effect and the weak country effect. It is natural to ask whether the markets recognize Chinese RM firms’ low financial reporting quality. We explore this issue in this section.
One commonly used proxy for the capital markets’ perception of financial reporting quality is the earnings response coefficient (ERC) (e.g., Wilson 2008; Chen, Cheng, and Lo 2014). In this section, we examine whether the ERC differs between Chinese RM firms and other firms. Column (1) of Table 8 reports the results based on quarterly earnings announcements. Using the standard research design, we find that Chinese RM firms have ERCs similar to those of matched U.S. IPO firms, Chinese ADR firms, and U.S. RM firms. These results indicate that the market does not recognize the low financial reporting quality of Chinese RM firms at the times when their earnings are announced.
In case the market reacts to the poor earnings quality of Chinese RM firms throughout the year, Column (2) of Table 8 reports the annual regression results, based on the regression of annual returns on earnings changes and levels. We find that the market reacts less positively to the earnings changes of Chinese RM firms than to those of other firms. In other words, the earnings changes of Chinese RM firms are viewed as less credible than those of other firms.
Overall, although we find that the market does not recognize the low financial reporting quality of Chinese RM firms at the times that quarterly earnings are announced, the market does react less positively to the changes in the earnings of Chinese RM firms throughout the year.
VII. CONCLUSION
In this paper, we find that Chinese RM firms have lower financial reporting quality (proxied for by the likelihood of accounting restatements and four accrual-based measures) than matched U.S. IPO firms, U.S. RM firms, or Chinese ADR firms.
However, we do not find any difference in financial reporting quality between U.S. RM firms and matched U.S. IPO firms.
TABLE 7 (continued)
(1) (2)
Growth 0.449*** 0.422***
(11.83) (10.62)
LEV 0.370* 0.287
(1.87) (1.34)
ROE 0.006 0.036
(0.08) (0.42)
Size 0.083*** 0.072***
(3.93) (3.07)
Capital_Need 0.000 0.004
(0.01) (0.11)
Loss 0.357* 0.311
(1.93) (1.63)
Op_Cycle 0.139*** 0.132***
(2.82) (2.81)
Inventory 0.940*** 1.005***
(2.61) (2.78)
Year effects Yes Yes
Industry effects Yes Yes
n 948 948
Adjusted R2 44.0% 42.6%
***, **, * Indicate statistical significance at the 1 percent, 5 percent, and 10 percent levels, respectively (two-tailed t-tests).
Column (1) reports the regression results based on the sample of U.S.-listed Chinese firms with the required data on corporate governance, financial reporting quality, and control variables:FRQit¼ a þ b1CRMþ b3Controlsitþ eit
Column (2) reports results from regressing the financial reporting quality measures on the fitted value (CRM_P) and the corresponding residual value (CRM_R) as estimated from the Chinese RM and Chinese ADR selection model, as reported in Column (2) of Table 6, Panel B: FRQit¼ a þ b1CRM
Pitþ b2CRM Ritþ b3Controlsitþ eit
The panel reports the coefficient estimates, t-statistics adjusted for firm- and year-level clustering (in brackets), the number of observations, and the adjusted R2. All of the variables are winsorized at the 1 percent and 99 percent levels.
Please see Appendix B for the definitions of other variables.
These results indicate that the lower financial reporting quality of Chinese RM firms results from the joint effects of using the RM approach and the weak legal enforcement over Chinese firms. Additional analyses indicate that compared with Chinese ADR firms, Chinese RM firms have lower CEO turnover-performance sensitivity (a measure of the strength of the bonding incentive). These RM firms also exhibit poorer corporate governance, which partly explains their low quality of financial reporting.
This paper extends the literature by shedding light on why Chinese RM firms have low financial reporting quality. Our results indicate that the RM process provides those Chinese firms that have weak bonding incentives and poor governance with the opportunity to access the U.S. capital markets, resulting in the poor financial reporting quality of Chinese RM firms.
These results should be of interest to regulators who consider the rules for RMs and to investors who trade these firms’
shares.
***, **, * Indicate statistical significance at the 1 percent, 5 percent, and 10 percent levels, respectively (two-tailed t-test).
