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SSRN Id1708148
SSRN Id1708148
Michael Firth1
Department of Finance and Insurance, Lingnan University, Hong Kong
Oliver M. Rui2
School of Accountancy, Chinese University of Hong Kong, Hong Kong
Wenfeng Wu3
Antai School of Management, Shanghai Jiaotong University, Shanghai, China
The authors thank Gordon Richardson and workshop participants at The Chinese University of
Hong Kong, City University, and Lingnan University for helpful comments on the paper. The
authors also acknowledge financial support from a Hong Kong SAR Competitive Earmarked
Research Grant (LU340307).
1
Corresponding author. Department of Finance and Insurance, Lingnan University, Hong Kong, China.
Phone: (852) 2616 8950. Fax: (852) 2462 1073. E-mail: mafirth@ln.edu.hk
2
Faculty of Business Administration, The Chinese University of Hong Kong, Shatin, Hong Kong, China.
Phone: (852) 2609-7594. Fax: (852) 2603-5114. E-mail: oliver@baf.msmail.cuhk.edu.hk
3
Management School, Shanghai Jiaotong University, Shanghai 200052, China.
Phone: (86) 21-52301194. Fax: (86) 21-52301087. Email: wfwu@sjtu.edu.cn
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Abstract
We examine the causes and consequences of falsified financial statements in China. Using
bivariate probit regression analysis, we find that firms with high debt and that plan to make
equity issues are more likely to manipulate their earnings and thus have to restate their financial
reports in subsequent years. We also find that corporate governance structures have an effect on
the occurrence and detection of falsified financial statements. There are significant negative
returns, increases in their cost of capital, wider bid-ask spreads, a greater frequency of modified
audit opinions, and greater CEO turnover. We also find that firms located in highly developed
regions suffer more severe consequences when they manipulate their accounts.
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Cooking the books: Recipes and costs of falsified financial statements in China
1. Introduction
High quality financial information is a necessary condition for an efficient and vibrant stock
market. However, trying to measure quality is a challenging task for researchers. The quality of
quality”.1 However, the measurement of earnings management and earnings quality as done in
accounting studies does not provide direct evidence that managers have manipulated earnings
(Agrawal and Chadha, 2005). In contrast, a financial restatement is often a direct admission by
accounting manipulations in prior years. Thus, the restatements are prima facie evidence of low
investigate the characteristics of firms that make restatements in order to understand why they
occur. We then examine the consequences of restatements. While there are several research
studies on restatements, they mainly use U.S. data and many of them relate to violations of
accounting principles (e.g., Anderson and Yohn, 2002; Hennes et al., 2008; Palmrose et al., 2004
Plumlee and Yohn, 2009).2 In contrast, we investigate falsified accounts rather than technical
1
Schipper and Vincent (2003) posit that earnings quality is multi-dimensional. Possible measures of earnings quality include
persistence of earnings, value relevance of earnings, ability of earnings to predict future cash flows, and the conservative
recognition of earnings.
2
There are also studies on accounting errors and fraud uncovered in the SEC’s enforcement actions in the U.S. (e.g., Karpoff et
al., 2009).
institutional backgrounds between China and the U.S. (Allen et al., 2005), we should not
automatically impute or generalize the findings from the latter to the former. Nevertheless, there
are some similarities between the two countries, not least of which is China’s willingness to
adopt or modify the best governance practices from the developed countries, and this allows us
we also extend the literature in two other important ways. First, we use a two-stage procedure
that examines the propensity to falsify the accounts and the reasons for its subsequent discovery
understanding of the forces behind financial restatements.3 Second, we recognize that there are
substantial differences in economic and market development across the different regions of
China and this can have a profound affect on our results. We therefore incorporate these regional
Restatements of the financial accounts are the result of a multi-stage process. The first stage
is the decision to falsify the statements and therefore commit financial fraud. Subsequent stages
include the discovery of the false accounting and the reporting of it in a restatement. However,
most prior studies use a basic probit or logit model of restatements and do not differentiate
between the different stages leading to the revelation of financial fraud (Dechow et al., 2010).
One innovation of our study is that we use a two-stage process where we model the propensity to
3
As we discuss later in section 3.4, there are practical problems in implementing the bivariate probit model and these need to be
overcome to achieve meaningful results.
4
As we will review and discuss later, there are several studies on financial restatements in China. These studies do not use a
two-stage process to explain restatements and do not control for a region’s economic and market development. Furthermore,
these other studies limit their examination of consequences of restatements to stock returns whereas we examine a large number
of consequences. For the stock returns analysis, we examine the first announcement of false accounting rather than its subsequent
disclosure as a restatement in the annual report.
subsequent period. To identify the characteristics of, and the motivations behind, the propensity
to falsify the financial statements and its subsequent disclosure, we use the bivariate probit
regression with partial observability technique. This approach allows us to overcome the
problem of distinguishing between the motives to manipulate the financial statements and the
Recent research has focused on institutional factors to explain earnings quality and
differences in quality across countries (e.g., Bushman et al., 2004; Raonic et al., 2004).
Institutional factors include the prevailing economic conditions, the governance of firms,
institutional and regulatory frameworks, and the legal environment (e.g., investor protection,
legal enforcement). One little understood characteristic of China’s reforms is the very uneven
distribution of economic and legal development across the country. Natural resources and human
capital resources account for some of the regional differences in development but political
connections with the country’s leadership elite are also very important. Great variations in
regional per capita income and education levels are one manifestation of the vast differences in
development across the country. We argue that the differences in regional development have
significant effects on the incidence of, and consequences of, falsified accounts. In particular, we
believe financial statement quality is higher for those firms located in well-developed provinces
and consequently investors rely heavily on financial statements in their decision-making. This
implies that the market will react strongly to the financial restatements of firms located in
well-developed regions but there will be a much more muted response in poorly developed
regions as investors have already discounted the low quality of financial reports. To test our
beliefs, we explicitly account for market development using a set of indexes designed to capture
of conducting inter-regional studies within one country is that we can capture the effect of
China has now emerged from the embryonic stage of capitalism and become a major
economic power with significant inward investment from other parts of the world. Portfolio
investment from the U.S. and elsewhere is accelerating as international investors search for high
growth markets with substantial domestic demand. One impediment to this growth, however, is
investors’ lack of knowledge about China’s capital markets environment and the quality of
financial information. These concerns are real as high quality financial information is a major
factor in assuring the supply of inward international investment. Our study is therefore important
as it yields key insights into the quality of financial information by making an in-depth study of
the causes and consequences of falsified accounts. We establish reasons that lead firms to
manipulate their financial statements and we examine whether there are safeguards or
governance features that help reduce the accounting fraud from taking place. We also investigate
the influences that lead to the detection and disclosure of the false accounting. We provide a
comprehensive examination of the consequences of restatements and this contrasts with prior
research studies, which tend to focus on one or two consequences at a time (e.g., stock returns or
absence of them may imply that investors ignore financial information altogether.
We identify 813 restatements in the period 2000 to 2005. Of these cases, 542 relate to the
corrections of non-financial information and we do not consider these any further in our study.
