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doi: 10.1111/j.1467-8411.2012.01334.x

A review of earnings management in China and

its implications apel_1334 84..92

Jingjing Yang, Jing Chi, and Martin Young*

This paper discusses the motivations behind the earnings management of

listed firms in China and provides evidence on earnings management
using various accounting measures. The literature shows that earnings
management occurs most often before the issue of securities or when a
firm is facing the risk of being delisted. While non-core income was widely
used to measure earnings management in China, as it is easily detected,
researchers are now focusing on accrual-based models. We explore the
underlying causes of earnings management in China, and conclude that
the two main causes are the concentrated ownership structure and the
strong political and economic connections between government and the
listed companies. We review the impact of corporate governance mecha-
nisms and government supervision on earnings management in China.

dence on earnings management of Chinese

Introduction
This paper aims to determine when, why, and
how listed firms manage earnings in China.
While a large number of studies have investi-
gated earnings management activities in listed
companies in developed nations, especially the
USA, focus has recently shifted to China, pri-
marily because of its growing importance.
China has overtaken Japan as the second
largest economy; and the market capitalisation
of its stock exchanges1 now also ranks second.
Many researchers have studied the moti-
vations for listed companies’ earnings man-
agement activities, measures of earnings
management, the relationship between listed
companies’ corporate governance and earnings
management, and mitigation of earnings man-
agement in China. We review the academic evi-
listed firms from various angles, make recom-
mendations for regulators, and provide some
suggestions for future research.
Earnings management in China differs
markedly from that in the USA for two main
reasons: China’s concentrated ownership
structure of listed firms, and the strong politi-
cal and economic connections between listed
firms and the Chinese government. Mancinelli
and Ozkan (2006) argued that ownership is
dispersed in common law countries with man-
agers usually playing the role of insiders; while
in civil law countries, ownership is highly con-
centrated and the controlling shareholders are
insiders who can effectively control the man-
agers. Earnings management in the USA,
where ownership is dispersed, is usually facili-
tated by listed companies’ managers to fulfil
their own goals. In contrast, both managers

* Jingjing Yang, PhD Candidate, Massey University, New Zealand and Lecturer, Jiangxi Normal University, China, Jing
Chi, Senior Lecturer, Massey University, New Zealand, and Martin Young, Professor in Finance, Massey University,
New Zealand.
1 The Shanghai Stock Exchange and the Shenzhen Stock Exchange.