This table reports results from the regressions of unexpected return (UR) over unexpected earnings at the quarterly level (Model (1)) and at the annual level (Model (2)). In Model (1), the dependent variable,URiq, is the cumulative abnormal returns in the three-day window around the earnings announcement date for firmi in quarter q, where the abnormal return is defined as the firm’s return less the CRSP value-weighted market return. UEiq. is firmi’s unexpected quarterly earnings in quarterq, which is measured as the seasonal change in earnings scaled by stock price at the end of the fiscal quarter q. In Model (2), the dependent variable,URit, is the cumulative abnormal returns one day after year t1’s earnings announcement until one day after year t’s earnings announcement, where the abnormal return is defined as the firm’s return less the CRSP value-weighted market return.UEit(Eit) is firmi’s change in (level of ) earnings in yeart, scaled by stock price one day after earnings announcement for fiscal year t1. Control variables include M/B, Size, and Loss. Please see Appendix B for the definition of control variables, except that the control variables are measured at the quarterly level for Model (1). The table reports the coefficient estimates, the corresponding t-statistics based on standard errors adjusted for firm- and quarter- or year-level clustering, the number of observations, and adjusted R2. All of the variables are winsorized at the 1 percent and 99 percent levels.
REFERENCES
Adjei, F., K. B. Cyree, and M. M. Walker. 2008. The determinants and survival of reverse mergers versus IPOs.Journal of Economics and Finance32 (2): 176–194.
Aguilar, L. A. 2011. Facilitating real capital formation. Speech given at the SEC Council of Institutional Investors Spring Meeting.
Washington, DC, April 4. Available at:http://www.sec.gov/news/speech/2011/spch040411laa.htm
Ang, J. S., Z. Jiang, and C. Wu. 2016. Good apples, bad apples: Sorting among Chinese companies traded in the U.S.Journal of Business Ethics134 (4): 611–629.
Bailey, W., G. A. Karolyi, and C. Salva. 2006. The economic consequences of increased disclosure: Evidence from international cross-listings.Journal of Financial Economics81 (1): 175–213.
Ball, R., A. Robin, and J. S. Wu. 2003. Incentives versus standards: Properties of accounting income in four East Asian countries.Journal of Accounting and Economics36 (1/3): 235–270.
Ball, R., and L. Shivakumar. 2006. The role of accruals in asymmetrically timely gain and loss recognition. Journal of Accounting Research44 (2): 207–242.
Burgstahler, D. C., L. Hail, and C. Leuz. 2006. The importance of reporting incentives: Earnings management in European private and public firms.The Accounting Review81 (5): 983–1016.
Carcello, J. V., B. T. Carver, C. S. Lennox, and T. L. Neal. 2014.When Bonding Fails: Audit Firm Oversight of U.S.-Listed Chinese Companies. Working paper, The University of Tennessee.
Chen, X., Q. Cheng, and A. K. Lo. 2014. Is the decline in the information content of earnings following restatements short-lived?The Accounting Review89 (1): 177–207.
Cheng, B., S. Srinivasan, and G. Yu. 2014.Securities Litigation Risk for Foreign Companies Listed in the U.S. Working paper, Harvard University.
Chi, W., D. Dhaliwal, O. Z. Li, and T. Lin. 2013. Voluntary reporting incentives and reporting quality: Evidence from a reporting regime change for private firms in Taiwan.Contemporary Accounting Research30 (4): 1462–1489.
Coffee, J. C., Jr. 1999. The future as history: The prospects for global convergence in corporate governance and its implications.
Northwestern University Law Review 93 (3): 641–708.
Coffee, J. C., Jr. 2002. Racing towards the top? The impact of cross-listings and stock market competition on international corporate governance.Columbia Law Review102 (7): 1757–1831.
Darrough, M. N., R. Huang, and S. Zhao. 2015.The Spillover Effect of Fraud Allegations against Chinese Reverse Mergers. Working paper, Baruch College–CUNY.
Dechow, P. M., and I. D. Dichev. 2002. The quality of accruals and earnings: The role of accrual estimation errors.The Accounting Review77 (Supplement): 35–59.
Dechow, P. M., R. G. Sloan, and A. P. Sweeney. 1995. Detecting earnings management.The Accounting Review 70 (2): 193–225.
Dechow, P. M., W. Ge, and C. Schrand. 2010. Understanding earnings quality: A review of the proxies, their determinants and their consequences.Journal of Accounting and Economics50 (2/3): 344–401.
DeFond, M., and M. Hung. 2004. Investor protection and corporate governance: Evidence from worldwide CEO turnover.Journal of Accounting Research42: 269–312.