The remaining 271 cases involve corrections to the income statement and the balance sheet. On
that firms are more likely to manipulate their financial statements if they make equity issues, are
highly levered, are controlled by the central government, and are located in less developed
regions. This proclivity to restate is tempered, however, if a firm has a high percentage of
directors with financial expertise. Given that false accounting has occurred, disclosure of it
through the medium of restatements is more likely when the board is independent and the firm is
The restatements have important consequences for firms. First, there is a significant
negative stock return when the accounting fraud is announced. Second, the restating firm’s cost
of capital increases and its bid-ask spread widens. Third, firms that are forced to restate their
accounts find it harder to sell more shares after the restatement. Thus, capital markets extract a
cost from firms that engage in false accounting. Fourth, there is increased uncertainty about the
modified audit opinions. Fifth, top management turnover increases implying there are costs to
managers as well as to the stockholders. In general, these consequences are much more
pronounced for firms located in better-developed provinces. Investors expect high quality
financial statements in the better-developed provinces and so when firms are forced to restate
We organize the remainder of the paper as follows. The next section briefly reviews China’s
economic reforms, regional development, and the rules regarding restatements. Section 3
discusses the research design and the sample. The characteristics of the restating firms are
China began its transition from a centrally planned socialist system to a market-based
economy in the late 1970s. The transition can be characterized as a gradualist approach with the
reforms slowly unfolding (Chen et al., 2006a). In 1990 and 1991, China opened its two stock
exchanges in Shanghai and Shenzhen, respectively, and there are now more than 1600 listed
firms whose combined market capitalization is the second largest in the world. The central or
local government and wholly state owned companies (SOEs) are often the major stockholders in
A major challenge for the economic reforms has been the need to develop the legal and
financial infrastructure necessary for private ownership and stock market investment. To his end,
China has copied, with modifications, the best practices from the U.S. and other developed
nations. For example, accounting standards have been introduced (the first standard appeared in
1993) and strong progress is being made to convert them to international standards. In 1998/9,
auditing firms disaffiliated from their former state owners and became independent. The first
auditing standards were introduced in 1995 and they have started to reflect international norms
and practices. The government has promoted the development of mutual funds and investment
banks to provide financial services and advice to individuals and corporations. China’s regulator
for securities markets and listed firms, the China Securities and Regulatory Commission (CSRC)
is modeled, in part, on the SEC in the U.S. and the Securities and Futures Commission (SFC) in
Hong Kong. The CSRC monitors listed firms and other stock market participants, which include
banks, accountants, and auditors. The CSRC investigates companies and their financial
statements on a regular basis and in special cases when there are allegations of wrong-doing
pursues those cases where it believes it has a strong chance of proving guilt.
Despite the gradualist approach to the economic reforms, bottlenecks have appeared that
impede progress. A major constraint is the lack of experienced and qualified personnel, a
problem that pervades the legal, economic, financial, business, and accounting/auditing sectors.
Another problem area is the lack of good ethical behavior by business executives, which is due
to ignorance and weak law enforcement that makes people think they can “get away” with fraud
and other wrong-doing. While companies in the developed world have evolved systems of
checks and balances and developed good corporate governance mechanisms in order to deter
fraudulent financial reporting5, these systems are more rudimentary in China. In some cases,
good governance systems exist on paper but they are not implemented in practice. In some other
cases, the implementation is perfunctory and amounts to little more than paying lip service to the
The CSRC requires listed firms to restate the financial statements when errors are detected.
In about 67% of cases (542 out of 813 cases), the restatement consists of correcting information
However, we limit ourselves in this study to an investigation of false financial reporting, where
the income statement and balance sheets have been corrected for previous manipulations.6
Companies are required to disclose the restated financial statements as a “Material Events
Special Alert”. The Special Alert is sent to the firm’s shareholders, the stock exchanges, and
5
However, this has not prevented all fraud as recent scandals attest (e.g., Enron, Worldcom, Parmalat, Royal Ahold, and HIH).
6
Our sample is restricted to deliberate distortions or falsifications by managers.
The restated financial accounts have to be audited. The accounting errors may have been
identified by a number of sources including the CSRC, the Chinese Institute of Certified Public
Accountants (CICPA) via their monitoring and quality assurance reviews, the firm’s auditors, or
the firm itself. The Special Alerts rarely state which source identified the accounting error. The
Alerts, however, do give details of the manipulated accounts, the money amounts7, and dates.
Appendix 1 summarizes the regulations covering restatements and Appendix 2 gives an example
of a Special Alert issued by WeiDa Medical Applied Technology Co. Ltd. WeiDa used a
fraudulent accounting treatment for shutdown losses and so reported a profit in 2002. The profit
enabled WeiDa to come out of its “Special Treatment” designation. However, after the
restatement, the profit became a loss and WeiDa was reclassified by the CSRC and the Shenzhen
Stock Exchange as a Special Treatment firm. The Special Treatment (ST) moniker means the
firm has two years of losses and risks being de-listed if the losses continue for a third year. The
ST designation is a warning to both the firm and to investors and is something firms want to
avoid and something that may drive the managers to falsify the financial statements.
Financial restatements in China have also been studied by Zhou and Ma (2005), Li (2008)
and Wu and Wang (2009). Zhou and Ma (2005) and Li (2008) examine all restatements including
those of a minor nature that do not include falsified accounts. All three studies use a basic
one-stage logit model. Between them, the studies find that firm size, financial leverage,
ownership, losses, and auditor have associations with the likelihood of a restatement. Li (2008)
reports a negative stock return of -2.26% that accompanied the announcement of the restatement.
In contrast, Wu and Wang (2009) reported a non-significant three day abnormal return of -0.48%;
7
Unfortunately, the level of disclosure of the money amounts involved (e.g., the distortion in net income) varies across cases.
The lack of a consistent disclosure of money amounts means we cannot use this information in our cross-sectional tests.
10
difficult to disentangle the impact of the restatement from the concurrent earnings announcement
for the latest year. None of these studies used a two-stage model and so they mix up the
propensity to falsify the accounts stage and the detection and disclosure of fraud stage. Moreover,
they limit their analysis of the consequences to stock returns and do not control for regional
differences in economic and legal development. Our study therefore extends prior China-based
research on restatements in terms of research method (two-stage model), control variables (e.g.,
********************
Appendices 1 and 2 here
********************
2.2. Regional development
While China’s reforms have led to rapid national economic growth and a substantial
increase in personal wealth, these gains are not evenly spread throughout the country (Demurger,
2001; Demurger et al., 2002; Tsui, 1996).8 In addition, the implementation of legal and financial
markets reforms have not been consistently applied throughout China.9 For example, the coastal
regions and the major municipalities (e.g., Guangdong, Beijing, and Shanghai) have developed
much faster than the western and inland provinces. In part, the regional disparities reflect the
preferences of China’s top leaders (e.g., the leaders’ favor the region they come from or where
We believe that the reasons for, and the consequences of, financial restatements will depend,
8
There is a strand of research that shows that differences in financial practice and economic performance across nations depends
on the legal and institutional underpinnings of the countries concerned (e.g., LaPorta et al., 2000; Bushman et al., 2004; Raonic et
al., 2004). These studies assume homogeneity within a country and while this is a valid assumption for most nations, it does not
apply in China where regional differences are enormous.
9
Although there are national laws, national accounting standards, and national governance guidelines, the enforcement of them
varies significantly across the regions.
11
financial executives and people’s views of ethics will likely differ across regions depending on
the degree of market development of the region. Most firms have a dominant investor and that
investor or its representative is located in the same province as the firm. The dominant investors
have a strong influence on the quality of the firm’s financial statements. These investors’ views
on ethics, governance, and attitudes towards minority shareholders will vary depending on where
they come from. Likewise, the judicial system, including, importantly, law and regulatory
enforcement, varies a lot across regions and this will have an impact on a firm’s incentives to
manipulate the financial statements. In particular, we expect that false accounting will be more
likely for those firms located in provinces with low legal and economic development (Xia and
Fang, 2005; Sun et al., 2005). Investors recognize that different levels of development may have
an impact on the quality of financial reporting and so they factor this into their decision-making.