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 YANG ET AL. — EARNINGS MANAGEMENT IN CHINA
and controlling shareholders of Chinese firms
could have incentives to manage earnings due
to the concentrated ownership structure. It has
been shown that most earnings management
occurs before specific corporate events [such as
Initial Public Offerings (IPOs) and rights
issues] and when a listed firm is facing serious
financial risks (Chen and Yuan 2004; Yu et al
2006; Liu and Lu 2007; Kao et al. 2009). This
evidence suggests that the controlling share-
holders of listed firms are likely to use earnings
management to achieve their agendas. Further-
more, few corporate governance mechanisms
are effective in controlling earnings manage-
ment, and regulators are often reluctant to seri-
ously punish listed companies that engage in
financial reporting fraud—especially those that
are state controlled, because they can help the
government fulfil many political and social
goals.
There are several different measures of
listed firms’ earnings management activities in
China. Non-core income has been found to be
one of the major accounting variables that
listed companies use to manage earnings.
However, since abnormal non-core incomes
are reasonably easily detected, attention on
earning management measures has shifted to
accrual-based models. Although recent studies
have extended the use of discretionary accruals
to include signed and unsigned ones that
proxy earnings management in the USA, this is
not the case for similar studies of the Chinese
markets, which are rare. Future research can
contribute more to the explanatory power of
signed and unsigned discretionary accruals for
corporate earnings management in China.
The remainder of the paper is organised as
follows. Earnings Management is defined and
Earnings Management in the USA is briefly
described. The section on Earnings Manage-
ment in China discusses the motivations of
listed firms’ earnings management activities in
China. The next section after this focuses on
earnings management measures. The fifth
section discusses the relationship between the
ownership structure of listed firms and earn-
ings management behaviours; while the sixth
explores means of mitigating earnings man-
agement in China. The last section provides
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© 2012 Crawford School of Public Policy,
The Australian National University and Blackwell Publishing Asia Pty Ltd.
conclusions and suggestions for stock market
regulators.
Earnings management definition and
earnings management in the USA
Earnings management is behaviour whereby
the managers of listed companies alter pub-
lished accounts to either mislead stakeholders
about the companies’ underlying performance
or to influence contractual outcomes (Healy
and Wahlen 1999). Through earnings manage-
ment, managers can shift income from future
accounting periods to the current accounting
period, or defer current income to future
periods, without violating accounting prin-
ciples. There are a number of ways in which
this can be done. For instance, managers can
estimate the expected lives or salvage values of
long-term assets; choose among accepted
accounting methods (straight-line and acceler-
ated depreciation methods, Last In First Out,
First In First Out, or weighted average
inventory cost methods); and make or defer
corporate expenditure (for example, R&D,
advertisement, and maintenance) (Healy and
Wahlen 1999).
In the USA, earnings management activities
by managers of listed companies are primarily
related to job tenure and executive compensa-
tion. Managers prefer to smooth earnings if
their job tenure depends on reported profits; as
such they may borrow future earnings in bad
times or stockpile earnings in good times for
periods when poor conditions are expected
(Fudenberg and Tirole 1995). Cheng and Warf-
ield (2005) reported that stock-based compen-
sation and ownership can provide managers
with motivation for earnings management as
this can increase short-term stock prices and
benefit managers. Bergstresser and Philippon
(2006) argued that managers whose overall
compensation is more sensitive to the compa-
ny’s stock price would have greater incentive
for managing earnings. Chi and Gupta (2009)
suggested that share price overvaluation inten-
sifies a manager’s income-increasing behav-
iour, as their compensation and career would
 ASIAN-PACIFIC ECONOMIC LITERATURE
be negatively affected by market belief that
they could not deliver the expected earnings.
Besides concern about compensation and
job tenure, managers may manipulate earnings
before specific corporate events in which finan-
cial statements play a significant role. DeAn-
gelo (1988) and Perry and Williams (1994)
argued that managers may understate reported
earnings by manipulating the discretionary
accruals before the announcement of manage-
ment buyout offers, so that they can take over
companies at lower prices. Defond and Jiam-
balvo (1994) argued that firms tend to manage
accruals to increase their reported earnings
when facing debt covenant violation. Rangan
(1998) and Teoh et al. (1998a) reported that
listed companies managed their earnings
upwards before Seasoned Equity Offerings
(SEOs), in order to increase the offering price
and attract more investors. Moreover, Chung
et al. (2002) concluded that earnings manipula-
tion could be used in labour union wage
negotiations, valuation of IPOs, takeovers,
management buyouts, and debt covenants.
Earnings management in China
In contrast to the dispersed ownership struc-
ture in common law nations, concentrated
ownership is pervasive among Chinese listed
firms, especially those controlled by China’s
central and local governments. At the end of
2009, the average shareholding of the largest
shareholder was 31 per cent, and more than 50
per cent of listed companies’ total shares out-
standing were held by the five largest share-
holders (Yang et al. 2011). In this situation, the
controlling shareholders are capable of
appointing managers and making other major
corporate decisions. Managers would have to
satisfy blockholders in order to guarantee com-
pensation and job tenure. Therefore, the con-
trolling shareholders also have the capability
and incentive to facilitate earnings manage-
ment. Previous research shows that earnings
management activities usually occur in China
before IPOs, when facing the risk of being
delisted, or before SEOs (especially rights
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The Australian National University and Blackwell Publishing Asia Pty Ltd.
issues) (Chen and Yuan 2004; Yu et al. 2006; Liu
and Lu 2007; Kao et al. 2009).
Earnings management before IPOs
It is not surprising that China’s listed com-
panies engage in serious earnings manage-
ment before IPOs, as reported profit is a
government-required criterion for going
public, and also the main determinant of offer-
ing prices. Aharony, et al. (2000) investigated
the financial reporting of China’s B and
H-share companies, and found that the mean
values of companies’ return on assets (ROA)
peaked in IPO years and declined thereafter.
Kao et al. (2009) also found that, on average,
China’s listed companies report a decline in
post-IPO profitability and experience poor
long-run stock performance. Further, they
found that listed companies with better
pricing-period accounting performance during
IPOs have larger declines in post-IPO profit-
ability, lower first-day stock returns, and worse
post-IPO stock performance (Kao et al. 2009).
Aharony et al. (2000) and Kao et al. (2009)
attributed the post-IPO underperformance to
serious earnings management by the compa-
nies before their IPOs, and argued that this is
induced by IPO pricing regulations based on
reported earnings. Chen et al. (2009) argued
that listed firms divert the proceeds from the
IPOs and rights issues to controlling share-
holders through payment of cash dividends.
The ability of such tunnelling may provide the
controlling shareholders with greater incentive
for earnings management before IPOs, as this
could drive up IPO prices and hence help the
firms raise more capital.
Earnings management when facing
the risk of being delisted
Post-listing on the Chinese stock exchange, one
of the primary motives for earnings manage-
ment, is to avoid being delisted. According to
the Chinese Securities Regulatory Commission
(CSRC), if a listed company reports a net loss
for a two-year period, it will be designated the
title of ‘ST’ (Special Treatment). If a company
reports a net loss for a three-year period, it will
© 2012 Crawford School of Public Policy,
 YANG ET AL. — EARNINGS MANAGEMENT IN CHINA