Doidge, C., G. A. Karolyi, and R. M. Stulz. 2004. Why are foreign firms listed in the U.S. worth more?Journal of Financial Economics 71 (2): 205–238.
Doidge, C., G. A. Karolyi, K. V. Lins, D. P. Miller, and R. M. Stulz. 2009. Private benefits of control, ownership, and the cross-listing decision.Journal of Finance64 (1): 425–466.
Feldman, D. N. 2009. China: Land of the panda, the Great Wall, and reverse mergers. In Understanding the Securities Laws 2009, Chapter 20. Practising Law Institute Course Handbook. Available at: https://discover.pli.edu/Browse/Title?start¼ 0&rows¼10&fq¼;2B;title_id;3A282B;18186;29;&facet¼true&qt¼legal_boolean
Floros, I. V., and K. Shastri. 2009a. A Comparison of Penny Stock Initial Public Offerings and Reverse Mergers as Alternative Mechanisms to Going Public. Working paper, Iowa State University.
Floros, I. V., and K. Shastri. 2009b.An Analysis of Alternate Paths Used by Non-U.S. Firms to List in U.S. Markets: Revisiting the Bonding Hypothesis. Working paper, Iowa State University.
Francis, J., R. LaFond, P. Olsson, and K. Schipper. 2005. The market pricing of accruals quality.Journal of Accounting and Economics 39 (2): 295–327.
Gillis, P. 2011.Understanding Chinese Frauds. Available at:http://chinaaccountingblog.com/weblog/understanding-chinese-fraud.html Givoly, D., C. Hayn, and B. Lourie. 2014.Importing Accounting Quality? The Case of Foreign Reverse Mergers. Working paper, The
Pennsylvania State University.
Gong, G., B. Ke, and Y. Yu. 2013. Home country investor protection, ownership structure and cross-listed firms’ compliance with SOX-mandated internal control deficiency disclosures.Contemporary Accounting Research30 (4): 1490–1523.
He, X., T. J. Wong, and D. Young. 2013.U.S. Listing of Chinese Firms: Bonding vs. Adverse Selection. Working paper, The Chinese University of Hong Kong.
Hennes, K. M., A. J. Leone, and B. P. Miller. 2008. The importance of distinguishing errors from irregularities in restatement research:
The case of restatements and CEO/CFO turnover.The Accounting Review83 (6): 1487–1519.
Hope, O.-K., W. Thomas, and D. Vyas. 2013. Financial reporting quality of U.S. private and public firms.The Accounting Review88 (5):
1715–1742.
Hung, M., T. J. Wong, and T. Zhang. 2012. Political considerations in the decision of Chinese SOEs to list in Hong Kong.Journal of Accounting and Economics53: 435–449.
Jindra, J., T. Voetmann, and R. A. Walkling. 2012. Reverse Mergers: The Chinese Experience. Working paper, The Ohio State University.
Lang, M., J. S. Raedy, and M. H. Yetman. 2003. How representative are firms that are cross-listed in the United States? An analysis of accounting quality.Journal of Accounting Research41 (2): 363–386.
Lang, M., J. S. Raedy, and W. Wilson. 2006. Earnings management and cross listing: Are reconciled earnings comparable to U.S.
earnings?Journal of Accounting and Economics42 (1/2): 255–283.
Lee, C. M. C., K. K. Li, and R. Zhang. 2015. Shell games: The long-term performance of Chinese reverse-merger firms.The Accounting Review90 (4): 1547–1589.
Lel, U., and D. P. Miller. 2008. International cross-listing, firm performance, and top management turnover: A test of the bonding hypothesis.Journal of Finance63 (4): 1897–1937.
Leuz, C. 2006. Cross listing, bonding and firms’ reporting incentives: A discussion of Lang, Raedy, and Wilson (2006).Journal of Accounting and Economics42 (1/2): 285–299.
Leuz, C., D. Nanda, and P. D. Wysocki. 2003. Earnings management and investor protection: An international comparison.Journal of Financial Economics69 (3): 505–527.
Licht, A. 2003. Cross-listing and corporate governance: Bonding or avoiding?Chicago Journal of International Law 4 (1): 141–
163.
Licht, A., C. Poliquin, J. I. Siegel, and X. Li. 2013.What Makes the Bonding Stick? A Natural Experiment Involving the U.S. Supreme Court and Cross-Listed Firms. Working paper, Interdisciplinary Center Herzliya, Harvard University, and The Hong Kong University of Science and Technology.