Assuming that investors believe the financial reporting quality of a firm located in a poor
developed province is low then they will not be surprised to see a restatement (compared to firms
intermediaries and legal environment (including investor protection and protection of property
rights). The index (MLEGAL) has a development score for each province and major
municipality and is compiled by China’s National Economic Research Institute (NERI) (Fan and
Wang, 2003). We also use a comprehensive index (MINDEX) of regional development (also
compiled by NERI), which captures the following aspects 10 : (1) the relations between
10
Demurger et al. (2002) also compile indices of regional development in China using data up to 1999. The Fan and Wang index
is more up to date and more appropriate for our needs.
12
burden in addition to normal taxes; (2) the development of non-state business, such as the ratio
of industrial output by the private sector to total industrial output; (3) development of product
markets, such as regional trade barriers; (4) development of factor markets such as FDI and
mobility of labor; (5) development of market intermediaries and the legal environment (e.g., the
protection of property rights). The comprehensive index (MINDEX) gives similar rankings to the
3. Research design
3.1. Sample
identify financial restatements in China in the years 2000 to 2005. These restatements are the
result of deliberate manipulation of the financial reports. We exclude firms in the finance and
financial services industries as they are subject to different regulations. The restatements and
some governance data are hand collected, while the other governance data and stock price data
are taken from the China Stock Market and Accounting Research (CSMAR) database.
Table 1, Panel A, shows the number of restating firms in each year. For example, in 2004
there are 18 firms listed on the Shanghai Stock Exchange that restated their financial statements;
these 18 firms represent 2.2% of all listed firms in Shanghai (818 firms) in 2004. On average,
about 3.7% of listed firms restate their financial statements each year. Panel B shows the industry
distribution of restatements. Quite clearly, the Agriculture industry has the highest incidence of
Panel C shows the regional distribution of firms that restate. For example, during
13
well-developed province as its market development scores (MINDEX and MLEGAL) are high.
There is a relatively high incidence of restatements for firms located in Hebei, Liaoning, and
Heilongjiang and a low incidence for firms located in Jiangxi. The correlation between the
proportion of restatements in a province and the market development score (MLEGAL) of that
province is -0.234, which is significant at the 0.05 level. Thus, there is a higher incidence of
restatements by firms located in less developed regions; this finding is consistent with our
******************
Table 1 here
******************
3.2. Control firms
We use control firms as a benchmark when evaluating the characteristics of, and
consequences of, financial restatements; Efendi et al. (2007) and Agrawal and Chadha (2005)
also use a control firm approach in their study of restatements and accounting scandals in the U.S.
The use of a control firm is important in our study as changes in government policy can affect
time-series comparisons (thus, before and after comparisons need to be evaluated against a
control firm). The construction of the control firm group is as follows. For each restating firm we
chose a non-restating firm that is in the same two-digit industry code, has been listed for the
same number of years on the same stock exchange, and is nearest in size (sales and total assets).
There are no significant mean and median differences between the sample and control firms as
regards company size (sales, total assets) and age (years since incorporation and years since first
listing).
14
financial characteristics of restating companies that differentiate them from non-restating firms.
Firms that restate had previously manipulated their earnings and in most cases this means
reported earnings are greater than they should have been. Possible motives for manipulating
earnings upwards are to avoid reporting three years of losses (firms are delisted if they report
three years of consecutive losses), to issue equity capital more cheaply by showing higher
profitability11, and to give confidence to the investors and creditors of highly levered companies.
Furthermore, CEO and top management compensation in Chinese firms is dependent on a firm’s
reported earnings (Firth et al., 2006a) and so managers may be tempted to fraudulently boost
reported net income. We therefore construct variables to capture losses, equity issues, and
leverage. LOSS is coded one (1) if the firm reports two years of consecutive losses in the year
prior to the manipulation and the manipulation turned a loss into a profit in the following year.
Here, the manipulation is made to ensure the company makes a profit and so avoid three years of
losses, which would lead to de-listing. SEO is coded one (1) if a firm makes an equity issue in
the year after the manipulation.12 LEV is the firm’s leverage (debt/total assets) at the date of the
financial fraud.
Manipulation is more difficult to do if the firm has good governance mechanisms in place
and so we examine the internal and external governance features of the company. These
governance features include some of those used in prior research (Agrawal and Chadha, 2005;
Chen et al., 2006b; Firth et al., 2007; Park and Shin, 2004; Xie et al., 2003). BOARD is the
11
Firms have to achieve specific earnings thresholds to issue seasoned equity offerings. For example, return on equity (ROE) has
to average 10% or more in the three years prior to an application to make a rights issue and to average 6% or more for a private or
public placement.
12
In sensitivity tests, we alternatively code SEO as one if a firm just satisfies the profitability criterion for making a SEO. The
results from using this alternative measure of SEO are qualitatively the same as the ones reported in this paper.
15
become less effective in constraining the wanton behavior of a CEO or executive chairman (who
might be behind the manipulation) (Jensen, 1993). On the other hand, large boards make it more
difficult for the CEO or chairperson to obtain unanimous consent for fraudulent, questionable, or
the board. These directors often represent the controlling shareholder or other major investor, or
are independent directors.13 The non-executive directors’ impact on earnings manipulation may
be different from that in the West (Dahya and McConnell, 2005) although the exact form of the
difference is an empirical matter. DUAL is coded one (1) if the CEO and Chairman is the same
person. If the CEO and chairperson is the same person they have a lot of power and they have
more ability to manipulate earnings if they want to do so (Brickley et al., 1997; Efendi et al.,
2007).
CFO is coded one (1) if the chief financial officer is a member of the board. If the CFO is
on the board this gives them more power and influence and non-financial directors will be more
willing to accept the advice of the CFO (either for or against manipulation). FINBACK% is the
understand the (potential) financial fraud and they either can acquiesce (in which case the
non-financial directors will follow their advice) or object (which would lead to less
manipulation). Thus, FINBACK% could have a positive or a negative relation with financial
13
Since 2003 listed firms have been required to have boards where at least one-third of the directors are independent. Before this
date there were few independent directors. Even after 2003 there are questions as to how independent the independent directors
are, and whether they fully understand their duties and responsibilities.
16
does not mean that deliberate manipulation will be reduced. Indeed, having financial expertise
enables directors and CFOs to undertake and perpetuate complex accounting fraud.
In the international literature, many studies argue that there are differences in audit quality
across audit firms and the Big4 auditors provide the best quality (Chung et al., 2009). In China,
the international Big4 audit firms typically audit domestic listed firms through their local
affiliates and so their quality is not identical to that of the Big4 in the U.S. and other developed
countries. In 2003, the CSRC identified and named 15 auditors that it believed had the highest
quality. We code Big15 one (1) if the auditor is one of the CSRC-designated auditors. The Big15
auditors may inhibit earnings manipulation and have a negative relation with accounting fraud.
We include three ownership variables in our analysis. They are: the proportion of shares
owned by the largest stockholder (TOP); a dummy variable (CENTRAL) set equal to one (1) if
the largest stockholder is the central government; and a dummy variable (PRIVATE) set equal to
one (1) if the largest stockholder is a private investor or a foreign firm. Chinese firms are
characterised as having a dominant stockholder who owns substantially more shares than the
second largest owner does (Chen et al., 2009a). The major stockholder is effectively the
controlling stockholder as the other institutional investors are not very active or vocal. In
determining ownership, we take care to trace the ultimate owner. A dominant owner (e.g., when
TOP is high) has a lot of influence over the firm. The dominant owner can be a force for good or
The bureaucrats who administer the central government’s shareholdings are usually career
civil servants who have little commercial acumen. Hence they exercise little oversight over a
14
In a different context, Guner et al. (2008) show that increasing financial expertise on U.S. firms’ boards does not always
benefit stockholders.
