation.

Alchian (1977) and Shleifer (1998)indicate that state ownership entails inferior governance quality compared to private ownership because of a contracting ability problem. Considering the formal literature, I predict that ownership concentration will lead to a weaker entrenchment effect in privately owned companies than in state-owned companies.

China has its own special ownership categorization scheme. Sun and Tong (2002) classify the firm's share-holders into three main groups: state, legal person and tradable A and B share. Each of them hold about 30% of the total stock in these listed firms.

Sun et al. (2002) suggest that the relation between state ownership and performance belongs to an inverted U-shape. While Wei and Varela (2003) claimed that the relation could be convex in fact.

Alchian (1961) suggests that private ownership firms should outperform government ownership firms on companies' performance.

According to Aharoni (2000), owners of private firms who have the revenue rights and residual control rights have an incentive to monitor the management behavior closely, thereby influencing a firm's performance positively.

Anna and Lin (2003) conclude that financial performance of mixed ownership structure companies tends to be poor compared with other types of ownership structure companies.

Research questions

The objective of this paper is to examine how ownership structure in Zhejiang province listed companies affects the companies' earnings quality. More specifically, I examine how ownership concentration influences the earnings quality in a company and the relationship between ownership identity and earnings quality. The specific questions of the research are:

  1. What is earnings quality?
  2. How to evaluate earnings quality?
  3. What is ownership structure?
  4. What is ownership structure in China?
  5. Whether and how ownership concentration influences earnings quality?
  6. What is the relationship between ownership identity and earnings quality?

Methodology

Research philosophy and approach

My paper belongs to functionalist paradigm. It is an objective regulation. (Jill Colllis & Roger Hussey,2003). The structure of my paper follows as that: starting point is theory. I will have a review of the existing literature on earnings quality, ownership structure and the relationship between ownership structure and earnings quality. The literature review will concentrate on the affection of ownership concentration and ownership mix on earnings quality. Then hypothesizes are logically deduced from theory. I will give two hypothesizes in this paper. After that it is tested through observation. Several models will be used to test the hypothesizes if they are positive. Furthermore, method is a specific research technique to collect and analyze data. It is good fit with theory, hypothesis and methodology. (Bob Ryan, Robert Scapens & Michael Theobald,1992). My paper mainly uses quantitative method. It involves collecting and analyzing numerical data and applying statistical tests. I use cross-sectional multivariate regression analysis to test the relationship between different variables. As for data, I mainly use existing secondary data. I collect data from China Stock Marketand Accounting Research Database (CSMAR) and company's annual report.

Research design

Ownership structure and earnings quality and testable hypothesis

My study focus on the relationship between ownership structure and earnings quality. Ownership has two dimensions: ownership concentration and identity of ownership. I believe both of them have influenced earnings quality in Zhejiang listed companies on SHSE. My general hypothesizes are: H1: The relationship between shareholding concentration and earnings quality follows an inverted U-shape pattern. H2: The firm's earnings quality is positively correlated with the fraction of legal person shares, but it neither negatively correlated nor uncorrelated with the fraction of state shares and tradable A-share held mostly by individuals.

Sampling selection

At the end of year 2009, there are 66 financial and non-financial Zhejiang companies listed on SHSE (Shanghai Stock Exchange). I use pooled firm-level data for 2007, 2008, 2009. The sample selection of this paper follows three principles. Firstly, due to different statutory demands, all banks, insurance and unit trusts companies were eliminated from the population of interest because they present different incentives and opportunities to manage earnings (Peasnell et al, 2000; Abdul Rahman & Mohamend Ali, 2006). Secondly, "ST" and "PT" companies are excluded from the samples because they have special financial position and operating outcomes compared with normally operated companies. Thirdly, companies with incomplete data disclosure in the annual reports will be eliminated. The final sample of this study consists of 60 non financial companies with complete data for earnings quality and ownership structure. Earnings quality data is gained from the China Stock Marketand Accounting Research Database (CSMAR) and any missing financial data were obtained manually from annual reports. Information for ownership was obtained by examining the disclosure in annual reports.

Variables

Dependent variables

There are many ways to evaluate earnings quality. In this paper, I choose ERC (earnings response correlation) to evaluate companies' earnings quality. ERC can use the information supported in a company's announcement to estimate of the change in a stock price.