Marosi, A., and N. Massoud. 2008. ‘‘You can enter but you cannot leave ...’’: U.S. securities markets and foreign firms.Journal of Finance63 (5): 2477–2506.
McMahon, D. 2012. SEC charges China firm with falsifying earnings.Wall Street Journal (September 5). Available at:http://www.wsj.
com/articles/SB10000872396390443686004577632783284352236
McNichols, M. F. 2002. Discussion of the quality of accruals and earnings: The role of accrual estimation errors.The Accounting Review 77 (Supplement): 61–69.
McNichols, M. F., and S. R. Stubben. 2008. Does earnings management affect firms’ investment decisions?The Accounting Review83 (6): 1571–1603.
Ndubizu, G. A. 2007. Do cross-border listing firms manage earnings or seize a window of opportunity?The Accounting Review82 (4):
1009–1030.
Organisation for Economic Co-operation and Development (OECD). 2010.OECD Economic Surveys: China. Available at:http://www.
oecd-ilibrary.org/economics/oecd-economic-surveys-china-2010_eco_surveys-chn-2010-en
Pagano, M., A. A. Ro¨ell, and J. Zechner. 2002. The geography of equity listing: Why do companies list abroad?Journal of Finance57 (6): 2651–2694.
Public Company Accounting Oversight Board (PCAOB). 2011.Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010. Research Note 2011-P1. (March 14). Available at:
http://pcaobus.org/research/documents/chinese_reverse_merger_research_note.pdf
Securities and Exchange Commission (SEC). 2011.Investor Bulletin: Reverse Mergers. Available at:https://www.sec.gov/investor/alerts/
reversemergers.pdf
Securities and Exchange Commission (SEC). 2012.Investor Bulletin: American Depositary Receipts. Available at:https://www.sec.gov/
investor/alerts/adr-bulletin.pdf
Shleifer, A., and R. W. Vishny. 1997. A survey of corporate governance.Journal of Finance52 (2): 737–783.
Siegel, J. 2005. Can foreign firms bond themselves effectively by renting U.S. securities laws?Journal of Financial Economics75 (2):
319–359.
Siegel, J., and Y. Wang. 2013.Cross-Border Reverse Mergers: Causes and Consequences. Working paper, Harvard University.
Srinivasan, S., A. S. Wahid, and G. Yu. 2015. Admitting mistakes: Home country effect on the reliability of restatement reporting.The Accounting Review90 (3): 1201–1240.
Stubben, S. R. 2010. Discretionary revenues as a measure of earnings management.The Accounting Review85 (2): 695–717.
Stulz, R. M. 1999. Globalization, corporate finance, and the cost of capital.Journal of Applied Corporate Finance12 (3): 8–25.
Templin, B. A. 2012. Chinese reverse mergers, accounting regimes, and the rule of law in China.Thomas Jefferson Law Review 34 (1):
101–151.
Teoh, S. H., I. Welch, and T. J. Wong. 1998. Earnings management and the underperformance of seasoned equity offerings.Journal of Financial Economics50 (1): 63–99.
Wilson, W. 2008. An empirical analysis of the decline in the information content of earnings following restatements.The Accounting Review83 (2): 519–548.
APPENDIX A
Measurement of Individual Accrual-Based Financial Reporting Quality Variables
This appendix describes the detailed measurement of the four individual accrual-based financial reporting quality measures used in this study.
Our first measure is the absolute value of discretionary accruals. Discretionary accruals are estimated from the modified Jones model, as inDechow et al. (1995). Specifically, we estimate the following regression model:
ACCRi;t¼ a1
1 TAi;t
þ a2ðDREVi;t DRECi;tÞ þ a3PPEi;tþ ei;t;
whereACCR is total accruals, calculated as the difference between income before extraordinary items and operating cash flows;
TA is total assets at the beginning of the year; DREV is the change in sales; DREC is the change in accounts receivable; and PPE is gross property, plant, and equipment. In the above equation, all of the variables are scaled by TA. The above regression model is estimated by industry-year using all firm-year observations (industries being defined based on two-digit SIC codes).
The regression residual is discretionary accruals (DA). We use the absolute value of DA (jDAj) as our first measure of financial reporting quality.