be designated the title of ‘*ST’, which is a
warning of being delisted. Listed companies
are valuable resources for capital raising, not
only for shareholders but also for central and
local governments. Therefore, controlling
shareholders are reluctant to see companies
de-listed and have strong incentives to
manipulate earnings when facing such a
serious financial risk. According to the empiri-
cal findings of Liu and Lu (2007), listed com-
panies that escape the risk of de-listing engage
in more serious earnings management than
companies that have been delisted.
Earnings management before rights issues
According to the requirements of the CSRC,
permission for rights issues is determined pri-
marily by the listed companies’ reported
accounts, especially their return on equity
(ROE). A listed company can only launch a
rights issue if its average ROE is more than 6
per cent2 over the previous three years. Listed
companies have an incentive to manipulate
earnings to meet the requirements for rights
issues, as this is an ideal way for them to raise
funds. According to Yu et al. (2006), listed com-
panies prefer to raise new equity rather than
borrow, as the corporate debt market is ineffec-
tive, and bank loans are restrictive in many
ways. Additionally, although SEOs have
become popular in recent years, this method of
capital raising was particularly difficult
through the 1990s and early 2000s due to regu-
latory constraints. Hence, rights issues have
been the primary way in which listed firms
raised capital from the stock market during the
past decade. A number of listed companies
have even had rights issues within three years
of their listings (Yu et al. 2006). Chen and Yuan
(2004), Haw et al. (2005) and Yu et al. (2006)
found that rights issuing firms had heavy con-
centrations of ROEs that just exceeded the ROE
threshold (10 per cent before 2001 and 6
per cent after 2001), and argued that rights
issuing companies manipulated reported
profits (measured by non-core income)
upwards to meet ROE benchmarks.
By manipulating earnings, listed firms not
only meet the ROE threshold for rights issues
but also drive up the issuing price and raise
more capital. It is noteworthy that some of the
controlling and other large shareholders are
unwilling to subscribe to rights issues in
China, as the shares they purchase would be
non-tradable3 (Huang et al. 2011). Conse-
quently, the majority of the rights issues are
subscribed by tradable shareholders, who are
mainly individual investors. Thus, controlling
shareholders would be motivated to adjust
reported earnings upwards so that they could
raise more capital from individual sharehold-
ers whose shareholdings are too small and
diffuse to monitor the use of the raised capital.
Earnings management measurements
Non-core income
Non-core income (also known as non-
operating income) is one of the most com-
monly used earnings management measures in
China (for example, Chen and Yuan 2004; Yu
et al 2006; Ding et al. 2007; Kao et al. 2009).
Listed companies arrange related party trans-
actions with their parent companies and clas-
sify profits or losses as non-core items,
especially when the parent companies are state-
owned enterprises (SOEs) (Ding et al. 2007).
Chen and Yuan (2004) and Yu et al (2006)
report that listed companies’ non-core income
makes up the majority of the companies’
increased accounting earnings prior to rights
issues. In addition, Kao et al. (2009) found that
IPO companies with higher reported profits