17
government’s economic and social goals and they may use the listed firm to meet these
objectives (e.g., by expropriating wealth away from the listed firm). Financial reports may be
falsified to hide these activities and to show better performance to the government. Based on the
above reasoning, we expect that firms where the central government is the largest shareholder
We use the t-test and Mann-Whitney Z-test to test for differences in means between the
restatement group and the control group. In addition, we use a bivariate probit model with partial
observability to identify the characteristics that help us differentiate between the restating firms
and non-restating firms. The bivariate probit model is described in the next section.
One inherent problem with the basic regression approach is that it is possible that the
non-restating firms have manipulated their financial statements but they have not restated them.
This can arise if the CSRC, the firm’s directors, and the auditors have not identified the
manipulation (or if the firm has identified the error, it may not want to disclose it). This issue
represents an identification problem and it reduces the ability of the model to explain the
restatement (Wang, 2004; Chen et al., 2006b) and makes it difficult to interpret the coefficients.
To illustrate, an independent variable (e.g., a governance variable such as Big15) could have a
negative effect on earnings manipulation and a positive effect in discovering it (and making a
restatement). The simple probit model does not catch this subtlety and the coefficient on the
variable will be difficult to interpret. One approach to resolve the inherent problem of treating
bivariate probit model with partial observability; see Poirier (1980) and Haque and Haque (2008)
18
the joint realizations of two latent variables (financial reporting failure and restatement)15:
Detected: Dj = 1 if firm j’s financial reporting failure is detected (i.e., earnings are restated).
Otherwise Dj = 0.
F j = x1 j β1 + u j
D j = x2 j β 2 + v j
where x1j is the vector of variables that helps explain a firm’s propensity to manipulate earnings
and x2j is the vector of variables that helps explain why financial reporting failure is detected. uj
Z j = Fj ∗ D j
P ( Z j = 1) = P ( F j = 1 & D j = 1)
= P( F j = 1) P ( D j = 1 | F j = 1)
= Φ ( x1 j β1 , x 2 j β 2 )
P ( Z j = 0) = P ( F j = 0orD j = 0)
= P ( F j = 0) + P( F j = 1) P ( D j = 0 | F j = 1)
= 1 − Φ ( x1 j β1 , x 2 j β 2 )
Full identification of the model parameters requires that x1j and x2j do not contain exactly the
15
The following section draws heavily on Poirier (1980) and Wang (2004).
19
Note that a simple probit model, which is used in most prior restatement studies, is as follows:
Z j = Fj = x j β + ε j
Pr( Z j = 1) = Pr( F j = 1) = Φ ( x1 j β )
If Dj is not always one, the coefficients in the simple probit model will differ from those in the
bivariate probit model. Wang (2004) uses a similar bivariate probit with partial observability
approach in her study of securities class action litigation in the U.S. Abowd and Farber (1982)
and Chidambaran and Prabhala (2003) are others who have used this method in their studies on
While the bivariate probit model is conceptually the best approach to use, there are practical
difficulties in implementing it. One issue is that there is no developed theory on what variables
and what functional forms explain accounting fraud and its subsequent disclosure. In the absence
of a formal theory, we use empiricism to develop an appropriate model. The peculiar nature of
identification in partially observed bivariate probit models (Poirier, 1980) results in the models
having poor convergence properties (see Farber, 1983; Heywood and Mohanty, 1993, 1994). The
poor convergence is exacerbated when there are a large number of independent variables (Haque
and Haque, 2008; Comola, 2009) and when the independent variables are correlated (Heywood
and Mohanty, 1994). We face similar problems in our tests. To improve convergence properties,
we explore a number of parsimonious models. The model (P(Fj=1)) that provides the best fit is:
The conditional detection model (P(Dj=1/Fj=1)) includes OUT%, CFO, FINBACK, CENTRAL,
BIG15, MLEGAL, and SEO. Regulators (CSRC, stock exchanges) may investigate firms making
SEOs and their examinations may culminate in the firm having to restate their financial
20
associated with the detection of fraud and the restatements of the accounts.
Financial restatements are likely to have negative consequences for firms and their top
changes in stock returns, cost of capital, capital raising exercises, bid-ask spreads, and the
incidence of modified audit reports. In addition, we examine whether restating firms are more
likely to change their CEO. We calculate these measures with respect to the control group of
firms.
estimate the cumulative abnormal stock returns of the firms around the restatement. We identify
the event day as the first day that the public is informed about the restatement. The abnormal
ARi ,t = Ri ,t − E ( Ri ,t | I t )
where ARi,t, Ri,t, and E ( Ri ,t | I t ) are the abnormal, actual, and expected returns for time period t,
respectively. It is the information on which the expected return depends. We use the market
adjusted returns model, the matched-firm model, and the market model to calculate the expected
returns. The three methods yield similar conclusions and so we just report the market adjusted
returns model results. We accumulate ARi,t to obtain cumulative abnormal returns (CARs), using
various event windows ranging from 10 days before to 10 days after the event day.
Easley and O’Hara (2004) show that information risks cannot be diversified away.
Information risk refers to the likelihood that firm-specific information pertinent to the investor
pricing decision is of poor quality. The restatements capture information risk in this study. Using
21
of capital. To examine whether financial restatements increase the cost of equity, we need to
estimate the expected rate of return on equity. There is, however, a continuing debate on how to
estimate the expected rate of return. The literature shows that reverse-engineering valuation
models are appropriate to obtain estimates of the expected rate of return on equity investment.
These reverse-engineering valuation models include the residual income valuation model, the
abnormal growth in earnings model, and the dividend capitalization model (e.g., Claus and
Thomas, 2001; Hribar and Jenkins, 2004, Daske, 2006; Attig et al., 2008; Pastor et al., 2008;
Chen et al., 2009b). However, all these models require estimating the future growth rate of a firm
and for this purpose most studies use growth rate estimates provided by financial analysts.
Where p jt is the stock price for firm j at the end of year t, bps jt and bps jt −1 are the book value
of equity for firm j at the end of years t and t-1, respectively. ROE jt is the return on equity for
firm j at the end of year t. r j is cost of equity and g j is the future growth of residual income. The
empirical testing of these types of models makes use of analysts’ earnings growth forecasts.
However, this approach has been criticized as the forecasts may be biased and therefore do not
accurately reflect the market’s expectations (Easton, 2006; Easton and Sommers, 2007; Easton
O’Hanlon and Steele (2000)16 transform the above model into the following regression
22
Where eps jt is the earnings per share at the end of year t. This regression may be estimated for
any group/portfolio of stocks to obtain estimates of the expected rate of return, r, and the
expected growth rate, g’ for the portfolio. Thus, there is no need for analysts’ forecasts of growth.
δ 0 is the estimated cost of equity for the portfolio and g = (r − δ1 ) /(1 + δ1 ) . Because there was a
lack of analyst growth forecasts in China at the time of our study, and because of severe conflicts
of interest that bias analysts’ forecasts, we adopt the O’Hanlon and Steele model to calculate the
cost of capital. We compare the difference in δ 0 between the restatement group and the
non-restatement group. To date, there have been few applications of the O’Hanlon and Steele
model and our paper is the first to use it on emerging markets data.