Our second measure is based on a modified version of the cross-sectionalDechow and Dichev (2002)model. TheDechow and Dichev (2002)model focuses on the strength of the relation between current accruals and past, present, and future cash flows. In particular, we use theDechow and Dichev (2002)model as modified byMcNichols (2002)andFrancis et al. (2005), adjusting for negative cash flows (Ball and Shivakumar 2006). Specifically, we estimate the following model for each industry-year that has at least 20 observations:
WCAi;t¼ a0þ b1OCFi;t1þ b2OCFi;tþ b3OCFi;tþ1þ b4DREVi;tþ b5PPEi;tþ b6DOCFi;tþ b7OCFi;t3 DOCFi;tþ ei;t; where WCA is working capital accruals, measured as the change in non-cash current assets minus the change in current liabilities (other than short-term debt and taxes payable), scaled by lagged total assets;OCF is operating cash flows, measured as the sum of net income, depreciation, and amortization, minusWCA, scaled by lagged total assets; DREV and PPE are defined as above; andDOCF is an indicator variable for negative operating cash flows. The residual from the above equation represents the component in the current accruals that is not associated with operating cash flows and that cannot be explained by the change in revenue or the level ofPPE. We use the absolute value of this residual (jDDj) as a proxy for financial reporting quality.
Our third measure is the absolute value of discretionary revenues based onMcNichols and Stubben (2008)andStubben (2010). Specifically, we estimate the following regression for each industry-year that has at least 20 observations:
DARi;t¼ a0þ b1DREVi;tþ ei;t;
where DAR represents the annual change in accounts receivable scaled by lagged total assets; and DREV is as defined above.
Discretionary revenue (DR) is the residual from this regression, and its absolute value,jDRj, is used as a proxy for financial reporting quality.
Our fourth measure is based on the ratio of the absolute value of accruals to cash flows (Burgstahler et al. 2006;Hope et al.
2013). Firms may overstate earnings to achieve certain targets or to report good performance in specific instances, such as equity issuance (Teoh, Welch, and Wong 1998). Similarly, in years with poor performance, firms may boost their earnings using reserves or engage in aggressive accounting practices. Earnings can be temporarily inflated due to accrual choices, but cash flows remain unaffected. In such cases, the higher the ratio, the lower the financial reporting quality. To avoid the effect of extreme values, we use the log transformation of this ratio,lnjACCR/OCFj, as our fourth proxy.
APPENDIX B Variable Definitions
Variable Definition
Dependent Variables
Restatement Restatement dummy equal to 1 if the financial statement of the firm in that year is restated later, and 0 otherwise;
Error Indicator variable for accounting errors, equal to 1 if the financial statement of the firm in that year is restated later and the restatement is classified as an error, and 0 otherwise;
Irregularity Indicator variable for accounting irregularities; equal to 1 if the financial statement of the firm in that year is restated later and the restatement is classified as an accounting irregularity, and 0 otherwise;
jDAj Absolute value of discretionary accruals, as described in Appendix A;
jDDj Absolute value of discretionary working capital accruals, as described in Appendix A;
jDRj Absolute value of discretionary revenue, as described in Appendix A;
lnjACCR/OCFj The natural logarithm of the ratio of the absolute value of total accruals to operating cash flows, as described in Appendix A; and
FRQ The financial reporting quality index, measured as the common factor from the principal component analysis of the four individual measuresjDAj, jDDj, jDRj, and lnjACCR/OCFj.
Independent Variables
RM RM firm dummy equal to 1 if the firm is an RM firm, and 0 otherwise;
China Chinese firm dummy equal to 1 if the firm is a Chinese firm, and 0 otherwise;
CRM Chinese RM firm dummy equal to 1 if the firm is a Chinese RM firm, and 0 otherwise;
M/B The market-to-book ratio, calculated as market value of equity divided by book value of equity;
Growth Sales growth, measured as the percentage change in sales;
LEV The leverage ratio, measured as total debt divided by total assets;
ROE Return on equity, measured as income before extraordinary items divided by shareholders’ equity;
Size Firm size, measured as the natural logarithm of total assets;
Capital_Need The percentage change in common stock, preferred stock, and long-term debt in the following year;
Loss The cumulative percentage of sample years that the firm reported a loss during the sample period;
Op_Cycle Operating cycle of the firm, measured as Inventory/Cost of Salesþ Receivables/Sales; and Inventory Inventory divided by total assets.