Independent variables and controlled variables

In order to test the hypothesis, we need to find some independent variables to evaluate the ownership structure. My primary independent variables across the regressions focus on the ownership concentration. CR1, CR10 and H10 will be used as independent variables. After that, FST, FLP and FTA are used as independent variables to evaluate the ownership mix.

According to the Fama-French three-factor model, risk, company size and growth will influence the stock returns. Therefore, I use LEV, SIZE and TQ as controlled variables to represent these factors respectively.

Empirical test

Using cross-sectional multivariate regression, I first regress earnings quality variables on concentration ratios without distinguishing different ownership mix. The purpose is to investigate whether and how ownership concentration influences earnings quality. After that, I examine effects on a company's earnings quality of state shares, legal person shares and tradable A- share held largely by individuals respectively. In order to test hypothesis, I will use some models. The basic model to evaluate earnings quality is:

The limitation of this dissertation

There are still some limitations in this paper. Firstly, the number of this paper's sample is not very large. I only choose Zhejiang listed companies on SHSE. Secondly, when I choose the controlled variables, I choose SIZE, LEV and TQ but I do not choose the sector as a variable. In fact, according to the former research, sector plays an important role in earnings quality. If we classify the samples by the sector, the samples will be very small. It cannot explain the importance of sector in the earnings quality. Thirdly, I use ERC (earnings response coefficient) to evaluate companies' earnings quality. But this model should be under efficient market hypothesis while if China's capital market is efficient should be considered. Therefore, further studies should focus on these limitations and put these factors into research.

Timing

June:

  1. writing introduction
  2. finishing the part of literature review

July:

  1. learning SPSS software
  2. data gathering
  3. data process

August:

  1. reveal the findings from the regression
  2. analyzing the findings of the regression
  3. finishing the conclusion of the dissertation

September:

  1. finish the draft of the dissertation and doing revision
  2. reference and typesetting of the dissertation

Reference:

  • Abdul Rahman, R. and Mohamed Ali, F.H. (2006),Board, audit committee, culture and earnings management: Malaysian evidence, Managerial Auditing Journal,21 (7), 783-804.
  • Agrawal, A. and Chadha, S. (2002) ,Corporate Governance and Accounting Scandals, Working paper, University of Alabama.
  • Alchian, A., 1961. Some economics of property, Santa Monica, CA: Rand Corporation,P2316.
  • Aharoni, Y.(2000), The performance of state-owned enterprises, in P.A. Toninelli, The Rise and Fall of State-Owned Enterprise in the Western World, Cambridge,Cambridge University Press, 49-72.
  • Bob R, Robert S & Michael T.(1992) Research Method and Methodology in Finance and Accounting ,London, Academic Press.
  • Dechow, P.M. and Dichev, I.D. (2002),The quality of accruals and earnings: The role of accrual estimation errors,The Accounting Review, Supplement,77, 35-59.
  • Hawkins. (1998),Corporate financial reporting and analysis: Text and cases,4th Edition, McGraw-Hill Book, p 132-154.
  • Fan, J.P.H. and Wong, T.J. (2002), Corporate ownership structure and the informativeness of accounting earnings in East Asia.,Journal of Accounting and Economics,33,401-425.
  • Francis, J., LaFond, R., Olsson, P.M. and Schipper, K. (2005), The market pricing of accrual quality, Journal of Accounting and Economics, 39 (2), 295-327.
  • Hotchkiss, Edith S. and Deon Strickland, 2003. Does Shareholder Composition Matter? Evidence from the Market Reaction to Corporate Earnings Announcements, Journal of Finance, 58(4), p.1469-1498.
  • Jensen, M.C. and Meckling, W.H. (1976), Theory of the firm: managerial behavior, agency costs and ownership structure, Journal of Financial Economics,3(40), 305-360.
  • Jill C & Roger H. (2003), Business Research, 2nd, Bristol,Palgrave Macmillam.
  • Penman.S and X-J. Zhang.(2002),The accounting conservatism, the quality of earnings and stock returns ,The Accounting Review, 77,237-264.
  • Shleifer, A. and Vishny, R.W. (1997), A survey of corporate governance, The Journal of Finance, 52, 737-783.
  • Sun, Q., Tong, W.H.S., (2002). How does government ownership affect firm performance? Evidence from China's privatization experience, Journal of Business Finance and Accounting ,29 (1&2), 1-27.
  • Wei, Z., Varela, O.(2003),State equity ownership and firm market performance: evidence from China's newly privatized firms, Global Finance Journal, 14, 65-82.

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