2 The requirement on ROE has varied slightly over time. During the period 1994–98, the ROE threshold for rights issues was
an average of 10 per cent for the previous three years. From 1998 to 2000, besides an average ROE above 10 per cent, the
rights issuing company had to have a ROE not less than 6 per cent for each of the previous three years. From 2001, the
ROE threshold was changed to be an average of 6 per cent for the previous three years.
3 Following the non-tradable share reform launched in 2005, around 80 per cent of non-tradable shares had become
tradable by the end of 2009. However, the CSRC only allows these shares to enter the stock markets gradually.

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 ASIAN-PACIFIC ECONOMIC LITERATURE

(that is, those that may have managed their
earnings) have a significantly higher level of
non-core income.
However, a major argument against the use
of non-core income as a measure of earnings
management is that it is extremely easy for
regulators and investors to observe. Chen and
Yuan (2004) suggest that the ability of regula-
tors to identify earnings management behav-
iour through manipulation of non-core income
has improved over time. Thus, the number of
the listed companies that use non-core income
to manipulate earnings should have declined
over time. Furthermore, Jian and Wong (2004)
and Ding et al. (2007) argue that privately
owned listed companies operate more inde-
pendently in the stock market and hence
would be less likely to arrange related party
transactions to make up non-core items. There-
fore, use of the non-core income measure may
not completely capture the extent of listed
companies’ earnings management in China.
Accrual-based models for measuring
earnings management
The accrual-based model is a more sophisti-
cated method of measuring listed companies’
earnings management activities. It has been
widely employed in studies of companies in
the USA and is gaining popularity in Chinese
studies. There are two main types of accruals
that can be used to measure listed companies’
earnings management activities in China: total
accruals and discretionary accruals.
Total accruals. Some studies begin with total
accruals, which are measured as the difference
between reported net income and cash flow
from operations, to proxy earnings manage-
ment (for example, Aharony, Lee and Wong,
2000; Liu and Lu 2007). However, total accruals
can be divided into two components. One is
due to the company’s normal business activi-
ties, while the other is discretionary accruals,
considered ‘abnormal’ (Healy and Wahlen
1999; Ding et al. 2007). Hence, it is likely that
the empirical results would be biased when
using total accruals to measure a listed compa-
ny’s earnings management behaviour.
Discretionary accruals. As the explanatory
power of total accruals is doubtful, most recent
studies regress total accruals on variables that
are proxies for normal accruals, such as sales
revenue and gross fixed assets (that is, prop-
erty, plant, and equipment). The residual (the
unexplained component of total accruals) of
the regression is then used to measure the
listed companies’ earnings management, and is
called the discretionary accrual. Jones (1991)
used discretionary accruals to estimate listed
firms’ earnings management in the USA. Jones’
(1991) accrual-based model4 has been
employed, or employed with adaptation to
Chinese accounting standards,5 by many
authors to determine the discretionary accruals
of listed Chinese companies (for example, Ding
et al. 2007; Liu and Lu 2007; Bo and Wu 2009).
As earnings management may increase
listed companies’ current income or defer
current income to a future accounting period,
studies have tested for earnings management
of a particular sign of the discretionary accruals
in the USA (for example, Jones 1991; Teoh et al.
1998b; Koh 2007). Discretionary accruals are
classified into two groups based on the sign:
positive discretionary accruals (income-
increasing earnings management) and nega-
tive discretionary accruals (income-decreasing
earnings management). Managers are likely to
use positive discretionary accruals to manage
earnings upwards and facilitate negative dis-
cretionary accruals to manage earnings down-