In order to test whether the difference in the cost of capital before and after the restatement
is significant, we employ the following regression with the before and after samples of the
eps jt
= δ 0 + rR ⋅ Restate + rA ⋅ After + rD ⋅ Restate ⋅ After
bps jt −1
p jt − bps jt
+ (δ1 + g R ⋅ Restate + g A ⋅ After + g D ⋅ Restate ⋅ After ) ⋅ + ε jt
bps jt −1
where “Restate” is a dummy variable, which is equal to one if it is a restatement firm, otherwise
equal to zero; “After” is a dummy variable, which is coded one if the sample is after the
restatement, else coded zero. The estimated coefficient of rD is used to test whether there is a
difference in the change of cost of capital between the restatement and control samples. The
coefficient of rR is the difference in the cost of capital between the restatement and control
samples before the restatement. The coefficient of rA is the difference in cost of capital before
23
particular, we use the realized market-adjusted return in the month prior to the restatement
(where we exclude the month of the restatement) and the one-month after the restatement. The
change in the market-adjusted returns indicates the change in cost of capital. As a comparison,
we calculate the change in cost of capital for the control group. We also examine changes in
Tobin’s Q as it has an inverse relation with the cost of capital (Daske et al., 2008).
Glosten and Milgrom (1985) argue that when information asymmetries exist among
investors, the less-informed investors are concerned they will systematically lose money when
they trade with well-informed investors. To protect themselves against the potential losses from
trading with more-informed investors, the less-informed investors will decrease the price at
which they are willing to buy and increase the price at which they are willing to sell. This will
result in higher bid-ask spreads and lower liquidity. Financial restatements can increase the
adverse selection problem by increasing information asymmetries between the less-informed and
better-informed investors. We therefore test whether restatements are associated with wider
bid-ask spreads.
modified (i.e., qualified) audit opinion (MAO) increases. The auditor may believe audit risk
increases after a restatement. We predicate this on the belief that a restatement signals that
management is less competent and more dishonest than previously thought. Issuing a modified
audit opinion is a rational response by an audit firm when they perceive the client has become
more risky. We therefore examine whether MAOs increase after a financial restatement.
The consequences we outline above relate to potential losses to investors. However, we also
examine the consequences for top management. In particular, we investigate whether CEO
24
manipulations of the accounts, we expect that the top manager is more likely to be replaced. In
the U.S., Hennes et al. (2008), find that outside director and top management turnover increases
after restatements; further, the dismissed executives suffer reductions in pay and benefits if and
when they find new jobs.17 Fich and Shivdasani (2007) find that outside directors lose reputation
Table 2 compares the financial and governance characteristics of restating and non-restating
firms. Restating firms have a small percentage of directors with an accounting and financial
background (the mean is 26.5%) when compared to the control firm (the mean is 31.1%). The
difference is significant at the 0.01 level. Thus, a relative lack of financial expertise in the
The other boardroom variables are not important in differentiating between restating and
non-restating firms. The Big15 auditors are less likely to have clients that restate their accounts.18
Restating firms are more likely to have an agency of the central government as the controlling
shareholder. Consistent with our hypotheses on the motives for accounting manipulation we find
that restating firms are more likely to have made an SEO, have two years of losses (followed by
a profit in the year of the financial manipulation), and have higher leverage. However, only SEO
is statistically significant. Firms located in the less developed provinces are more likely to restate
******************
Table 2 here
17
However, earlier evidence (e.g., Agrawal et al., 1999) found no evidence of increased CEO turnover.
18
Similar results obtain if we use the Big10 or the international Big4 (Big4’s local affiliates) in place of the Big15.
25
false accounting and the subsequent restatements. To examine the joint impacts of the different
variables, and to model both the fraud and the disclosure of fraud, we turn to bivariate probit
regression with partial observability. Table 3 shows the results.19 The P(Fj=1) column represents
the fraud model while the P(Dj=1/Fj=1) column represents the detection and reporting of the
false accounting. Companies making SEOs and highly levered firms are associated with the
propensity to commit fraud and this is consistent with the motives for false manipulation that we
discussed earlier. These firms have incentives to report higher earnings and this may lead them to
issue false financial statements. LOSS has a positive sign as expected although it is not
Firms that have many directors with a financial background are less likely to be associated
with financial statement fraud. Earlier, in section 3, we argued that finance-competent directors
could have a positive relation with fraud (e.g., they have the ability to perpetrate complex
financial fraud) or a negative relation (e.g., they have high ethical standards and understand the
harmful effects of financial fraud). Our results show that financially-savvy directors help to
reduce accounting fraud. Listed firms that are controlled by the central government are more
likely to have fraudulent financial statements. This reflects the lack of oversight exercised by the
government bureaucrats and-or their efforts to falsify the accounts to show better performance.
Firms located in highly developed provinces have fewer financial frauds.20 This reflects more
rigorous law enforcement and perhaps a better appreciation of good ethics. In contrast, a weak
19
As mentioned previously, there is no theory to guide us in the selection of variables and so we examine a number of
corporate governance mechanisms and various functional forms of the model. Correlations among the variables render some
models very unstable. The reported results provide the best fit.
20
The reported results use MLEGAL for the development index. However, similar conclusions are drawn when we use
MINDEX instead of MLEGAL.
26
In the detection model, we find that OUT%, CENTRAL, and MLEGAL are significant.
Firms with more independent boards are more likely to detect and disclose false accounting
reports while state controlled firms are less likely to report fraud. False accounting is more likely
******************
Table 3 here
******************
5. Consequences of restatements
Table 4 shows the market-adjusted returns for the restating firms. We have sufficient returns
data for 267 observations; in four cases, the shares are suspended from trading. There are
significant negative abnormal returns in the periods [-10, 1], [-5, -1], [0, 5], [-5, 5], [0, 10], and
[-10, 10] where day 0 is the announcement date. Disclosure of a restatement results in a
statistically significant fall in stock price.21 The stock returns analysis indicates that investors
accounting fraud causes a decline in prices. Panel B shows that the returns are more negative for
companies located in highly developed provinces (MINDEX and MLEGAL above the median)
although the differences are not statistically significant. The results are also shown in Figure 1.
*********************
Table 4 and Figure 1 here
*********************
5.2. Cost of capital
21
Morck et al. (2000) demonstrate that stock returns in China are not very sensitive to firm-specific news; instead, an individual
firm’s returns are strongly linked to market-wide movements. The fact that we find a significant negative abnormal stock return is
therefore unusual and shows that investors treat accounting restatements seriously.
27
before and after the restatement date for the restating firms and for the control firms (a control
sample firm uses the same restatement date as the matched restatement firm). The cost of capital
( δ 0 ) is 3.94% before restatement and 5.89% after restatement.22 The corresponding costs of
capital for the control group are 3.96% and 4.08%. Our estimates of cost of capital are plausible.
While the estimated cost of capital is lower than many estimates for U.S. firms, there are good
reasons for this. First, the interest rate on bank deposits has been fixed at 1.71% or 1.98%
throughout the period of our study and so our estimates of cost of equity capital are
approximately one and a half to three times the interest rate. Second, people in China have very
few investment opportunities unlike their counterparts in the West. Bank deposits and stock
investment are the only two investments ordinary people can make (in very recent years real
property has become an investment opportunity but only for the wealthy). The Chinese people
have very high saving rates but very few investment alternatives in which to invest. This leads to
a lower cost of capital than in Western countries. The Chinese government set the interest rate
low (which leads to a lower cost of capital) to achieve high growth and high employment. The
low cost of capital has led to a high growth rate in GDP and poor profitability by Western
standards (as the hurdle rate is low); this corroborates the findings in Chen et al. (2006a). China’s
ability to impose low interest rates and cost of capital is facilitated by the non-convertibility of its
We find that the cost of capital increases by 1.96% for the restating firms but it increases by
just 0.11% for the control sample. The rate of increase (from 3.94% to 5.89%) is 50% and this is
much higher than the percentage increase reported in the U.S. (Hribar and Jenkins, 2004). To test
22
Our estimation procedure uses a firm’s stock price and this price may be influenced by an announced rights issue (SEO). In
light of this, we repeat all of our cost of capital analyses on the sample of restatement and control firms that do not have rights
issues. The results are very close to those reported in Table 5. We thank the reviewer for alerting us to this question.