4 Jones’ (1991) accrual-based model is shown as:

Total accrualsi ,t Total assetsi ,t −1 = α 1 total assetsi ,t −1 + α 2 ΔR
Rev i ,t total assetsi ,t −1 + α 3 PPEi ,t total assetsi ,t −1 + ε i ,t
DRevi,t is the change of revenue, PPE i,t-1 is gross property, plant, and equipment, ei,t is discretionary accruals.
5 Liu and Lu (2007:889) note: ‘Most studies using the US data define total accruals as the difference between earnings before
extraordinary items and operating cash flows. Under the Chinese GAAP, so-called “one-time” items, such as extraordi-
nary items and discontinued operations, are not reported separately. . . . both “above the line” and “below the line” items
in an American income statement are included in China’s operating income.’ Thus, Liu and Lu (2007) define the total
accruals as the difference between net income (NI) and cash flows from operating activities in China.

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 YANG ET AL. — EARNINGS MANAGEMENT IN CHINA

wards to create accounting slack (Koh 2007). In
addition to the use of signed discretionary
accruals, recent studies also use unsigned
(absolute) discretionary accruals to measure
earnings management (for example, Berg-
stresser and Philippon 2006; Hribar and
Nichols 2007). Unsigned earnings manage-
ment does not differentiate income-increasing
from income-decreasing management and can
increase the likelihood of rejecting the null
hypothesis (no earnings management) (Hribar
and Nichols 2007). The few studies on earnings
management in China have employed either
discretionary accruals with a particular sign
(for example, Bo and Wu 2009) or unsigned
discretionary accruals (for example, Firth et al.
2007). Future studies should provide addi-
tional evidence on earnings management in
China by using both of these measures.
Ownership structure and earnings
management
As described earlier, due to the concentrated
ownership structure in China, listed firm man-
agers mainly manipulate earnings for the
benefit of controlling shareholders. Therefore,
the earnings management activities of listed
companies with different ownership structures
or controlled by different types of controlling
shareholders (that is, state-controlled vs. pri-
vately controlled) may differ. Liu and Lu (2007)
report that agency conflict6 between control-
ling shareholders and minority shareholders
account for a significant portion of earnings
management in China. The controlling share-
holders, who usually hold non-tradable shares
and cannot benefit from share price apprecia-
tion, have strong incentives to expropriate the
wealth of listed companies and to mask true
company performance to conceal this expro-
priation from minority shareholders (Liu and
Lu 2007).
In addition to the conflict between control-
ling shareholders and minority shareholders,
the political connection between listed compa-
nies and the government is another major
factor affecting earnings management.
Aharony et al. (2000) found that IPO compa-
nies with more government protection have a
higher chance of being listed and therefore
have less incentive to manipulate earnings.
Furthermore, some studies report that state-
controlled listed firms engage in less earnings
management activities than privately con-
trolled listed firms (for example, Bo and Wu
2009). These studies suggest that state-
controlled firms receive more financial support
from the government and hence can relatively
easily escape financial risk. Moreover, state
shareholders do not pay as much attention to
the share price as do private shareholders, as
most state-owned shares are not tradable.
Another reason why state-controlled listed
firms are less likely to manipulate earnings
could be that state shareholders (especially the
central government and its agencies) have
more concern about the transparency and vola-
tility of the stock markets.
How to restrict listed companies’
earnings management in China?
Corporate governance mechanisms
Good corporate governance in the USA is
regarded as the ability to mitigate listed com-
panies’ earnings management activities (for
example, Shleifer and Vishny 1997; Xie et al.
2003; Gillan 2006). Some studies have tested
the impact of corporate governance mecha-
nisms on listed firms’ earnings management in
China. For instance, Firth et al. (2007) found
that foreign shareholders’ ownership and large
or active supervisory boards may reduce the
level of corporate earnings management.

6 The literature suggests that agency conflict under a concentrated ownership structure is the conflict between controlling
shareholders and minority shareholders (for example, Claessens et al. 2000; La Porta et al. 2000). These conflicts are
exacerbated in China because the shares of listed companies are split into non-tradable shares held by controlling
shareholders and tradable shares held by minority shareholders (Zou et al. 2008).