28
between the cost of capital before and after restatements and the results are shown in Panel B.
The coefficient rD is positive and statistically significant (rD = 0.018). Thus, one important
consequence for a restating firm is that there is a significant increase in its cost of capital. Panels
C and D show that the increase in the costs of capital for restating firms are more prominent for
those companies located in highly developed provinces (MINDEX and MLEGAL above the
median). This result is consistent with investors believing that firms located in highly developed
provinces have high quality financial reports and so the occurrence of a restatement causes a
We also use realized market-adjusted returns to represent a firm’s cost of capital. The results
show a significant decline in cost of capital from before to after the restatement (Table 5, Panel
E). In contrast, there is no change in cost of capital for the control sample. Table 5, Panel F,
shows that the increases in cost of capital are mainly for those firms located in more highly
developed provinces. The results for the stock return estimates of cost of capital (Panels E and F)
are similar to the estimates of cost of capital using the O’Hanlon and Steele (2000) method
(Panels A and C). Thus, our conclusions are robust to the two different measures of cost of
capital.
Daske et al. (2008) argue that an increase in the cost of capital, ceteris paribus, should lead
to a decrease in Tobin’s Q. We therefore examine the changes in Tobin’s Q from before the
restatement to after. Tobin’s Q is calculated as (total assets – book value of equity + market value
of equity)/total assets. We show the results in Table 5, Panel G. There is a significant decline in
Tobin’s Q for the restatement firms, which implies an increase in the cost of capital. Panel H of
29
developed regions.
Another consequence of the disclosure of false accounting is that firms may find it more
difficult to sell new shares.23 This is partly the result of the increases in cost of capital discussed
above. As a direct test of the ability to sell new shares, we examine the proportion of firms that
make SEOs in the three years prior to restatement and the proportion that make SEOs in the three
years after a restatement. The results are shown in panel I of Table 5. Restating firms make more
SEOs before the restatement than do the control firms although the difference is not statistically
significant (p=0.364). After the restatement, the proportion of firms making SEOs falls
dramatically for the restating firms. The reduction is more severe for the restating firms than for
the control firms.24 The evidence indicates that restating firms find it much more difficult to
******************
Table 5 here
******************
5.3. Bid-ask spread
We compute the average bid-ask spread for the month prior to the restatement date and
compare it with the bid-ask spread in the one month after restatement.25 A comparison is then
made with the control group. We show the results in Table 6. Panel A shows the bid-ask spread
increases for the restatement firms but declines for the control group firms. The difference in the
changes (0.0122%) is significant at the 0.01 level. Our result contrasts with the U.S. experience
23
We thank the reviewer for suggesting this analysis.
24
The proportion of control firms that make SEOs also falls. The reduction in SEOs over time reflects capital controls imposed
by the government (via the CSRC) in the later part of our sample period. This illustrates the importance of using control firms as
benchmarks.
25
We follow Cai (2004) and others and calculate the spread as (Ask – Bid)/(Ask + Bid)/2. Note that prices are quoted in fen and
the minimum price movement is one fen (approximately $0.001U.S.). Thus, bid-ask spreads are small in comparison to those in
the U.S.
30
spreads. In Panel B we show that the increase in bid-ask spreads is stronger for firms that are
located in provinces with high market development (i.e., those with MLEGAL scores above the
median). The results show that firms that need to restate their financial statements are viewed as
******************
Table 6 here
******************
5.4. Modified (Qualified) audit reports (MAOs)
When a firm admits, via a financial restatement, that its prior accounts are erroneous this
implies the errors are a deliberate act by management and that the governance structures and
monitoring mechanisms are unable to prevent such an act from occurring. This is likely to
increase the audit risk as perceived by the external auditor. A rational response of the auditor to
the increased audit risk is to increase the threshold for giving a clean opinion. Therefore we
expect to see an increase in the proportion of modified audit opinions (MAOs) being given to
restating firms after the restatement. To test this hypothesis, we compare the change in MAOs
from before a restatement to after and compare this change to the control group. The results are
shown in Table 7. In Panel A we see that there is an increase in MAOs for restating firms
whereas the control group has a decrease. The difference is statistically significant with a p-value
of 0.002. In Panel B we find that the relative increase in MAOs for restating firms is mainly
******************
Table 7 here
******************
5.5. CEO turnover
So far, we have considered the consequences of false financial reporting for investors by
31
there could also be consequences for top management. We therefore examine CEO turnover
before and after the restatement (one year before and one year after26) and compare this to the
control group.27 Table 8 shows the results. The turnover increases after a restatement (to 30.8%);
thus, about 31% of CEOs lose their jobs within one year of the restatement. In comparison, the
turnover rates decline for the control group. The difference in changes in turnover rates for
restating and non-restating firms (10.5%) is statistically significant. The evidence suggests that
accounting restatements have costly consequences for CEOs. The CEOs are more likely to be
dismissed after a restatement as they carry the responsibility for the false accounting. Our results
are consistent with those reported in the U.S. (Hennes et al., 2008). Panel B shows that the
increases in CEO turnover after a restatement do not depend on the level of market development
where the firm is located. Unfortunately, we are unable to trace where the CEO goes after
leaving the restating firm and are therefore unable to ascertain whether they obtain a worse (or
similar, or better) position.28 Thus, we cannot carry out the type of analyses undertaken by
Karpoff et al. (2008a) in the U.S. Furthermore, we do not have data on the other officers and
directors of the firm and so we cannot examine the consequences of restatements on them.
******************
Table 8 here
******************
6. Conclusion
26
A review of the public announcements that disclose the CEO replacement indicates that falsified financial statements are a
major reason for top executive dismissal.
27
In a robustness test, the control group is refined to match restatement firms and non-restatement firms based on return on
assets. We do this because prior research (Firth et al., 2006b) shows that a firm’s profitability is an important factor in the
executive turnover decision. The results from this additional test mirror those reported in Table 8 and so our findings are robust to
alternative specifications of the control group.
28
Some CEOs may return to government jobs, parent SOEs, or move to foreign firms. Data on the top management jobs at these
organizations are not publicly available.
32
regulators, and other parties. However, the measurement of quality is contentious and a broad
consensus on its definition remains elusive. Nevertheless, if a firm restates its financial
statements it represents an admission that its prior accounts are false. Financial restatements are
extensively studied in the U.S. but there is relatively little literature on restatements in other
countries. To help remedy this deficiency our study examines restatements of financial reports in
China.
Falsified financial statements are common in China. We find that firms are more likely to
manipulate their financial information when the firm issues new equity and when it is controlled
by the central government. The manipulation allows a firm’s financial statements to look better
than they should although it leads to a restatement in a subsequent year. The relations between
restatements and governance variables are complex. For example, firms that have many directors
with a financial background are less likely to have restatements. The percentage of independent
directors and the presence of a CFO on the board have no relation with fraudulent financial
statements. We find no evidence that a major audit firm inhibits financial fraud in listed firms.
Restatements are more likely for firms located in less developed provinces. Detection and
reporting of false accounting is more likely when the central government is not the major
stockholder and when firms are located in more developed regions. There is some weak evidence
Financial restatements in China have economic consequences. Stock prices fall, cost of
capital increases, access to capital markets declines, and bid-ask spreads widen. Restatements
increase the risk perception of the firm as manifested in widening bid-ask spreads and an
increase in modified audit opinions. Top management is not immune to the consequences of
33
restatement.
Our results also show that the causes and consequences of restatements depend on where
the firm is located. Although there are national laws, standards, and governance guidelines, the
application and enforcement of them varies a lot. In particular, the application and enforcement
are greater in more developed provinces. Thus, investors expect better financial reporting quality
in highly developed provinces and so restatements are a major shock that lead to negative
consequences for firms (e.g., an increase in the cost of capital and widening of the bid ask
spread). In contrast, investors believe that firms located in poorly developed provinces have
lower quality financial statements and so restatements are less of a shock. While many previous
studies have shown that the institutional and legal environment of a country have an impact on
firm value and accounting quality, our study shows that there can also be differences inside a
country. Thus, in large transition and emerging market economies, the progress of change can be
very different across the regions of a country and this will have an impact on the prevalence and
34
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39
In order to regulate how listed companies disclose the correction of financial information, to
enhance their credibility and promptness and to protect the legal rights of investors, the China
Securities Regulatory Commission issued “Preparation Conventions of Information Disclosure
by Companies Offering Securities to the Public No. 19 – Correction of financial information and
related disclosures”. These conventions apply to all publicly listed companies.
1. In order to regulate how listed companies disclose the correction of financial information, to
enhance their credibility and promptness and to protect the legal rights of investors, the China
Securities Regulatory Commission has issued the Preparation Conventions of Information
Disclosure by Companies Offering Securities to the Public No. 19 in accordance with the
“Company Law of the People’s Republic of China” and the “Securities Law of the People’s
Republic of China”.
3. Companies that fit the above criteria should release to the public a “Material
Events Special Alert” to disclose the corrected financial information.
4. The modified financial statements should follow the related formats set by the China
Securities Regulatory Commission.
5. After a previous set of annual financial statements has been corrected, the modified annual
financial statements should be audited by a qualified CPA firm.
40
8. All amended items on the modified financial statement should be highlighted in bold.
9. If a company modifies the annual financial information released three years or before, which
has no effects on the financial statements over the past three years, it is not required to reveal the
amended financial information thereafter.
10. The China Securities Regulatory Commission reserves the rights to interpret the terms and
conditions of the convention.
41
Our company and all the members of the board of directors guarantee the verity, correctness and
completeness of this announcement. And we take joint responsibility for any possible false
record, misleading statement and significant omission in this announcement.
Our company released the annual report of year 2002 and its abstract on April 24th, 2002. After
an investigation by the Shenzhen Stock Exchange (SZE), it is found that our company’s
accounting policy for 1,122,300 yuan of shutdown losses is not appropriate. According to the
requirement of the SZE, we restate the following data:
Original: the main profit this year in the income statement and operation data abstract: net profit
after deduction of non-recurring gains and losses amounts to 66,779.52 yuan
Restatement: net profit after deduction of non-recurring gains and losses amounts to
-1,055,520.48 yuan
Due to the adjustment of the net profit after deduction of non-recurring gains and losses, the
related changes are as follows:
Earnings per share after deduction of non-recurring gains and losses -0.00094 yuan
Net asset yield rate after deduction of non-recurring gains and losses (diluted) -0.91%
Net asset yield rate after deduction of non-recurring gains and losses (weighted average) -1.26%
Earnings per share after deduction of non-recurring gains and losses (diluted) -0.00094 yuan
Earnings per share after deduction of non-recurring gains and losses (weighted average)
–0.00094 yuan
After deduction of non-recurring gains and losses, the net profit of our company is a loss.
According to the related regulation, the stock of our company will remain under the special
treatment.
Announcement here by
42
43
44
45
Mean Median
Variables Difference Difference
Restate Control Restate Control
(P-value) (P-value)
BOARD 2.251 2.228 0.024 (0.283) 2.197 2.197 0.000 (0.309)
OUT% 0.778 0.762 0.016 (0.257) 0.778 0.778 0.000 (0.235)
DUAL 0.116 0.147 -0.030 (0.337) 0.000 0.000 0.000 (0.337)
CFO 0.216 0.220 -0.004 (0.915) 0.000 0.000 0.000 (0.732)
***
FINBACK% 0.265 0.311 -0.046 (0.009) 0.267 0.293 -0.026 (0.361)
**
BIG15 0.159 0.237 -0.078 (0.036) 0.000 0.000 0.000 (0.036)**
TOP 0.419 0.440 -0.021 (0.207) 0.399 0.407 -0.008 (0.71)
PRIVATE 0.246 0.211 0.034 (0.377) 0.000 0.000 0.000 (0.377)
*
CENTRAL 0.164 0.103 0.060 (0.056) 0.000 0.000 0.000 (0.056)*
GROWTH 0.265 1.300 -1.035 (0.231) 0.132 0.133 -0.001 (0.990)
LOSS 0.052 0.030 0.022 (0.242) 0.000 0.000 0.000 (0.242)
*
SEO 0.164 0.089 0.075 (0.061) 0.000 0.000 0.000 (0.061)*
LEV 0.506 0.465 0.041 (0.16) 0.473 0.448 0.026 (0.194)
***
MINDEX 6.305 6.825 -0.520 (0.001) 6.030 6.685 -0.655 (0.028)**
MLEGAL 5.925 6.448 -0.524 (0.011)** 5.180 5.900 -0.720 (0.095)*
VariablesDefinition
BOARD the number of board directors
OUT% the proportion of directors who are not members of the management team
DUAL a dummy variable taking the value one if the chairman and CEO positions are
held by the same person
CFO a dummy variable coded one if the CFO or general accountant is on the board
FINBACK% the percentage of directors who have an accounting or financial background. If a
director has a professional certificate of “Accountancy” or “Economy”, we take
her/him as having an accounting/financial background
BIG15 a dummy variable coded one (1) if the auditor belongs to the 15 auditors that are
designated by the CSRC as a good reputation auditor
TOP the proportion of shares owned by the largest stockholder
PRIVATE a dummy variable that equals one if the ultimate controlling stockholder is a
private or foreign investor, else it equals zero
CENTRAL a dummy variable that equals one if the ultimate controller is the central
government, else it equals zero
GROWTH the sales growth in the two years prior to the date of the restatement
LOSS a dummy variable taking the value one if the firm had recorded a loss in each of
the two years prior to the accounting manipulation and made a profit in the year of
the manipulation
SEO a dummy variable taking the value one if the firm makes a SEO in the year after
the accounting manipulation
LEV debt to total assets
46
47
P(Fj=1) P(Dj=1|Fj=1)
estimate p-value estimate p-value
OUT% 0.120 0.798 5.559 0.096
CFO 0.165 0.358 -0.223 0.587
FINBACK -0.680 0.062 -1.990 0.213
CENTRAL 0.846 0.001 -2.849 0.004
BIG15 -0.098 0.574 -1.502 0.105
MLEGAL -0.135 0.000 1.369 0.001
LEV 0.710 0.026
LOSS 0.106 0.780
SEO 0.341 0.009
Intercept 0.446 0.336 -6.271 0.048
Model summary
Chi-square 69.45
Prob > chi2 (0.001)
Test of rho =0 Chi-square 19.97 Prob > (0.001)
chi2
Variables Definition
OUT% the proportion of directors who are not members of the management team
CFO a dummy variable coded one if the CFO or general accountant is on the board
FINBACK% the percentage of directors who have an accounting or financial background. If a
director has a professional certificate of “Accountancy” or “Economy”, we take
her/him as having an accounting/financial background
CENTRAL a dummy variable that equals one if the ultimate controller is the central
government, else it equals zero
BIG15 a dummy variable coded one (1) if the auditor belongs to the 15 auditors that are
designated by the CSRC as a good reputation auditor
LOSS a dummy variable taking value the one if the firm had recorded a loss in each of
the two years prior to the accounting manipulation and made a profit in the year of
the manipulation
SEO a dummy variable taking the value one if the firm makes a SEO in the year after
the accounting manipulation
LEV debt to total assets
MLEGAL the legal environment index of the province where the firm is located
48
0.5
0
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
-0.5
-1
-1.5
-2
-2.5
49
This table shows whether the cost of capital of restatement firms increases after the restatement.