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 ASIAN-PACIFIC ECONOMIC LITERATURE
Liu and Lu (2007) reported that outside/
independent directors can restrict listed firms’
earnings management, while cross-listed firms,
which have shares listed on the Hong Kong
Stock Exchange, or have issued B-shares,
usually have lower levels of earnings manage-
ment. However, other corporate governance
mechanisms, such as noncontrolling large
shareholders’ ownership (the sum of the
second to the tenth largest shareholders’ own-
ership), the type of the auditing firm (particu-
larly whether they are one of the ‘big-four’
multinational auditing firms), the auditors’
opinions, the managerial ownership, and
whether the CEO also holds the position of
board chair, are reported to be less likely to
restrict listed firms from manipulation of earn-
ings (Liu and Lu 2007; Bo and Wu 2009).
Supervision by regulatory bodies
Regulatory bodies can play a significant role in
monitoring listed companies’ financial report-
ing. However, this may not always be the case
in China. As the state-controlled listed firms
dominate the stock markets, regulatory bodies
may face a dilemma when supervising listed
companies’ opportunistic behaviour. On the
one hand, earnings management harms the
accounting transparency of listed firms and the
benefits of minority shareholders (mainly indi-
vidual investors). Therefore, regulators have a
strong propensity to minimise earnings man-
agement and other opportunistic behaviour for
the sake of the stability and development of the
stock markets. On the other hand, these com-
panies can help the government achieve politi-
cal and social objectives (for example, boosting
government reputation, maintaining employ-
ment, supporting social welfare, paying taxes,
and financing public projects). The regulatory
bodies may even be willing to help state-
controlled firms in protected industries gain
listing on the stock exchanges (Aharony et al.
2000). In this case, regulators could be reluctant
to punish listed firms that engage in serious
financial reporting fraud or de-list firms with
continuous losses.
Chen and Yuan (2004) suggest that, even
though regulators’ ability to detect companies’
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earnings management activities has improved,
many listed companies still gain rights issue
approval through manipulating non-core
income, which is easily detected. Conse-
quently, it is unlikely that regulators will sig-
nificantly restrict earnings management
activities of companies (especially SOEs) when
these companies launch IPOs or rights issues,
or are facing the risk of being delisted.
Conclusions and suggestions
We can see that, due to the concentrated own-
ership structure and managers’ minor owner-
ship role, the role of managers in corporate
earnings management is much smaller in
China than in the USA. The main causes of
earnings management in China are the concen-
trated ownership structure and the strong
political and economic connections between
the government and listed firms. The literature
shows that earnings management in China
occurs mainly when listed companies are
involved in specific corporate events (that
is, IPOs and rights issues) or face the risk of
being delisted. Therefore, individual investors
should pay extra attention to the reported
profits of newly listed firms, those firms plan-
ning to make rights issues, and those firms
facing serious financial risk.
Recent studies on earnings management in
China have employed two main proxies in mea-
suring listed companies’ earnings management
activities: non-core income and discretionary
accruals. However, there has been less use of
the non-core income measure recently, as it can
be easily detected by regulators and investors
and is therefore less likely to be manipulated by
firms. Privately controlled listed firms, which
operate more independently, are also less likely
to arrange related party transactions to make up
non-core items (Jian and Wong 2004; Ding et al.
2007). While US studies have extended the use
of discretionary accruals (that is, discretionary
accruals with a particular sign, or absolute dis-
cretionary accruals) in measuring earnings
management, these measures have not yet been
widely implemented in Chinese earnings man-
agement studies. Future research should
© 2012 Crawford School of Public Policy,
 YANG ET AL. — EARNINGS MANAGEMENT IN CHINA
attempt to provide additional evidence on
Chinese earnings management by employing
various extensions of the discretionary accruals
measure.
Currently, most corporate governance
mechanisms are reported as being unlikely to
restrict earnings management behaviour in
China. Furthermore, supervision by regulators
of listed companies’ financial reporting may
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