We estimate the cost of capital using the method of O’Hanlon and Steele (2000):
eps jt p jt − bps jt
= δ 0 + δ1 + ε jt
bps jt −1 bps jt −1
where epsjt and bpsjt are the earnings per share and book value per share of firm j in year t,
respectively. pjt is the closing price of firm j in year t. The estimated intercept term δ 0 = cost of
capital (r), and the estimated parameter δ 1 = (r – g)/(1 + g), where g is the expected growth rate.
We conduct the above regressions with the restatement sample and control sample before and
after the restatement, respectively. The results are shown in Panel A.
In order to test whether the difference in cost of capital before and after the restatement is
significant, we employ the following regression with the before and after samples of the
restatement and control samples:
eps jt
= δ 0 + rR ⋅ Restate + rA ⋅ After + rD ⋅ Restate ⋅ After
bps jt −1
p jt − bps jt
+ (δ1 + g R ⋅ Restate + g A ⋅ After + g D ⋅ Restate ⋅ After ) ⋅ + ε jt
bps jt −1
where “Restate” is a dummy variable, which is equal to one if it is a restatement firm, otherwise
equal to zero; “After” is a dummy variable, which is coded one if the sample is after the
restatement, else coded zero. The estimated coefficient of rD is used to test whether there is a
difference in the change of cost of capital between the restatement and control samples. The
coefficient of rR is the difference in cost of capital between the restatement and control samples
before the restatement. The coefficient of rA is the difference in cost of capital before and after
the restatement for the control sample. The results are shown in Panel B.
50
In order to test whether there is any difference in terms of cost of capital for firms under different
market development conditions, we employ the following regression:
eps jt p jt − bps jt
= δ 0 + rMindex ⋅ After ⋅ Mindex + (δ1 + g Mindex ⋅ After ⋅ Mindex) ⋅ + ε jt
bps jt −1 bps jt −1
where “After” is a dummy variable, which coded one if it is after the restatement, otherwise zero.
Mindex is MINDEX, or MLEGAL, which are defined in Table 1. The estimated coefficient of
rMindex indicates the effect of Mindex on the change in cost of capital after the restatement. GMindex
captures the effect of MINDEX and MLEGAL on the change in expected growth rate after the
restatement. The results are reported in Panel D.
Panel D: The effect of market development index (MINDEX, MLEGAL) on the difference
in the cost of capital from before to after the restatement
δ0 rMindex Adj-R2
coefficient p-value Coefficient p-value
MINDEX 0.038 (0.000) 0.003 (0.014) 0.225
MLEGAL 0.037 (0.000) 0.003 (0.006) 0.228
Panel E: Market-adjusted stock returns from one month before to one month after the
restatement (%)
Restatement sample Control sample
Before the After the Difference Before the After the Difference
restatement restatement restatement restatement
0.018 -1.341 -1.360 0.714 0.339 -0.375
(0.031)** (0.600)
Panel F: The effect of market development index (MINDEX, MLEGAL) on the difference
in the market-adjusted one-month stock return before and after the restatement
MINDEX (MLEGAL) < median MINDEX (MLEGAL) > median
Before the After the Difference Before the After the Difference
restatement restatement restatement restatement
51
Panel G: The Tobin’s Q in the year before and after the restatement (%)
Restatement sample Control sample
Before the After the Difference Before the After the Difference
restatement restatement restatement restatement
1.588 1.422 0.166 1.483 1.418 0.064
(0.001)*** (0.139)
Panel H: The effect of market development index (MINDEX, MLEGAL) on the difference
in the control sample-adjusted Tobin’s Q in the year before and after the restatement
MINDEX (MLEGAL) < median MINDEX (MLEGAL) > median Difference
between two
Before the After the Difference Before the After the Difference groups’
restatement restatement restatement restatement difference
MINDEX 0.054 0.009 -0.045 0.068 0.005 -0.063 -0.008
(0.417) (0.353) (0.85)
MLEGAL 0.027 0.020 -0.006 0.095 -0.006 -0.101 -0.085
(0.914) (0.108) (0.039)**
Panel I: The proportion of firms making SEOs before and after restatement
Three years prior to the Three years after the Difference
restatement restatement
Restatement firms 0.328 0.097 -0.231
Control firms 0.286 0.133 -0.153
Difference 0.042 -0.035 -0.078*
(0.364) (0.276) (0.091)
52
To test whether accounting restatements affect the liquidity of the stock, we compare the bid-ask
spread before and after the restatement for restatement firms and control firms, respectively. We
calculate the average daily relative effective spread for one-month prior to and one-month post
the restatement announcement for each firm. In Panel A, we provide the results of the bid-ask
spread. We then divide the restatement sample into two groups based on the MINDEX or
MLEGAL score. One group is firms with MINDEX (MLEGAL) scores below the median, while
the other group is firms with MINDEX (MLEGAL) scores above the median. We report the
bid-ask spread one-month before and after the restatement for these two groups. The results are
shown in Panel B.
Panel A: The differences in bid-ask spreads before and after the restatement
Before the restatement After the restatement Difference
Restatement firms 0.0717% 0.0788% 0.0070%
Control firms 0.0889% 0.0837% -0.0052%
Difference -0.0172% -0.0049% 0.0122%***
** and * indicate the 5% and 10% significance levels of the t-statistics.
Panel B: The comparison of the bid-ask spread before and after the restatement for the
restatement firms grouped by MINDEX (or MLEGAL)
Below the median Above the median The
difference
Before the After the Difference Before the After the Difference
between
restatement restatement restatement restatement
the two
groups’
difference
MINDEX 0.0812% 0.0814% 0.0002% 0.0636% 0.0708% 0.0072% 0.0071%
MLEGAL 0.0805% 0.0759% -0.0045% 0.0645% 0.0762% 0.0117%** 0.0162%*
** and * indicates the 5% and 10% significance levels of the t-statistics.
53
Panel A:
Year -1 Year 0 Difference -1,0
Restatement firms 4.69% 9.59% 4.91%
Control firms 5.51% 3.31% -2.21%
Difference 0.83% -6.29% -7.11%
p-value = 0.002
Panel B:
Year -1 Year 0 Difference -1,0
MINDEX Above the median 5.04% 13.45% 8.40%
Below the median 1.75% 0.88% -0.87%
Difference -3.29% -12.57% -9.28%
p-value =0.001
MLEGAL Above the median 2.50% 9.17% 6.67%
Below the median 4.43% 5.31% 0.89%
Difference 1.93% -3.86% -5.78%
p-value =0.039
54
Panel A: The difference in CEO turnover before and after the restatement
Before the restatement After the restatement Difference
Restatement firms 28.5% 30.8% 2.3%
Control firms 26.8% 18.7% -8.2%
Difference 1.7% 12.1% 10.5%**
** and * indicates the 5% and 10% significance levels of the t-statistics.
Panel B: Comparison of CEO turnover for the restatement firms grouped by MINDEX and
MLEGAL
MINDEX MINDEX/MLEGAL MINDEX/MLEGAL The
or Below the median Above the median difference
MLEGAL Before the After the Difference Before the After the Difference between
restatement restatement restatement restatement two
CEO CEO CEO CEO groups’
turnover turnover turnover turnover differences
MINDEX 33.04 36.61 3.57 23.28 27.59 4.31 0.74
MLEGAL 33.62 33.62 0.00 22.32 30.36 8.04 8.04
55